Rossputin.com Rational Thinking About Our World

As the stuffed shirts on Capitol Hill fulminate about evil speculators driving up the cost of oil, many of us who understand economics and markets better than politicians do have written about the misguided and dangerous proposals to rein in "speculation" in commodity markets.

Never mind that what the critics are defining as speculation would be called investment in any other scenario, and never mind that the majority of the new "speculative" money is coming from pension funds and other large investment pools simply trying to diversify among asset categories and make the best returns for those people whose financial futures they are entrusted with.

On Tuesday, in both his prepared remarks and in answers to questions from Senators, Federal Reserve Chairman Ben Bernanke offered the best defense of speculators and the best general explanation of oil prices that I've heard from anyone in a position of significant political power.

Following are the highlights of Bernanke's testimony specifically related to oil markets and speculators:

From his prepared remarks:

The elevated level of overall consumer inflation largely reflects a continued sharp run-up in the prices of many commodities, especially oil but also certain crops and metals. The spot price of West Texas intermediate crude oil soared about 60 percent in 2007 and, thus far this year, has climbed an additional 50 percent or so. The price of oil currently stands at about five times its level toward the beginning of this decade. Our best judgment is that this surge in prices has been driven predominantly by strong growth in underlying demand and tight supply conditions in global oil markets. Over the past several years, the world economy has expanded at its fastest pace in decades, leading to substantial increases in the demand for oil. Moreover, growth has been concentrated in developing and emerging market economies, where energy consumption has been further stimulated by rapid industrialization and by government subsidies that hold down the price of energy faced by ultimate users.

On the supply side, despite sharp increases in prices, the production of oil has risen only slightly in the past few years. Much of the subdued supply response reflects inadequate investment and production shortfalls in politically volatile regions where large portions of the world's oil reserves are located. Additionally, many governments have been tightening their control over oil resources, impeding foreign investment and hindering efforts to boost capacity and production. Finally, sustainable rates of production in some of the more secure and accessible oil fields, such as those in the North Sea, have been declining. In view of these factors, estimates of long- term oil supplies have been marked down in recent months. Long-dated oil futures prices have risen along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to come.

The decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices. The precise size of this effect is difficult to ascertain, as the causal relationships between oil prices and the dollar are complex and run in both directions. However, the price of oil has risen significantly in terms of all major currencies, suggesting that factors other than the dollar, notably shifts in the underlying global demand for and supply of oil, have been the principal drivers of the increase in prices.

Another concern that has been raised is that financial speculation has added markedly to upward pressures on oil prices. Certainly, investor interest in oil and other commodities has increased substantially of late. However, if financial speculation were pushing oil prices above the levels consistent with the fundamentals of supply and demand, we would expect inventories of crude oil and petroleum products to increase as supply rose and demand fell. But in fact, available data on oil inventories show notable declines over the past year. This is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil or other commodities in the longer term.

And from the Q&A:

Question from Senator Tom Carper (D-DE): "The third factor that we keep coming back to is the role that speculation is playing. We've touched on this at least indirectly here today. Just give us some advice. I think we're going to debate -- seriously debate, probably before the beginning of next month, legislation dealing with speculation to try to curb the excesses that may be occurring there. If you could give us some advice, it would be timely and much appreciated."

Bernanke:

Well, I think, as I said, based on the evidence that's available, I would not estimate that speculation or particularly manipulation is a significant part of the rise in oil prices. That said, the CFTC and others are looking at the data and trying to evaluate that. These are very difficult matters. We don't want to do anything that will stop the futures markets from having their legitimate functions, serving their legitimate functions of providing liquidity and hedging.

So, you know, my advice would be to go slow and carefully and to take the insights that you get from the CFTC and others who are directly -- associated directly overseeing these activities. I would -- despite the concerns -- and I fully understand the concerns about high gas prices -- I don't think it's likely that you can have a big effect on gas prices with short-term moves in the futures markets. And I would urge careful and deliberate action in this area.

And a question from Senator Mel Martinez (R-FL): "I wonder if you might dwell just for a moment on the speculation side as to why you don't see that as a fundamental part of the problem, but then also what we could do to be more helpful in the area of transparency and oversight."

Bernanke:

Well, there would be -- there are a number of pieces of evidence against the view that speculation is a primary force. I mention in my testimony the absence of hoarding or inventories that you would expect to see if speculation was driving prices above the supply/demand equilibrium. There are a number of studies which show that there is little or no connection between the open interest taken by noncommercial traders in futures markets and the movement -- subsequent movements in prices. It's also interesting to note that there are many commodities, or at least some commodities, that are not even traded on futures markets, like iron ore, for example, which have had very large increases in prices. So I think the evidence is terribly weak.

That said, I think that transparency in futures markets, information available to the overseer, the CFTC, is a positive thing.

One never knows whether the Senators actually cared about the answers to these questions or whether they are just looking for backup for something they're planning to do no matter what. I hope that Republicans in Congress heed Bernanke's words and recognize that attempts to curtail "speculation" will do far more damage to the most liquid commodity markets in the world, right here in the US, than they will do to lower American's cost of living.

An Open Letter to Congress

From John J. Lothian

When futures prices go up, they are advertising for selling. When prices go down, they are advertising for buying. With futures prices going up for crude oil and many other commodities, a truth has emerged in the cash markets that we have not grown our farming, drilling, mining or processing capacity to meet the increasing demand of a developing global economy. High commodity prices are sending an important message.

We need to listen to that message and respond.

We need to respond to higher prices with more selling. We need to find a way to meet the growing global demand with real production of oil, metals, grains, fibers and many other commodities. We need the higher prices to spur the investment in that production. This is a demand pull rally in prices, not a supply shock. We should not be shocked that millions of Chinese who work in factories in cities (rather than in agriculture in the country) need to buy food, transportation and clothing. This change in lifestyle has created a change in demand with higher wages and a rising living standards. Look at the label on the goods you buy and the clothes you wear and you can find similar economic /human migration stories in other countries around the world.

Laws artificially muting market prices will only make the problem worse. And messing around with a global problem in a narrow nationalistic way, especially in a way that exacerbates the problem, is the kind of thing that can lead to wars. People need to be fed, clothed and kept warm. They need transportation to get to work and move their goods and services around the world. History has shown free markets are the best mechanism by which this can be accomplished.

One of the tragic economic errors after World War I and causes of World War II was the rent control laws in Germany in the 1920s. With an upper bar on rent prices due to a well-intentioned but tragically flawed law, it was difficult to find housing. People would not move because they were locked in to a rent-controlled apartment. Landlords were forced to accept less than the open market would yield, and as a result they would let the apartments fall into disrepair because they could not afford to pay for the upkeep. New housing was not built, because the return on the controlled rents was less than the cost of capital to build it.

Listen to what the higher prices are telling us. We need more selling. More selling can come from new supplies, or from consumers switching from one choice to another. Higher prices spur changes in consumption. They create the economic conditions for new technologies, systems and ventures to emerge and compete. These are the ingredients of economic growth. Government should not pick the winners, the market should.

Some investors figured all this out before others. This spurred the development of an investment class in commodities, using futures contracts as proxies for the underlying physical products. Long-only commodity index funds have emerged as a major fundamental factor in the futures markets. Billions of dollars are linked to indices of commodities.

While traditionally these participants would be classified as “speculators,” they are in fact investors. Many of these funds fully fund each and every contract they buy. Margins on a $16 contract of soybeans might be $3000, but these investors are putting aside the full $80,000 to invest in these commodities on an un-leveraged basis.

These investors are putting their capital on the line, daring the market to find the selling to match their buying. There is nothing wrong or illegal in the way these market participants are using the futures markets. In fact, there is a lot that is right about it. Millions of investors use similar investing strategies to invest in other asset classes, including equities, fixed-income and real estate funds. The free flow of capital into this area is delivering an important message we need to heed. We need more selling. We need more production, processing and refining capabilities. We need to spur the market to allow alternatives to develop. We listen and respond to the market every day. This is no time to stop listening.

Proposals in Congress to raise the margins on futures contracts would have no impact on many of the long-only index funds as they have 100% in cash or equivalents of the contracts’ value. On the other hand, increased margins would reduce the number of traditional speculators. That would lead to less efficient markets, higher execution costs and generally higher prices.

When Treasury Bonds were introduced in the 1970s, the bid-offer in the cash market for Treasuries was regularly a full basis point wide, or $1000 between the bid and offer. The successful introduction of Treasury bond futures allowed that bid-offer to narrow to 1/32 or $31.25. Investors offered transparent, liquid markets can do more with their money.

Speculators come in different shapes and sizes, the same is true with hedgers. Commercial concerns are impacted by these higher prices and the accompanying volatility. Some hedges are held for months on end, and spiraling capital costs can kill a company. Some grain elevators have stopped taking forward-priced contracts because they can’t afford to finance the hedges for the farmers. This is a concern. Increased margins on market participants would only make this situation worse. We need more sellers, not less.

Speculators have often been vilified through the ages. In the current real estate crisis, many of the worst impacted areas for foreclosures were where the highest level of speculative activity occurred. Politicians publicly stated about how they wanted to help fix the problems in real estate but did not want to reward the speculators.

The first Treasury Secretary of the United States, Alexander Hamilton, was faced with a similar speculative situation in the early days of the republic. It seemed that many debts had been issued by the 13 colonies during the Revolutionary War to fund it. Original owners of the debt were often soldiers themselves, merchants or others. After the war, convinced these bonds would never be repaid by the colonies; many holders sold their holdings to speculators who paid pennies on the dollar.

Hamilton’s great plan was to nationalize all that debt of the new states and to issue new USA debt to replace it, thereby establishing a national debt market. By repaying the state debt, some owed to foreign holders too, he also raised the credit rating of the country in the world’s markets. However, in order to execute his plan, he had to handsomely reward the speculators who had accumulated the debt from the original buyers. Lucky for us that Hamilton did the right thing for the country and the hard thing to do politically.

As Congress contemplates how to respond to the political and economic risks we are faced with globally because of the jump in commodity prices, let’s remember the tragedy that sprung from German rent controls, the value of transparent, efficient and fair markets and the wisdom and political courage of Alexander Hamilton. Let’s remember higher prices mean we need more selling, not more regulation. Let us remember to listen to the market.

Many Americans are discovering something disturbing in the supermarkets this summer. Just in the past few weeks, there has been a stealth increase in the price of two of the four major food groups, namely breakfast cereal and ice cream.

The Cinnamon Toast Crunch that you claim to buy for your kids has gone from 14 ounces to 12.8 ounces. The Cheerios have gone from 10 ounces to 8.9 ounces. And for after dinner, that container of ice cream which you have thought for years was half a gallon but was really only 1.75 quarts is now only 1.5 quarts. If you are wondering how much the prices of these items have dropped as a percentage of the size reduction the answer is almost precisely 0%.

Although cereal and ice cream are the two most visible examples of “downsizing”, it’s also happened in many other of the most common products Americans buy, from mayonnaise to crackers to chewing gum.

The cause is no surprise to anyone who trades commodities or eats food. (Commodities traders are frequently too busy to eat...) The three charts below show one year of futures prices from June 20, 2007 to June 20, 2008 in corn, soybean oil, and crude oil. Although it captures the most headlines, crude oil is the laggard with “only” a 95% price increase in the past year, half of the gain for corn futures. While people may not think much about the price of petroleum when looking at a box of cereal or a tub of ice cream, the cost of our food can be as affected by oil as by its direct inputs due to the cost of running a factory and transportation of ingredients going in and final product heading out to supermarket shelves.

The bottom line is that the food companies have to protect their bottom lines. And that means passing along at least some fraction of their cost increases to customers. According to a consumer affairs representative at General Mills, they hadn’t increased prices since 2005. What’s different about this price increase is that it’s being done, if not exactly secretly, in a way designed to minimize its impression on consumers.

Food companies from General Mills to Kraft to Wrigley have determined that while shoppers will tolerate a higher price per ounce or per piece, we have reached a point where won’t tolerate a higher price per box or per pack. If a person has a $100 budget for food, she can live with paying an extra few cents per ounce of cereal, but not with a box of cereal that costs more than $4. So instead of raising the $4 box to nearly $5, the price stays the same but the amount of cereal in it decreases.

Each company has a slightly different spin on their downsizing. General Mills says that their package sizes were larger than competitors’ packages, so similar sizes will let consumers compare better. (Yes, and I liked the larger packages better!) And they do directly acknowledge that “consumers are more likely to pay the same price for a smaller package than more for the same package.” The company also notes that their changes are tested and examined by focus groups before being put in place: “Our decisions are based largely on extensive research”.

Other products with high grain content are being downsized as well. Triscuit crackers, a Nabisco/Kraft product, have replaced their 13 ounce box with a 12 ounce box. But Ritz and Wheat Thins haven’t downsized. According to a Kraft representative, “prices change more than sizes with Nabisco products”. He added that the company is reducing costs so that it can minimize cost increases or package downsizing, including working on “source reduction”, namely reducing the size and cost of packaging without reducing the quantity of product. For example, a 16 ounce package of Chips Ahoy cookies has been reduced to 15.5 ounces net weight, without putting in fewer or smaller cookies, by using thinner paper, less plastic, and changing the way the package opens. Of course, they claim that their motivation to reduce packaging is “for environmental reasons”, but I’m more pleased that they’ve found a way to lessen price increases for my cookie fix.

Lay’s potato chips have gone from a 13 ounce package to 12.5 ounces. When asked about public reaction, a Lay’s representative was…representative of the industry: “Customers are not happy about it, but they understand and they’ll continue to buy the product.”

Other packages have been downsized as well. Hellmann’s mayonnaise went from 32 ounces to 30 ounces, and even the Wrigley chewing gums in the “slim package”, such as Big Red, Extra, and DoubleMint have gone from 17 pieces to 15 pieces, effectively a 12% price hike.

But for this dessert-aholic, the real trauma comes from the downsizing of ice cream packages. Breyer’s, Dreyer’s, and Edy’s have all dropped their container sizes from 1.75 quarts to 1.5 quarts, nearly 15% less mint chocolate chip or Moose Tracks to satisfy the summer snacker. According to Breyer’s, a division of Unilever, “while (higher ingredient prices) are an industry-wide problem, we’re working to offset cost increases through hedging, reformulation, and cost savings programs.” The “r-word” scares me.

A representative for Edy’s, a Nestlé company, made a point which sounded like she knew my ice cream habits: “In addition to the price of ingredients going up generally, consumers want more indulgent ingredients, like cookies and swirls and cake mixes.” She added that they faced “a very difficult decision” between maintaining package size and maintaining quality, and they decided on the latter.

While I don’t like paying the same price for a smaller container of ice cream, if my options are tolerating 1.5 quart boxes versus having to give up my Breyer’s Fried Ice Cream Overload (“Cinnamon caramel light ice cream swirled with honey caramel with cinnamon tostada pieces”), it’s not really a difficult decision.

Here's another must-read article by someone from the outside looking in on the dangerous econo-nonsense being proposed by those who want to stop "speculation" in futures markets.

see "Misguided US plan to curb oil futures speculation", The Australian, 6/26/08
http://www.theaustralian.news.com.au/story/0%2C25197%2C23923062-5005200%2C00.html

With $4 gallons of gasoline, it is no surprise that energy is becoming a major issue in our upcoming elections. What is surprising is the remarkable adherence by Democrats to grievously and obviously failed policies, suggesting everything from maintaining the bans on oil and gas exploration off our shores to windfall profits taxes to simply nationalizing the oil industry (although Maxine Waters actually said “socialize” when she couldn’t think of the word “nationalize”.)

The American public is ahead of the politicians on this issue, and far ahead of the Democrats, with a Rasmussen survey last week finding that “67% of voters believe that drilling should be allowed off the coasts of California, Florida and other states.” According to the survey, offshore drilling is supported by 85% of Republicans, 57% of Democrats, and 60% of independent voters. Even John McCain has changed his tune, now calling to end the federal ban on offshore drilling.

The Department of Energy’s Energy Information Agency (“EIA”) recently put out its “Revised Early Release Annual Energy Outlook 2008” which should have us all worried about the prospects for energy prices if the Democrats get their way. The forecasts have been noticeably modified since their 2007 report, with the expectation for energy consumption in 2030 down 10%, but still an increase of 18%. But this is not a change anyone should be happy about, though radical environmentalists will be, because it is based in large part on a lowered forecast for GDP (from 2.8% growth to 2.4% growth) and personal income (down $1.3 trillion in 2030) and raised forecasts for energy costs and inflation. Just so you get an idea of what we’re talking about here, this is $1.3 trillion: $1,300,000,000,000.00 Even to the US Congress, that’s a big number.

Particularly striking is the note in the EIA’s overview that “the inclusion of EISA2007 is by far the most important” factor in their changes. EISA2007 is the Energy Independence and Security Act of 2007 which forces up the fuel efficiency of automobiles, effectively bans incandescent light bulbs by 2014, and massively increases the amount of biofuel required to be added to gasoline. (If you know how we can save the planet by burning our food, please let me know.) In other words, the government is saying that EISA will be a primary factor behind our GDP being reduced by two trillion dollars in 2030 and behind their expectation of imported oil costing $70/barrel instead of $60/barrel in that same year. Also, the EIA slightly raised their expectations for “primary energy intensity” meaning that despite what we’re told will be substantial gains in efficiency from EISA, EIA raised its forecast for the amount of energy required per dollar of GDP. It’s very much like the efficiency gains at Al Gore’s house.

Although any sensible approach to reducing high oil prices would include conservation measures, the primary focus must be on increasing supply. And that is exactly what could be done by the Federal Government lifting the ban on offshore drilling and by all governments making it less difficult to drill on multi-use public lands (not in National Parks) and ANWR.

The resources of just 11 major onshore federal land areas are estimated by the Bureau of Land Management to be 21 billion barrels of oil and 187 trillion cubic feet (“TCF”) of natural gas. Of this, the “mean oil reserve case” for ANWR is 10.4 billion barrels, or 50%. Of this land, only 24% is “accessible under standard lease terms”, with that 24% representing only 3% of the oil and 13% of the gas contained in the 11 land areas.

And, according to the government’s Minerals Management Service, “oil and gas resources in undiscovered fields on the OCS (2006, mean estimates) total 86 billion barrels of oil and 420 trillion cubic feet of gas. These volumes represent about 60 percent of the oil and 40 percent of the natural gas resources estimated to be contained in remaining undiscovered fields in the United States”. Much of this comes from Alaska. For the lower 48 states, EIA estimates 40 billion barrels of oil either undiscovered or inferred, and 213 TCF of gas, not including “unconventional” recovery such as “tight gas”, or gas from shale or coal formations.

It should be noted that resource estimates tend to be conservative. For example, in 1997 Alaska’s Prudhoe Bay reserve was estimated at 9 billion barrels of oil. To date, it has produced 15 billion barrels and is going strong. Similarly, 1984 estimates of Gulf of Mexico reserves were 6 billion barrels and 60 TCF. Since then, 13 billion barrels and 152 TCF have been recovered.

For context, EIA estimates that the US will consume about 8 billion barrels of oil and 23 billion TCF of gas in 2030.

The costs of exploration, especially offshore, are enormous. According to Andy Radford, Policy Analyst at the American Petroleum Institute ("API"), “if you’re in deep water (the vast majority of offshore opportunities), you’re looking at upwards of $200 million to drill a single well. Once you include lease costs and the costs of building a platform for full-fledged production at a site, you’re looking at $1.5 billion, or even $2 billion in the deepest water.” However, according to Radford, advances in 3-D and 4-D seismic technology have made such costs better bets, even though just the seismic mapping of a resource can cost $100 million. Essentially, the 3-D technology allows accurate location of a resource and the 4-D technology allows much better assessment of the best spot to drill into in order to drain the reservoir most efficiently. This allows far fewer wells to be drilled, something which should please environmentalists, oil companies, and consumers.

There are three most-common arguments against allowing offshore drilling: Environmental impact, non-producing existing leases, and time to production. Both arguments can be rebutted clearly and simply with facts. Regarding the environment, of all the billions of barrels of oil we’ve produced, less than 0.001% has spilled. And, according to the API’s Radford, “although over 100 offshore structures were destroyed by hurricanes Katrina and Rita in 2005, there was no significant release of hydrocarbons.”

As far as current leases not generating production, Radford points out that shallow water leases are typically five years, with deep water 8-10 years. “That’s what it takes to do the exploration you need” to prepare for production. A ‘non-producing’ lease is not an ‘inactive’ lease.” In other words, the process of mapping a leased area to determine whether production is feasible and economic, then drilling one exploratory well if it seems justified can take up to three years by itself. Exploration companies are working very hard in currently-leased areas to see if they can be turned into productive resources. Since they lose the leases which cost millions or tens of millions of dollars if they don’t generate production within those time frames, the implication that oil and gas companies are somehow slacking off with existing leases is ridiculous. Finally, I would not that it takes a certain kind of mind to argue on one hand that we shouldn’t allow new drilling because oil companies are slackers and at the same time argue that we shouldn’t allow new drilling because it takes 10 years to get to production in many cases, such as might be expected in ANWR. Furthermore, the argument that changing our policy will have no short- or medium-term impact on energy prices represents a fundamental misunderstanding of the way markets work, including the way speculators trade.

According to Richard Ranger, another API analyst, history shows that carrots work a lot better than sticks in bringing energy resources home to Americans: “In 1995, people were talking about the Gulf of Mexico as a ‘mature resource’. Clinton signed the Deep Water Royalty Relief Act under which the federal government waived their 12.5% royalty until either a price or production threshold was met. Since then, natural gas production in deep water is up 407% and oil production is up 386% in the Gulf. The increase in crude oil production attributable to that Act is about a million barrels per day, nearly equal to our imports from Saudi Arabia.” (And more than we import from Venezuela.)

Onshore opportunities in the lower 48 are nearly as large as offshore, even without the tremendous potential of oil shale and other unconventional sources which may become economically viable with the advent of new technology such as “hydraulic fracturing”, which cracks rock and “expands the zone”, allowing more energy (especially natural gas) to be retrieved and making such projects worth pursuing.

The good news is that we do have a choice because our nation has tremendous energy reserves, if only the Democrats would let us get at them. But, as API’s Ranger notes, “As people from both coasts move to the West, where many of our onshore resources are concentrated, we are seeing more application of the BANANA principle: Build Absolutely Nothing Anywhere Near Anybody.” Unless and until that changes or is overcome, Americans should expect environmentalists, liberal multi-millionaires, and their foot soldiers in Congress to continue to saddle us with high energy prices.

Although the pain in Americans’ wallets has woken us up to the issue, most still do not understand either the magnitude of the demands for energy we will need to meet in coming decades or the ability of our own onshore and offshore resources to satisfy much of that increase in demand. In other words, if we keep doing what we’ve been doing y preventing development of domestic supplies of energy, we will see price increases and shortages that will make us long for the good old days of $4 gasoline.