Monday, May 26, 2008

Crude Oil Bubble Trouble

Up on Capital Hill, Michael Masters of Masters Capital Management hedge fund gave some insight into the oil crisis as quoted from MSNBC
If you're wondering why driving to work has gotten so expensive, you might want to peruse your pension fund's investments. That's because speculation by institutional investors pouring money into the commodities market may be largely to blame for spiking oil prices, according to testimony on May 20 before the Senate Committee on Homeland Security & Governmental Affairs.

The margin requirement for trading commodities on the NYMEX is 6%. So one oil futures contract 1,000 barrels of crude worth $131,000 can be leveraged with only $8,000 of margin money with a reserve kicker of $3,000. 16 to 1 is pretty good leverage.

Another thing to look at is the amount of oil we use. The US consumes about 22 million barrels per day (b/d), China about 7 million b/d. Total world production is about 87 million b/d. China is not about to set the world on fire with an increase in consumption any time soon. We are the gas hogs, and at these prices you can bet your bottom dollar that we are consuming a lot less gasoline. Look at the Consumer part of the list below. There is not much credibility to the idea that the Chinese are gobbling up oil.

Back in the 1970's we had a supertanker glut. They produced too many. It looks like we have another now.Here's a curious tidbit from Crude Production Blog dated April 18, 2007 (13 months ago).

The cost of transporting 2-million barrel consignments of crude oil from Middle East ports on supertankers may extend a three-week decline because there are too many ships available for hire.
About 104 tankers can reach Persian Gulf ports by May 18, according to a report today from Paris-based ship broker Barry Rogliano Salles. That's already enough to cover the entire month's demand, based on April shipments. More vessels will become available later in the month, increasing the glut.

The biggest supertankers can hold 550,000 tons of oil at 7.2 barrels per ton, which is about 4 million barrels, figure about 4,000 futures contracts. Round trip time from Saudi Arabia to New Orleans is 65 days. Maybe they are full and sitting parked somewhere waiting for oil to hit $200 a barrel.

What's going on??? Refineries are probably cutting back on production of gasoline; people are cutting back on driving. Inventory has to be building up. We have an unknown number of tankers that could be hiding large quantities of oil. We have a lot of investment funds that got burned on real estate, the commodities market could be their last chance to get whole (or get sucked into a black hole).

Look at the chart above. It's a three year chart of the oil futures. Looks a little like the housing bubble. Nah, it's just my imagination running amok again!

There was a corner of the silver market in 1980. Here is a quote from (the correction is my doing)

In the fall of 1979, the Hunt Brothers, along with some wealthy Arabs formed a silver buying pool and bought up 200 million ounces- the equivalent of half the world's deliverable supply. The price of silver had moved from $2 per ounce in 1973 to $5 per ounce in early 1979 and then rocketed as high as $54 in early 1980.

The officials at COMEX moved to check this cornering of the silver market by raising margin requirements [by only allowing liquidation orders]. The highly leveraged Hunt Brothers were unable to meet their margin calls, and were forced to sell. The price of silver fell dramatically; on March 27th 1980 the price fell 50% in one day, from $21.62 to $10.80. The Hunt Brothers were forced to declare bankruptcy. Bache Group, which handled of the trades for the brothers, was financially ruined.

Oil has gone from $55 a barrel on up to $132 a barrel. Inflation could account for about $30 of that increase. I wouldn't blame this mess on the oil companies, this has all of the ear marks of a speculative corner of the oil market by parties unknown.

The commodities markets are going to have to limit the number of contracts written and only accept liquidation orders like they did with the Hunts. It's kind of like sticking a broom handle into the spokes of a moving bicycle. It will be quick and brutal. Hold on to your SUV and your hat, another bubble is about to pop.


Anonymous said...

An investigative business journalist from here in Texas (Ed Wallace) just published a two-part article on the oil market (Google news search for Ed Wallace and ICE); the supply has far outstripped demand and prices are a function of futures contracts run amok; accelerating out of control.

According to him, it's only been possible due to some shady legislation that Enron helped push through in 2000 along with the help of some Texas politicians and their lobbyist wives.

It's no surprise since that coincides with Texas deregulation of its electric market; ironically, our skyrocketing electric rates here in Texas are tied to the price of natural gas which has only quadrupled in price since then.

This will be one heck of a bubble burst!

Jim in San Marcos said...

Hi Anon 8:38

When you mentioned ICE, I knew you had been reading some of the goodies I read.

There is a very serious problem and this is just a blog trying to simplify things so everyone has a chance to see the big picture.

I have read some of the articles and they seem extremely poorly documented. They make claims but have nothing to support them.

Nymex in New York and the ICE Futures in London are going to have to get together to solve this problem.

I am not so sure that they really want to move on this issue but they will have to in the near future. If oil were to hit $200, they would have to shut down the game. My only issue is why not shut it down now.

Thank you for your comments

vipness said...

Hi Jim,
Interesting writeup as always. I agree that commodities are headed for bubble trouble someday. However I believe this could play out for many years with much higher prices. I was pretty young in the 70s, so I'm trying to learn more about those times. How did the trade deficit compare? Were their foreign nations with rather large dollar reserves? I am thinking that the "savers" of the world would have no problem supporting higher commodity prices, while the U.S. struggles on. Just a thought. Regards!

vipness said...

correction - there not their

Were there foreign nations with rather large dollar reserves?

I'm Not POTUS said...

I'm reminded of something Barney Frank said on Bill Maher.
He argued that he is trying to fix housing because vested interests have the financial system held hostage.

These BIG MONEY vested interests have been backed into the commodities corner. How in the heck do you coax a leopard out of the corner without getting your face slashed to pieces?

Do "they" have anywhere left to go? Where else can they store wealth? Equities are trashed, Treasuries are a joke, if we push them out of commodities what can they do?

If politicains do manage to stick the broom in the spokes of oil, where do the fat cats land? Flat broke? Not if they can help it.

These are the types of people who will take everyone down with them. Nero burning Rome style Mad Max, dogs and cats living together stuff. Mass hysteria!!!!!

Jim in San Marcos said...

Hi Vipness

I too was young in the 70's. I was paying more attention to girls than the economy.

I am really looking hard at the Two dollar increase in gas. It can't last for a long time IMHO. This is a tax on the consumer. This Tax involves everything we consume that has transportation costs. 50 cents could be handled by the economy.

Something doesn't add up here. Consumption of oil did not increase in any dramatic fashion. The world market can't take this price increase. I don't see the price of oil sustainable above $90 per barrel.

Maybe I am just more optimistic than you. Thank you for your comments.

Anonymous said...

I was a kid in the 70's, it left me somewhat distrustful of things, there is nothing worse than taking a kids favorite candy bar, making it way smaller and charging a way lot more money for it.

On another note, the media is talking about "those speculators" causing a runup in oil. George Bush's Bio listed him as an oil speculator. If the man in the White House is one, it makes one wonder.

Jim in San Marcos said...

Hi I'm not Potus

It won't be the politicians that stick the broom handle in the spokes, it will be the commodity exchanges like the CBOT and ICE.

The thing to remember about commodities is that it is a zero sum game; a loser for every winner.

With oil though, we pay for gas at the pump. To rephrase it, we are paying through the ass.

I'm hoping that the commodity exchanges trash the speculators.

Oil at $90 figures out to $2.50 a gallon.

Thank you for your comments.

Anonymous said...

Speaking of crude oil and unintended consequences, you may find this fun. Strangely, electric rates in Texas' deregulated electric market are pegged to natural gas rates, which themselves are pegged to crude oil prices (I don't know why).

As such, we've had several "strange" spikes in electric spot market prices this month; the PUC is investigating. Within the past two weeks, two electricy providers (we call them "middlemen") have gone bankrupt, throwing all of their customers onto the spot market rate (3 to 4 times the national average rate). I'm one of the customers; I had a yearlong fixed-rate contract.

Next week, three more electric providers are expected to go bellyup, throwing tens of thousands more onto the spot market rates.

By the end of Summer, the Texas deregulated electric market may actually implode as people simply cannot pay a $900 monthly electric bill.

Could you?

And strangely, it's caused by crude oil prices. Go figure.

Anonymous said...

O, G, Texas is suffering high electricity bills because of an unregulated market? California sends her sympathy.

Jim in San Marcos said...

Hi Anon 8:41 and 10:39

Both of you have given me an issue to follow up on for a later post. The electric infrastructure grid for the whole nation is falling apart from age, especially the East coast.

I know if I turn on my A/C for 4 days in a month, my bill goes up about $100. I've got better ways to spend a C note. Gasoline comes to mind.

I remember Texas 40 years ago. You spent a lot of time in the drug store or bowling alley, they had air conditioning.

Thank you for your comments