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Personal correspondence with Phil regarding how oil speculation affects oil prices.

Personal correspondence with Phil regarding how oil speculation affects oil prices.

Man moving drums in warehouse with forklift

Phil to Ilene:

This is a complicated issue as it’s not just the act of creating a contract.

Let’s say there are 100,000 barrels of oil in the world and 10 are sold each day and they are shipped from various places in various amounts but generally there are, at any given time, 30 days of oil at sea (300 barrels).  If I am taking straight delivery, I would contract with the producers to deliver me 1 barrel of oil per day for a year or 5 years or whatever for $50 a barrel.  My interest is to have a steady supply and the producers interest is to have a steady demand.  He wants to charge as much as possible, I want to pay as little as possible.

Enter the speculators.  Rather than me (the actual user) haggling with the producer directly (as is done in most business transactions), the speculator steps in and offers to buy as much oil as the guy can produce for $40.  I can’t do that because I only need one barrel a day but if the guy can make 1.3 or 1.6 barrels a day or he can add a new pump and make 2 barrels a day, knowing he has a buyer at $40, he will be thrilled (assuming the profits work selling 2Bpd at $80 vs 1Bpd at $50).
In a perfect world, the speculator is simply taking on some risk and will make the difference between the $40 they are paying and the $50 I am willing to pay and they will sell the excess for $40-50 and make a nice overall profit.

But then the speculators get greedy.  They know I NEED 1 barrel per day and perhaps there was some seasonality to pricing or natural fluctuation but all the speculator has to do is wait for the price to rise and then hold it there.  If supply is uneven, they can divert some to storage.  They are still buying it, creating demand but they are not delivering it so there is suddenly a “shortage” where none existed before.   As they accumulate more barrels in storage (say 100) they realize that getting the price up to $60 makes them not only $10 a day more per barrel they sell me, but it increases their “wealth” by 20% as the 100 barrels they have in storage are now valued at $60 – even though they are actually unwanted barrels that have been manipulated out of circulation.

Given this situation, it is always in the interest of the speculator to encourage demand, even when supply will fall behind.  They can encourage highways to be built, block public transportation, fund the use of plastics for everything, get government to stockpile oil, discourage clean air laws and block alternative energy legislation and encourage auto companies to make gas guzzling cars and extend credit to anyone who wants to buy a cargo truck to take the kids to the grocery store.

It is also in the interest of the speculators to curtail supply, which also boosts the value of what they have.  They can do this by teaching the producers to form a cartel to control prices, they can downgrade refiners and get clean air legislation passed so none can be built, they can refuse to lend money for oil exploration or give money to groups who are against drilling or use their PR departments to vilify governments who are able to supply oil but are not under their thumb.  They may even start a war or two to destroy existing supplies and knock out competitors’ competing operations.

Another fun thing speculators can do is to get other people to speculate.  Once you get more and more people speculating (and ETFs are great for this) then more and more product is pulled off the free market and into the hands of speculators, who end up hoarding something they actually have no use for, except as an investment.  You can goose speculation all kinds of ways – by making people think they can get rich, by making up stories of shortages, by manipulating price spikes – you name it.

On top of all that, you can manipulate the contracts on the “free” market.  All you have to do is get a friend (me) to agree to jack up the price with you.  You and I have 100 barrels of oil in storage and another 30 barrels in ships on the way and contracts for more years at $40 a barrel (say 750 barrels).  We have a few stories printed in the news about peak oil and demand and whatever nonsense and then I offer a barrel (1 of 10 sold that day) for $61 on the open market and you buy it.  Then you offer a barrel (10% of a normal day’s trading) at $62 and I buy it.  Then I offer the barrel for $63 and you buy it and then you offer the barrel for $64 and I buy it.  What has happened?  You and I have spiked the volume of trading by 40% for the day and ramped the price up 6.5% by trading the same barrel back and forth 4 times.

You paid $61, I paid $62 (+1 to you), you pay $63 (+1 to you) and I pay $64 (+1 to you) so the whole scam costs me $1 but we have raised the “value” of our 800 barrels of oil by $4 ($3,200), not a bad ROI for a day’s work.

So that’s the short version of how it works.  It’s kind of like the 4 blind men who feel an elephant and each guy thinks it’s something else because the part he’s feeling is so different from the others – unless you step back and get the whole picture, it’s hard to make sense of it but once you do get the big picture, the parts become obvious….

See also: Goldman’s Global Oil Scam Passes the 50 Madoff Mark!

 


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