Are High Oil Prices All About Supply & Demand? Maybe Not

A couple of days ago I talked about how high oil and gas prices pose a threat to the “recovery” of the economy. Now I want to turn to the causes.  Why are oil and prices high?  Is it all just supply and demand, or are there more sinister forces at work?

Many, and I’d venture to say most, mainstream economists tend to say it’s simply supply and demand.  The world, particularly China, is consuming and demanding larger quantities of oil at the existing prices (demand curve is shifting rightward).  They also assert that the cost of getting new oil is increasing as easy-to-get reserves dwindle and drilling for new oil gets more exotic and costly. This shifts the supply curve to the left. That’s a textbook description of how to get rising prices.

I’ll accept that this may be a major part of the story, but to me there’s still something else going on.  Simple supply and demand in the cash delivery markets for oil don’t seem to explain the specifics of either the 2008 spike or the 2011 spike in prices.  In 2008 prices spiked significantly in a few short months with gas reaching $4.00 a gallon by summer.  Yet the U.S. and the other major developed, industrial countries were actually slowly sliding into recession at the time.  Recession reduces the demand for oil.  Earlier this year, the supposed story was the sudden stoppage of Libyan shipments of oil in February.  But Libya only accounts for a little less than 2% of world supply.  Even with a very inelastic demand curve, the price increases seemed out of line.

Of course I’m not alone in thinking there’s something else going on.  Two common ideas are that oil speculators are causing the damage by driving the oil futures price too high and that oil companies are conspiring to raise the prices.  I’ll take the latter first.  I’m skeptical of an oil company conspiracy to raise prices.  It’s not that I doubt they would if they could, it’s just that even with the concentration in the oil industry, I don’t see a price fixing cartel as being feasible.  Too many different cultures of companies and way too many ways to cheat on the cartel.  Historically OPEC has had a hard time getting it’s member producing countries to hold to their own quotas.  I just don’t see it.  Besides such an oil company conspiracy doesn’t explain the timing.  Don’t get me wrong, I fully expect the oil companies are milking the market increase in prices for all it’s worth, including shady practices.  Yes, they mark up the refined inventory immediately to match replacement costs for new crude when price goes up, but they won’t mark down inventory prices until it’s sold when crude prices decline.  Not a savory bunch of characters, but I still don’t see them as the cause.

Instead, I’m inclined toward the speculators theory as being significant.  Normally, most economists are loathe to blame speculators as the cause of high prices for delivered & produced oil.  This is because most speculators don’t actually buy oil. They buy “futures contracts”. (for an explanation of futures contracts, see my post “What’s A Derivative?“).  Economic theory of futures contract markets suggests that it’s extraordinarily difficult to artificially manipulate the eventual delivered price of a commodity by driving up the futures prices.  Or at least the theory suggests it’s tough to do for a long period of time.  If futures prices are irrationally high, meaning they are higher than physical supply-and-demand justify, speculators who buy at the too-high futures price will eventually lose money when the contract fulfills physically.  For example, suppose they contract now in June to buy a barrel next December at a fixed price of $110 even though today’s June delivered price is only $100.  That’s speculation.  They are speculating that the physical price in December will be even higher than $110, say at $120.  They’ll take their barrel at $110 in December and sell it in the open December physical market and make a profit. They hope, that is.  If the futures prices are consistently too high – meaning they forecast future high delivered prices – but the physical delivered prices never get that high, then the speculators take a loss.  That’s mainstream accepted theory and dynamics.

But the mainstream (and theoretical) view is based on the assumption that now player (buyer) in the market is large enough to manipulate the market.  The mainstream view also holds that the “fundamental prices”, meaning the physical supply-and-demand, must ultimately keep the futures market honest.  Historically that’s been true for oil and a few other very widely traded commodities.  But it’s also been possible in the past for some thinner traded commodity futures contracts to get manipulated.  The Hunt brothers in the 1979-1980 got caught in a famous attempt to corner the silver market. One of the keys to Hunt brothers’ attempt was extraordinary financial leverage.

What I’ve wondered about in both 2008 and this year is the possibility of the major banks, the global scale too-big-to-fail banks, through favored hedge funds and off-balance sheet trading operations could be manipulating the market.  In my scenario, I picture a classic 1920’s style stock market “corner” style operation.  A few major operators with deep pockets keep trading with each other. They keep driving the futures price up and up.  Then as the rising prices attract attention, the littler investors begin to enter the market to get in on the “action”.  That’s when the bank traders start to sell. Initially they keep the price rising, but eventually the bank shorts oil futures and pulls the rug out.  Futures prices collapse back to more realistic levels and the banks get richer – trading profits it’s called.

I have no real evidence of this, nor do I have the time to investigate.  I think it’s a possibility though.  After all the big banks are showing record profits this year and last, and they sure aren’t doing it by making constructive loans to get the economy going.  It’s mostly all “trading profits”.

Recently this news came out that the Commodities Futures Trading Commision has filed charges against some speculators alleging a scheme in 2008 to manipulate physical inventories to create the appearance of tight supplies and then make a killing in the leveraged futures market on the price moves.  So may indeed be possible.  And the speculators charged here are relatively small beans compared to the financial resources of the big banks and hedge funds.

I’m just sayin’ I’m not convinced at all that it’s just all supply and demand in the physical market.