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Tuesday, March 11, 2008

Are Oil Hedge Funds to Blame?

The US is very shortly staring at $4 per gallon gas in its near future. Oil was at $108 a barrel today and given that those are 55 gallon barrels that is nearly $2 per gallon...for crude oil! The $1 Trillion Question is, Why?

What has changed in 24 months in order to send oil from $50 to over $100? Is it demand? Nope, demand is rising 10%+ and will probably slow down to very low growth due to consumers driving less. Has OPEC turned off the spicket? Nope. There have been fluxes, but for the most part...no. Iraq and Venezuela have been an issue, but not enough to cut supply by half. Which is what it would take to double the price (at least in a linear fashion). This report from WTRG shows more great slides to review for yourself.

From the report:
The U.S. petroleum industry's price has been heavily regulated through production or price controls throughout much of the twentieth century. In the post World War II era U.S. oil prices at the wellhead averaged $24.20 per barrel adjusted for inflation to 2006 dollars. In the absence of price controls the U.S. price would have tracked the world price averaging $26.16. Over the same post war period the median for the domestic and the adjusted world price of crude oil was $18.53 in 2006 prices. That means that only fifty percent of the time from 1947 to 2006 have oil prices exceeded $18.53 per barrel.

Until the March 28, 2000 adoption of the $22-$28 price band for the OPEC basket of crude, oil prices only exceeded $24.00 per barrel in response to war or conflict in the Middle East. With limited spare production capacity OPEC abandoned its price band in 2005 and was powerless to stem a surge in oil prices which was reminiscent of the late 1970s.

I was puzzled, why the super rise then? Then I ran across another, bit older article from Fortune about Oil Traders and Oil Hedge Funds. While this article is a bit out of date it really lays out where the groundwork for this bubble has come from. Oil Hedge Funds. Talk about printing money for the last three years!

It works like this: I think oil is gonna rise, so I buy a "future contract" for oil at x date at x price. The fellow I am buying the future is betting the other way. So let's say I think oils going to go to $125 by Christmas (Gosh I hope not, but as an illustration) I would put a bid out to get the lowest possible price for that December 2008 oil. Timmy thinks it is going to $115, so he is happy as punch to sell me all the oil I want for $125! So he takes my bid at $125...It is now December. Oil is at $150! I get to buy it at $125 and Timmy is selling it to me at that price, even though the market is $25 higher now. So I made $25 per barrel!

The only issue is that you do not have to hold it all the way to December. If the market looks like it is going against him Timmy can sell the contract off, probably at a loss, but better than it could have been.

When this is out of control it can become a real Ponzi Scheme, in Biblical terms you rob Paul to pay Peter. Exactly like what was going on with housing. The problem with a Ponzi Scheme is that you eventually run out of suckers and it crashes!

Which is exactly why OPEC doesn't want to jack production (even if they could) way up. They all expect a big crash. Irrational Exuberance, to quote Mr. Greenspan.

While the housing market (the other Ponzi Scheme) is to blame as well, oil touches every budget point, for everyone and I believe our biggest true inflation issue. They government could step in and freeze oil prices, but that would kill any reason for the oil companies to reinvest, which leads to higher future prices.

A crash is coming. And I hope it won't be too late!


Father Sez said...

This is a great post.

I have also been wondering about this.

Recently Goldman Sach's wrote that they expect oil to be US200 per bbl.

Like the Indian Finance Minister quoted, "there appears to be no conceivable reason for this increase in oil price".

Probably, like you have said, there are financial intermediaries in the equation, and they have a lot to do with this increase.

I would really enjoy seeing them get the finger from all of us consumers.

RacerX said...

Thanks for the kind words!

I really hope that it doesn't get near $200, but it could. This house of cards has to collapse at some point, But it is whacking the economy in the mean time. It is a lot of money going to nothing!

Sharon said...

How does this explain the obscene profits that Exxon/Mobil and other oil companies are experiencing? I do not understand why we have to add to their profit lines?

RacerX said...

It completely explains the profits. They sell the oil regardless of current price. If traders jack up the price to $108...thats the price. As a commoditiee they don't work on a "cost-up" model. If it costs them $10 a barrel to produce (too low BTW) and the market pays $100, the make $90.

Thanks for the visit!

John Cardillo said...

Excellent article.

Its the only explanation that makes any sense.

I've been comparing the prices of other energy sources and was surprised to see how expensive oil and gasoline have become.

In fact, it costs nearly 3 times more to run a gasoline powered vehicle than one powered from electricity from the grid.

Sooner or later consumers are going to learn this. How can there not be a revolt and crash.

See related article The Irrational Price of Oil.

RacerX said...

Welcome John and thanks for commenting!

I think this is going to be a watershed for consumers. I believe more will push for electrics nd hybrids, making them profitable w/o government money.

Unfortunately, I believe, demand is just a samll part of this. as the traders trade it up in value with nothing to back it up.But maybe it will make the prices crash quicker.

At $4 gallon please are starting to scream at Congress, which means they will jump in and muck it up too! Especially since Hedge Funds are some of the largest political backers!

Thanks again for visiting and commenting!

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