2007-11-16

Understanding Speculation

One of the "reasons" people think that is causing the crude oil price to soar is this magical thing called Speculation. Speculation is essentially people in the marketplace who have enough money to either buy or sell goods or shares, and do so in order to profit from price movements.

Speculators differ from other investors because these other investors are buying or selling goods or shares in order to make money from interest or dividends or selling to an end user.

The problem is that most of the market indulges in speculation rather than in "normal" investment. That is why prices rise and plunge so often. Without speculators, it could be argued that the true price of goods and shares is more likely to be determined.

Powerful speculators can sometimes move entire markets. George Soros speculated in 1992 that the British Pound would devalue, and used his considerable financial prowess to force down the price. Since the Pound's price had been linked to other currencies in the European Union, the Bank of England was forced to use its reserves to buy back the Pound to keep the currency within certain price guidelines. They failed. The Bank of England lost billions, Soros made over one billion pounds in profit, John Major's Conservative government was humiliated, and the European Union started to seriously consider creating a new currency to make economic conditions safer for Europeans.

So, is the price of oil the result of speculation? The answer to that is undoubtedly yes, but only in the sense that all markets, from shares to oil to pork bellies to gravel, have people who have enough money to speculate.

But speculation is a phenomenon that leads to inevitable conclusions. Everyone knows about Tulip Mania, one of the first instances of speculation in recorded history that took place in the 17th century. Speculation into the price of tulips made some people immensely rich as more tulips were bought and sold to feed people's desire to, well, make money out of rising tulip prices. The inevitable result of this situation was a complete collapse in tulip prices and the financial ruin of many people involved in speculating.

The thing about price is that price is a way of measuring not just the cost in producing and selling something, but also its value to the marketplace. This is where profit comes in. If a person owns a lawn mowing business that costs him $50 per day to run, and makes him $100 per day in sales, then he is making a profit. The higher the price gets, the more demand there is for his services.

Let's get back to oil. At over $90 per barrel the price of oil is at an historic high. If the price was merely the result of speculation then at some point the oil price will collapse back down to pre-2004 levels (below $30 per barrel). The thing is, though, that this collapse in price would also be accompanied by a large increase in supply. Speculation itself, in theory, causes the market to supply greater amounts of goods or shares in order to satisfy this demand. Put simply, if speculation was causing the oil price to be this high, then we would also see greater amounts of oil produced, more oil carriers sailing our oceans and higher crude oil stocks.

But we're not. US stocks of Crude oil are, in fact, depleting. They're not depleting very fast, but they are certainly not increasing at this moment.

One reason for this might be that Opec and other oil producers have simply not ramped production up fast enough to cope, and that, when they do, supplies will increase and prices will fall. The problem with this sort of reasoning is that oil prices have been going up since 2004 and, while production did ramp up for two years or so, in the past 12 months oil production worldwide has declined while the price has continued to climb. Prices, therefore, must be affected by this decrease in oil production.

So why aren't these nations pumping enough oil? Is it some plot by the Middle Eastern nations to punish America and the world? That actually makes little sense because the people who run these nations are motivated by profit, and it is not profitable to keep reducing supply.

Of course, the other reason why these nations aren't pumping enough oil is because they can't. Peak Oil theory has empirical evidence that the productivity of oil wells declines once half the oil in the reservoir has been pumped out. When factoring in all the oil discoveries throughout the 20th century, Peak oil scientists have concluded that world oil production will inevitably go into decline. Already there is evidence that this has occurred.

Speculation will always affect the price of oil, but, then, so will the limits of geology. Given that speculation causes increases in production, and given that oil production has not increased over the past 12 months, it is reasonable to conclude that the world has passed its peak.

And, as Peakniks will say, the age of cheap oil will soon be over.

© 2007 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/

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1 comment:

Dave Lankshear said...

The thing about price is that price is a way of measuring not just the cost in producing and selling something, but also its value to the marketplace. This is where profit comes in. If a person owns a lawn mowing business that costs him $50 per day to run, and makes him $100 per day in sales, then he is making a profit. The higher the price gets, the more demand there is for his services.

Is this a typo? High cost = lower demand, or “demand destruction”. But if an upward movement is sensed by investors, then demand for shares might go up. So I can only think you meant “more demand for his shares?

This following bit was brilliant.

Let's get back to oil. At over $90 per barrel the price of oil is at an historic high. If the price was merely the result of speculation then at some point the oil price will collapse back down to pre-2004 levels (below $30 per barrel). The thing is, though, that this collapse in price would also be accompanied by a large increase in supply. Speculation itself, in theory, causes the market to supply greater amounts of goods or shares in order to satisfy this demand. Put simply, if speculation was causing the oil price to be this high, then we would also see greater amounts of oil produced, more oil carriers sailing our oceans and higher crude oil stocks.

This argument also applies to alternatives. All the "market is always right" economists that can't be bothered learning a little physics have always assured me that "when the price of oil gets high enough, the alternatives will all flourish and we'll be OK."

Instead, we read about ethanol plants going bankrupt because of the high cost of the fossil fuels it takes to grow ethanol.

Next cornucopian argument please?