This seems so obvious that we have been putting off the task of actually writing it out. Since several economists have been tripping over their own equations and assertions in order to prove a point in the mainstream media, producing nothing but confusion, we felt compelled to take the time to write out some thinking points for your consideration.
We would also like to preface this by saying that of course there is speculation in the oil market. There is a degree of speculation in all markets which are not purely mechanistic, centrally controlled, where variables are not certain. These are known as 'free markets.'
Speculation is nothing more than the arbitrage of information. The better question is: is this market being manipulated? That is another question better answered by the power of subpoena and a good hard look at the market regulation and significant players who tend to have access and control of important market information. That question often goes unasked and unanswered. An unregulated or loosely regulated market is likely to be corrupted over time. This is the way of the world except in the eyes of ardent romanticists, and some academic papers.
The most commonly observed condition in US commodity markets is called contango. That means that prices in future delivery months are progressively higher than in the nearest delivery months. Why is this so common?
The reason for this is simple: the Federal Reserve is creating an often gradual but persistent monetary inflation which we have seen for almost the last 100 years.
This is same reasoning behind the mechanism of most discounted cashflow analyses so commonly used in finance. There is also the 'perceptual' element. As the perception of future inflation increases increasingly the current prices of things begin to reflect that inflationary bias in their future prices.
Let's suppose you own some 'commodity,' something like a rare coin.
Lets assume that market perception and pricing seems to reflect a steady increase in the price of your coin for a variety of reasons including demand and simple inflation.
As the perception of inflation increases, the 'demand' for your coin may start increasing more geometrically, because it is viewed as protection from that monetary inflation. The price increases for such coins can become rather dramatic as a result, as we saw in the last flight from monetary inflation in the US back in the 1970s-1980s.
How does one make a decision then to sell that coin?
There are two motivations at least: the 'need' to sell to obtain short term funds and the desire for a optimum or 'fair' price from your point of view. If you do not need the money for some urgent reason, like a child's tuition or the gasoline bills, then you can ignore that impulse for a sale. If not, if you do need to exchange the rare coin for money urgently, then there is a range price dampening motivations from discretion to distress.
For now let us take the urgent need for cash out of our equations.
We are left then with the determination of a fair price, or profit maximization. How do we determine such a price target?
One common way to do this is to at price history. But even recent history may be stale news in active markets. The other way is to investigate offered prices, from the near term demand driven prices, perhaps with less regard to other factors, and further out to a calmer waters in the months and years out, depending on one's timeframes. The way this has been expressed is that today's prices are a voting machine, while future prices are a discounting machine.
A rational investor will look out at the broad market perception of prices in the future, run a kind of discounted cashflow on the basis of THEIR own inflationary expectations and other assumptions, and then arrive at something approximating a fair price for the near term. That discounting needs to include storage costs, opportunity costs, probability of exogenous events, etc.
This is the price at which the market will clear for those not under duress, personal factors such as a short term need for cash aside. If the market is making a fair price is will clear, and there will be little hoarding of supply. If for some reason the market is presenting sellers with an artificially low price that is determined to be so, such as in the case of wage and price controls or rigged statistics, then hoarding will occur. Hoarding will only occur as prices increase if they are being held down artificially despite the increases, all other things being equal.
Hoarding would be more probable in a market with artificial price controls, and/or no futures market which would make current price more subject to near term duress. Why hoard, when one can 'sell it forward' in a futures market. This involves more than just storage costs, but the 'half life' of the products and their fungibility to future sales, their utility towards storage.
In a prior blog we attempted to explain how there really is no 'spot market' but just the price at which transactions are occurring on an individual basis. The real mechanism for price discovery is in the near term futures markets, and the 'front month.'
Monetary inflation is a clear input to oil prices for oil prices in US dollars, besides supply and demand. There are also the opportunities for exogenous events to disrupt supply, as in the case of war or accidents or natural disasters. Or demand, as in the growth of new economies and demand for oil.
The probability of these events becomes an opportunity for speculators to calculate their like impact on the future price of a commodity, and then take positions accordingly. This is 'betting.'
The net of all this is that what the oil market is telling us is that the published government inflation numbers are bunk, and that in discounting the expectations of future prices, the market is demanding higher prices. There is also a perception that oil demand will increase, and supply may be disrupted.
Does this involve speculation? Of course, since the probability of exogenous events is not a 'knowable' variable, with any degree of certainty, unless you cheat, in the case of certain well known market equations, and assume a 'normal distribution.'
Commodity and currency markets are notorious for overshooting or overrunning trends. Why is this? It is because of the speculative element, but that may be a discussion for another day.
There is an undeniable increase in demand from the developing economies, who may actually be subsidizing the price of oil to their own people to stimulate growth, as in the case of China. There is also the potential for 'peak oil' and the debate surrounding that macro event. But these are all inputs into prices with degrees of probability, fruitful for speculation, all made more likely by a surfeit of money with no better productive outlets for its use.
We hope this helps. It is not that complex. But for some reason the establishment does not find itself capable of discussing the perception of the current monetary inflation, refusing to discuss broad monetary measures like M3 and the manipulation of common Consumer Price Index number with simply outrageous assumptions and changes.
This meets and exceeds 'no-brainer' status because not only is oil increasing in price in US dollars, but so too are almost all commodities. We also wonder if a sustained distortion of inflation statistics does not in fact mimic artificial wage and price controls, ultimately leading to supply shocks and shortages?
You can usually tell when an 'expert' doesn't know, does not wish to say, or does not wish to admit an error because they tend to retreat into equations and technical jargon. Trust us on this one. In this case, economists are badly failing to fulfill their role in society, as is the broad news media. The reasons for this are also a good topic for another day's discussion
