Energy expert: Oil-spike story needs more unraveling
By Jay Hancock
Jan 12, 2009 | 11:10 AM
Robert McCullough, the energy finance expert who was key in exposing so much of the shenanigans at Enron after that company collapsed, responds to my post (and Barry Ritholtz's comments incorporated in my post) pooh-poohing the 60 Minutes piece on oil speculation.
McCullough: The basic problem with a snarled ball of twine is that straightening it out takes more time than most people are willing to give -- including 60 Minutes. I made that mistake when they called me in September. Remember, most of the "facts" you have heard are surmises -- often run backwards from results -- since the CFTC has far less command of the forward markets than they had in the past and no one follows spot markets at all.
Hancock said: I was looking forward to the 60 Minutes piece last night on oil speculation. Unfortunately, the piece was thin and extremely unenlightening. Morgan Stanley took huge positions in crude! Who knew! Barry Ritholtz has a good summary of things that were unmentioned or glossed over, below. I'll add one more. The piece threw around huge volume numbers on oil contracts traded vs. oil delivered, correctly showing there was lots of speculation. But it never explained how the spot price got to be be $145.
McCullough replied: Spot and forward markets have become almost perfectly correlated. This happens when market participants have no independent opinions on the future prices -- often when the market is characterized by high concentration and the trading strategies of the majors are more important than the fundamentals.
Hancock said: Forward markets are where the speculation takes place.
McCullough replied: Actually wrong. The basic spot forward gambit employed so effectively by Enron and others involves running up spot in order to liquidate a forward position at a profit. The CFTC actually fined Enron for this in 2003 (courtesy of our investigative efforts.)
Hancock said: Morgan Stanley and everybody else can trade futures all day because if you sell a contract before maturity you don't have to take delivery. But if speculation was the main driver, how did the spot price get so high also? The spot price reflects deliveries that have to be stored or sold and consumed, and speculation is much less of a factor.
McCullough replied: Since we have no data on spot markets for oil, this is simply a surmise. My testimony at the Senate in September recommended that we start getting some since we do follow such data for other energy types. I suspect that you are assuming that the spot market is a supermarket where you need to worry about buying more than you can place in the trunk of your car. This is not a very good model. You can run up prices on the NYMEX and then either buy storage or simply keep your supertanker in port for another day. Remember, oil moves very, very slowly around the U.S. and the world -- at approximately a walking page along the pipeline.
Hancock said: In fact NYT columnist Paul Krugman argued that speculation was a minimal factor because the huge, unsold inventories that would have indicated hoarding and speculators just didn't exist. The high spot price suggests that booming demand from China and the other factors Ritholtz mentions were also key factors.
McCullough replied: Ah, Krugman. Suffice it to say that his crystal ball has been a bit cloudy ever since he accepted consulting fees from Enron. Having no data, he is assuming the state of inventories. If kept within the U.S. we have some data from the EIA. If kept anywhere else, no such luck. Since tankers take 90 days to round the horn to get to Houston, the definition of inventory requires some careful thought.
Barry Ritholtz said: But merely claiming that the run up in Oil prices was due to unprecedented speculation misses the big picture of what actually occurred. And, it reflects a lack of understanding of how markets work, and the psychology of booms, bubbles and busts.
Here are a few factors that I believe the folks at 60 Minutes either misunderstood or overlooked completely during the run up from $20 to $100:
1. Oil is priced in US Dollars. Since 2001, the Dollar fell 40% (from 120 to 72); Oil rise nearly 5 fold over the same period. And Oil's collapse occurred over a period when the dollar formed a short term bottom; it has certainly had its most significant rally in years (72 to 88).
McCullough replied: This is a particularly painful boil to lance. Exchange rates vary between the U.S. and every different trading partner. The U.S. dollar fell relative to the Euro, which is the one region where we do not buy oil. The exchange rate with our oil suppliers changed very little. Our major oil supplier exchange rates even improvedEven if you believe that wily Europeans bid up all the oil prices with their Euros (and where did they put all the oil?), the scale of the oil price run up dwarfs the exchange rate changes.
Ritholtz said: 2. Over the same period that Oil prices were rising, the US was fighting two major wars in the Middle East, Iraq and Afghanistan. These impact prices via psychology and risk of supply disruption — especially at a time when producers were running flat out.
McCullough replied: True, to a degree, but the wars were in place before the spring run up. I actually ran the news against the run up and there is virtually no correlations to be found.
Ritholtz said: 3. Energy prices rose during a global economic expansion (fueled by low rates and cheap money); Oil fell during a period that marked the beginning of the US recession and the start of a global slowdown.
McCullough replied: Another painful boil to lance. The EIA forecasts demand and supply very, very well. Their forecasts of both supply and demand were spot on in 2008. Their price forecasts were, well, hopelessly wrong. The famous Chinese and Indians automobiles are particularly humorous. We forecasted their demand very well, mainly since you have to make the car before you run it on the highway. Since we knew how many cars they make, we know exactly how much fuel they are likely to use.
Ritholtz said: 4. Since 2001, Commodities of all sorts rose significantly: Steel, aluminum, cement, cotton, soy, livestocks, foodstuffs, precious metals, etc. Were they all driven by speculation, or was something else going on?
McCullough replied: CFTC surveillance of these markets has also gradually been reduced to a fraction of previous efforts. To a degree, there is a chicken and the egg problem with commodity prices since, while oil in the U.S. is mainly used for plastics, home heating oil, and gasoline, the rest of the world uses it for electricity and transportation which does tend to increase other prices. Gold, of course, is always a special case. While I don't necessarily subscribe to the central bank gold lending price collapse hypothesis, it does tell an interesting story
Ritholtz said: 5. Since the 1% Fed funds rate of 2002-03, inflation has had a dramatic impact on ALL prices — from medical costs to insurance to education to health care to transportation to housing to food and energy. That 60 Minutes failed to even mention inflation in a piece on Oil prices is a terrible oversight on their part.
McCullough replied: Again, inflation just doesn't do much to explain the price of oil doubling until July 3, 2008 and then falling by 75% to December 31st.
Ritholtz said: 6. Throughout the 1990s and 2000s, cars were increasingly replaced with SUVs and trucks in the United States. Not only did these get appreciably worse gas mileage, that fleet transition took place as the total US miles driven rose. Over the past 20 years, people have lived increasingly further away from their jobs. Hence, increased US demand for energy accompanied (and increased prices).
McCullough replied: Again, this assumes our supply and demand forecasts were off. They just weren't. I can walk you through the forecasts if you would like.
Ritholtz said: 8. 60 Minutes interviewed Mike Masters, a hedge fund manager who had testified before Congress that speculation was driving prices. They omitted to mention he was talking his book. His holdings in energy sensitive stocks — with large positions, the vast majority in call options, in AMR Corp (AMR), the parent of American Airlines, Delta Air Lines (DAL), General Motors (GM), UAL Corp (UAUA) and US Airways (LCC) — were responsible for his fund losing 35% of its value before the Fall 2008 market collapse..
McCullough replied: I also testified at that hearing with a somewhat more sophisticated analysis. The CFTC did a pretty good job of trashing his numbers. They did not criticize mine, by the way.
Ritholtz said: 9. China boomed~! More and more global manufacturing outsourcing saw factories being built throughout China. They also went through a wild process building out the nation in preparation for the 2008 Olympics held there. Oh, and China, like the US, also began filling its Strategic Petroleum Reserves. Another small country, India, was booming over this period also.
McCullough replied: Boy this boil takes a lot of lancing. Again, we called world demand and supply very well over 2008. You can check the EIA web site if you need corroboration. Chinese automobiles are not hard to forecast, but Oklahoma sweet crude prices totally escaped us.
Ritholtz said: 10. The rise of extremist terrorist groups like al-Quada, the hostility of Iran towards the West, supply and political disruptions in places like Nigeria, and overt hostility to the US by oil producers like Venezuela President Hugo Chavez also contributed to drive prices up. The political factors were also omitted.
McCullough replied: Curious story here. OPEC complained that they were not reveiving the high prices. Venezuela's own web site shows lower prices for crude exports to the U.S. than the U.S. EIA data shows that we paid to Venezuela. OPEC increased production in July to help lower prices.