<DrumBeat: May 16, 2006The Oil DrumDriving In America>

112 comments on (Still) Waiting for the Crash in Commodities

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Hellasious on May 17, 2006 - 3:39am Permalink | Subthread | Parent | Comments top
Dear TII/RC,

You are spot on. Call a spade a spade and let the masses froth at the mouth. When prices depart vertically from facts it's time to piss against the wind. You will get wet for a while, no doubt, but soon it will be the crowd that will look for umbrellas.

Oil Fact (just one): The daily volume of oil and oil product futures traded in NYMEX and ICE (ex-IPE) alone, currently exceeds global daily oil exports by a factor of 10-to-1. When you add the spot market and the OTC derivatives the ratio gets much bigger. Last year it was 5-to-1; I don't know where the ratio was at the bottom of 1998, but I would guess alot lower. We are getting drowned in paper oil.  

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smekhovo on May 17, 2006 - 5:32am Permalink | Subthread | Parent | Comments top
So what? The volume of other derivatives traded (foreign exchange and interest rate contracts)outstrips the volume of the underlying assets to a vastly greater extent than with oil. Who cares?
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Hellasious on May 17, 2006 - 6:00am Permalink | Subthread | Parent | Comments top
Currencies, bonds, stocks, etc. are not commodities, though they do trade in futures exchanges. Comparison between the two is completely inappropriate and irrelevant. Think of just this: currencies are units of measurement, not goods themselves.
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smekhovo on May 17, 2006 - 6:16am Permalink | Subthread | Parent | Comments top
Currencies have value. Commodities have value. Under our economic system, the distinction you make is no more than a phantom of the mind.
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wkwillis on May 17, 2006 - 7:20am Permalink | Subthread | Parent | Comments top
We can print increasingly large amounts of money, and have. We can mine increasingly large amounts of metal, and haven't. It's going to take a while for the copper mines to increase enough to make up for the way the dollars have been increasing. Figure on a lag time of five years minimum, and that's assuming that we don't do something really, really, stupid, like fight a war with the Moslem world.
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Hellasious on May 17, 2006 - 8:10am Permalink | Subthread | Parent | Comments top
Currencies are a means of measuring and thus exchanging values. They have no inherent utility value themselves; that has been so for ages.
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tate423 on May 17, 2006 - 8:36am Permalink | Subthread | Parent | Comments top
This is only true of Fiat money.  If we remained on the gold standard or any hybrid with silver, their would be implied value (i.e. dollar for set amount of gold).
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Hellasious on May 17, 2006 - 8:47am Permalink | Subthread | Parent | Comments top
Well, of course. Gold or silver currency is just...gold or silver.
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smekhovo on May 17, 2006 - 8:48am Permalink | Subthread | Parent | Comments top
Where on the financial pages can I find a list of utility values (in your sense)?
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tate423 on May 17, 2006 - 9:05am Permalink | Subthread | Parent | Comments top
Utility values are derived by any given person in the absence of money.  So if there were utility values published I think they would be completely open to interpretation.  
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Hellasious on May 17, 2006 - 9:16am Permalink | Subthread | Parent | Comments top
Nowhere. That is the point.
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smekhovo on May 17, 2006 - 9:40am Permalink | Subthread | Parent | Comments top
So why should I worry about them, if I am interested in what the oil price will be? And why should I be concerned about the high volume of trading in derivatives of oil contracts?
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tate423 on May 17, 2006 - 10:01am Permalink | Subthread | Parent | Comments top
You will need an understanding of derivatives and wikipedia is great for that.  Basically derivates have created a lot of "stuff on paper".  Businesses engage in off balance sheet activities like credit swaps where two companies basically swap credit access so on net they are both better off, but barely.  Bur barely when talking about billion of dollars, turns into a lot.  So when we are trading 10 times the amount of oil available, it shouldn't take much more to figure out the consequences.
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smekhovo on May 17, 2006 - 10:21am Permalink | Subthread | Parent | Comments top
My question was a rhetorical one. I cannot for the life of me see why the price of oil should be likely to fall sharply, just because more futures and derivatives of oil are traded than there is physical oil being delivered.
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tate423 on May 17, 2006 - 10:35am Permalink | Subthread | Parent | Comments top
I see you're point.  I think futures trading may have sped up the price increases a little faster and now that the long term implications are becoming more and more clear, the futures traders are going to make that much more money as they ride this down.
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Hellasious on May 17, 2006 - 12:30pm Permalink | Subthread | Parent | Comments top
Because when there is a sudden rush to close open positions in futures and other derivatives and the "paper" stuff overwhelms the "real" stuff 10-to-1 there is no demand for the excess from the physical trade (eg hedging) and therefore a plunge ensues. Since prices for the "real" stuff today get set to a very large extent by marking to the futures market (the tail wagging the dog) the price of physical "stuff" collapses as well.

The game can be played from the other direction as well, of course; and it has been - oh boy has it ever...

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tate423 on May 17, 2006 - 12:39pm Permalink | Subthread | Parent | Comments top
But back to the original point, what hellasious describes most likely won't happen as the finite nature of oil will become too large to ignore.
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smekhovo on May 17, 2006 - 12:44pm Permalink | Subthread | Parent | Comments top
Your answer would explain a strong movement of the price in any direction. But it does not address my question, because
  1. You still have to show empirically that trading has actually become more volatile with the growth in derivatives volume. By the way, I doubt this is true.
  2. You have not shown why we should in the near future expect a sudden rush to close open positions.
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tate423 on May 17, 2006 - 12:57pm Permalink | Subthread | Parent | Comments top
Emperically volatility in the current market is actually at it's lowest levels in decades.  I can't find the right chart though.  I will keep looking.  

There will be no suden rush to close position due to the finite nature of oil. I think most people here would agree that there will be no price collapse sans some unforseen catastrophic event that produces more oil.

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Hellasious on May 17, 2006 - 1:54pm Permalink | Subthread | Parent | Comments top
I'm sorry, but at this point I respectfully suggest you refer to a good book relating to the basics of commodities futures and options trading. The questions you pose indicate you are unfamiliar with most all basics and while I would be otherwise inclined to provide such an education I am afraid the medium is not appropriate.

Sincerely,
Hellasious

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Oil CEO on May 17, 2006 - 2:30pm Permalink | Subthread | Parent | Comments top
Well, if the medium is not appropriate, you could at least refer the readership here to a good book relating to the basics of oil futures trading. I think that would suffice for providing such an education.
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tate423 on May 17, 2006 - 2:32pm Permalink | Subthread | Parent | Comments top
Whenever you want to learn anything head on over to wikipedia.com  It may not be completely accurate it will provide a very thorough basic foundation for most queries.
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Hellasious on May 18, 2006 - 2:30am Permalink | Subthread | Parent | Comments top
Any search in your favorite internet bookseller will turn up dozens of books - pick whichever you like best. Alternatively, if you want to get more serious about this, NY Inst. of Finance has several appropriate courses. Again, this site is obviously not the medium for commodities training, so I must take a pass at providing it myself, here.

There is a comment further below about all the futures contracts being used for hedging and therefore their current huge volume is immaterial. That is false for two reasons:

  1. Hedging involves the transfer of risk: futures trading is a zero sum game. If you win, I lose. So, if you are a producer and sell 1.000 oil contracts short to hedge from its price going down someone else has to assume that risk. That someone is called a speculator. A market needs both, otherwise it cannot function. There are plenty of speculators in this market. How many?

  2. Assume that every single barrel of oil that was produced and exported in the world was hedged daily. That's some 50 million barrels, or 50.000 contracts in the futures market(1.000 barrels each). The current daily volume in NYMEX and ICE in futures alone is abt. 700.000 contracts (including gasoline, htg oil, etc). Adjust for Sat. and Sun. and it comes to 500.000/day. That is extremely excessive vs. every conceivable hedging requirement and a good measure of just how rampant speculation is in this market, right now. And that is before we take into account the regular OTC spot oil market, listed options and other OTC derivatives. This market is hot and frothy that we should call it..cappuccino.

There are a heck of alot more dots to connect to show the full picture, but I have already taken up way too much space, for which I hope you forgive me.
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Oil CEO on May 18, 2006 - 6:54am Permalink | Subthread | Parent | Comments top
Fair enough. What is the daily volume of Nymex/Ice oil futures trading, excluding all the refined/distilled products such as the the gasoline and home heating oil you mention?

I agree that speculation is certainly influencing the current market. I am just not convinced that it is either hugely significant or necessarily a bad thing.

Can you provide some simple historical data so that one might compare the current level to the year 2000? 1995?

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Hellasious on May 18, 2006 - 7:41am Permalink | Subthread | Parent | Comments top
Just the crude oil is currently abt. 570.000 contracts/day or 410.000/day adjusting for Sat. and Sun. You should not deduct the products however, since they all come from the same barrel of oil. But it is still huge, even if you do deduct them. In 2000 it was around 180.000 and in 1995 around 120.000 - both oil only and adjusted for Sat and Sun.

Rampant speculation is extremely significant in shaping prices (just remember dotcoms) and as to good or bad, it depends. Extremes such as these are never "good", in that it is never a good idea to let the tail wag the dog. Or allow Enron (and several Wall Street prop desks) to set prices for electricity in CA - if I may draw an extremely timely parallel.

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aceditor on May 18, 2006 - 7:12pm Permalink | Subthread | Parent | Comments top
It is very possible that every contract relates to a real barrel of oil. I cannot see how it could come to pass that there were more contracts than barrels. If 410000 contracts are sold per day then that translates to 410 million barrels. World oil consumption 83 million barrels so about 5 to 1. However the same contract could be easily sold 5 times in a day. This is the cause of the high trading volume. Look at share volumes.. Since the internet boom volumes have risen dramatically however the total number of shares issued in some companies hasn't changed. Furthermore, it is likely that it is because due to the very low spare capacity, oil has to be incredibly efficiently delivered around the world, this means that at any one moment one refinery might need more or less from different suppliers but overall there is very little room for mistakes, resulting in contracts changing hands on a very regular basis.
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aceditor on May 18, 2006 - 7:41pm Permalink | Subthread | Parent | Comments top
Oops sorry i'm being foolish. We are talking about futures contracts so there are 72 days worth of contracts at one time, ie 83 million * 72 = approx 6 billion barrels. If 410 million barrels worth are traded daily that is 14% of total contracts. This level of activity is required for the logistical reasons quoted above as well as speculation.
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Stoneleigh on May 17, 2006 - 4:06pm Permalink | Subthread | Parent | Comments top
Why not ask the powers-that-be at TOD if you can put together a guest post on the topic?
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smekhovo on May 17, 2006 - 9:25pm Permalink | Subthread | Parent | Comments top
A guest post from a pump-and-dump (or in this case, short-and-dump)artist? That'll be a first!
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smekhovo on May 17, 2006 - 4:07pm Permalink | Subthread | Parent | Comments top
Get back to me when you think of answers, eh, Mr. Expert?
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dsemenov on May 17, 2006 - 2:47pm Permalink | Subthread | Parent | Comments top
Who cares if derivatives oustrip phys assets, most expire anyway and simply used as a hedge during their life.
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tate423 on May 17, 2006 - 3:06pm Permalink | Subthread | Parent | Comments top
That's the point.
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LevinK on May 17, 2006 - 12:45pm Permalink | Subthread | Parent | Comments top
It might mean that the amount of speculation in the oil trade has increased considerably. The logical result is larger volatility. Personally I wouldn't be so surprised if oil retreats to $50 or less in some panic driven sell-off. Why not? Recent pieces of information suggest that the market is not so tight to sustain those prices (yet), especially if Iranian saga settles down (my prediction) and the scheduled projects come online (also very likely, IMO).

IMO we often forget that PO is an event measured with decades; in the meantime there is enough room for many boom & bust cycles.

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IFeelFree on May 17, 2006 - 1:42pm Permalink | Subthread | Parent | Comments top
You've mentioned two events that might cause oil prices to retreat, although a crash seems highly unlikely. I can think of a 100 events that could cause oil to go much higher in a very short time (terrorist attack on oil facility, bad hurricane season, Iran invasion, domestic terrorist attack, runaway inflation, etc.) It's not just the supply/demand issue (although that is compelling), it's also the fact that so much of the world's oil supply is located in politically unstable areas of the world. Unless peace breaks out all over, I don't see oil prices declining below $60.
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tate423 on May 17, 2006 - 1:49pm Permalink | Subthread | Parent | Comments top
I don't care what the crude price is I see a price floor in the STL area at maybe $2.50 and that might be low.  I just don't see it ever being cheaper than that.  The barrel price doesn't translate well to most people.
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stranger on May 20, 2006 - 1:05am Permalink | Subthread | Parent | Comments top
I think volume traded is a misleading number because the same contract can change hands many times which increases the volume while the open interest of the underlying commodity stays the same. Still, Im sure there has been an increase in paper oil and pure speculation.
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Hellasious on May 20, 2006 - 2:45am Permalink | Subthread | Parent | Comments top
Dear Stranger,

Volume traded on a daily basis vs. the "real" stuff is a very good (actually the best) indicator of how much speculation vs. actual physical trade is going on. Of course each contract changes hands dozens of times, that is the nature of speculation. Just compare futures volume/physical oil in 1998 at the bottom of oil prices, to today's ratio. It is easily triple to quadruple. Speculation attracts more speculation until the whole bubble pops. Commodities are also very prone to rabid speculation and violent price moves because of leverage: margin is very, very low, typically 3-5% and sometimes alot less, if you double leverage as many hedge funds do. Just remember the mess those Nobel laureates and their bond hedge fund got into a few years back..the Fed had to bail them out. There will be no Fed bailout for commodities' speculators - of that you can be certain.

Someone further up used the total daily oil production in the ratio (84 mbpd) - that is ok if you are just comparing ratios over time, but not for just once. Exported oil volume is a much better figure to use to gauge hedging needs: eg Iran produces ca.4 mbpd but exports 2.5. The rest it uses locally, selling at prices way below market and does not need to hedge. Same goes for almost all other producers, except the US, UK, Norway and a few more.

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Stoneleigh on May 20, 2006 - 12:08pm Permalink | Subthread | Parent | Comments top
Commodity tops, like stockmarket bottoms, are driven by fear and therefore tend to be sharp spikes such as we are currently seeing.
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