The arbitrageur of last resort

If you think $135 oil is a speculative bubble, that the only basis for current prices is want of a pin, here’s a plan. If you’re right, there’s a market failure. Those with access to physical oil are accommodating the bubble for some reason, when they could, should in theory, sell forward in quantity and insist upon delivery, forcing speculators who cannot accept physical oil to close their positions at desperation prices. Note you don’t have to overwhelm all the specs. Prices are set at the margin. You just have to sell with intent to deliver contracts representing somewhat more than demand for actual delivery to force oil off a cliff and crush the specs like bugs. If private arbitrageurs won’t do this — perhaps those who can, don’t, because they benefit more from high headline oil prices than they lose from foregoing a one-time arb &mdash then perhaps government should step in.

The US Strategic Petroleum Reserve could sell $135 oil forward in very large quantities, and refuse to close its contracts prior to delivery.

If you are right, and oil is an ordinary speculative bubble, then prices will fall sharply, and the petroleum reserve will be able to recover all the oil it sold cheaply, turning a profit for taxpayers.

But, if you are wrong, and oil prices are due to either current fundamentals or informed speculation on future supply and demand, then players interested in consuming or storing the product will step in as prices begin to fall and start buying. Prices would fall a little, but the drop would be transient, and the petroleum reserve would take a loss when it eventually repurchases to replenish.

It’d be a gamble. But if you think this is a bubble, a quick Federal pricking would be far less damaging public policy than curtailing unleveraged speculation. If you’re not so sure it’s a bubble, if you think it’s possible that current or future supply and demand justify current prices, then you should definitely not be banning speculators, who are doing the good work dissuading us from squandering what is precious. If you think current prices are a monetary phenomenon, that selling oil forward trades a valuable commodity for depreciating paper, then you don’t think this is a bubble at all, and limiting speculation is just a way of preventing would-be speculators from evading an inflation tax and spreading disquieting news.

I don’t know whether current oil prices a speculative bubble or not. Maybe, maybe not. Maybe the best way to find out is with the help of a nice long pin.


45 Responses to “The arbitrageur of last resort”

  1. Ha. Awesome post.

    I know markets are forward looking and all that, but I don’t understand how the “fundamentals” justify the move we’ve seen in the past couple months. Is Chinese and Indian demand so much greater today than it was six months ago? Is the Middle East suddenly less stable than it was one year ago, five years ago, thirty years ago? Have we reached “peak” oil and now face, today, the prospect of such rapidly diminishing supply that oil prices move like NASDAQ stocks circa 98-00?

    I don’t doubt there will be greater demand for oil from a greater number of people in the future. I do think the market price will be reasonable, though, because if it reaches 12 dollars a barrel, or whatever, people will adjust. Dramatically. As they always do.

    Shorting oil is the right trade. The problem is that it could go to 200 before crashing back down to 70. And who needs that aggravation? Ask Julian Robertson of Tiger what it’s like to short a bubble a couple years too early.

  2. 12 dollars a gallon for gas, I mean, which is what one “expert” claimed we could see. NASDAQ 6000, baby.

  3. Alessandro writes:

    Clear thinking as always! How can the main stream media get this whole speculators/bubble thing so wrong?

    Speculators in general are not the problem. The problem is either real supply/demand, or dumb speculators placing misguided bets without doing proper research.

    In the first case higher prices are the correct market outcome, in the second case the fools and their money will be parted eventually.

    Housing was not different. And the real problem is the moral hazard of gov’t trying to bailout the fools.

  4. Harald Korneliussen writes:

    Melancholy Korean: “I don’t understand how the “fundamentals” justify the move we’ve seen in the past couple months.”

    I think it’s not so much the fundamentals changing, but a psychological shift to accepting them. I’ve followed a peak oil website for some time now (the Oil Drum). They generally believe in an all-liquids peak in 2010, and have said so for the last three years. Many people there put their money where their mouths were, and they have actually made significant money. Again and again “reputable” analysts like Daniel Yergin have predicted that prices would fall, and again and again they have been wrong. I think the “plenty of oil, we just need to drill more” people have finally lost confidence.

    As far as I can see, we are now technically past peak oil anyway. It’s only other liquids that keep production in a sort of plateau, and many of these liquids are less energy-dense than crude. It could be that SA has a lot of spare capacity, of course, but if they do, and are not using it, that means they have adopted a whole new geopolitical strategy.

    But by all means, Steve’s trick would be awesome.

  5. anon writes:

    I’d be interested in a detailed response to MK’s point –

    ” I don’t understand how the “fundamentals” justify the move we’ve seen in the past couple months.”

    If its not speculation, why has the demand curve shifted so dramatically in the relatively short time frame of the past 6 months? An extra 2 billion people didn’t suddenly start driving cars in this short time frame. The fundamental explanations typically offered don’t explain the time dimension disconnect.

  6. br writes:

    With due resepct to the group, I think the discussion gets distracted by the freight that use of the word “speculation” seems to carry.

    “Monetary phenomenon” is somehwat a better fit to the facts, but phyiscal realities about the location of oil deposits, the requisites for extraction in resources and time contribute substantially, as does an existing built-out economic structure littered with SUVs and jet airplanes and energy intensive methods to achieve “productivity” (e.g very centralized manufacturing and lotsa shipping), and countries building (China) doing so similarly enough to represent huge prospective demand, and, what is, frankly, psychology and perceptions of security and propriety and what can be changed and what we couldn’t possibly figure out to do differently — even if there is an obvious differently to be done.

    It is a soup — the flavor is in all the ingredients.

    So…… suppose the government sells 135 dollar oil forward — tries to flood/drown the market, get it to “behave” down into the 60-70 buck a barrel range. There is every prospect that…

    1. The “market” will conclude that any conservation really is politcally impossible, and will anticipate the fullness of demand from now until forever and will continue to price accordingly.

    2. Somebody(bodies) else will just say “that’s nice” and transfer to their own “Strategic Petroleum Reserve” knowing pretty much how much they will have to suck up and what it will take to manage the matter. Steve says it happens at the margins. There you go. (Argument that something like this has been done once by Asia w/ steel)

    3. Further big financial bets will be made against the government becuase… well, what has it just done: traded oil that is useful for creating heat and motion for US dollars that are actually only marginally useful and of which there is a copious (not easily reducible) supply and which get created in increase every time sounds of whimpering are heard from a building downtown.

    Etc. This doesn’t mean that we don’t have a notable economic problem and that prices that should track value and suitably guide resource alloction haven’t. That they’ve been doing unhelpful things, over-encouraging some activities and under-encouraging (over-valuing and under-valuing, use what words work for you that recognize that the system isn’t performing especially well and oil price changes — yesterday we were throwing it around and today we are desperate — what can’t we figure out?) That we have too much loose money and not enough real liquidity (in the James Grant sense of the term liquidity, all bills are covered). If there is a lesson, it is not so much about “speculation” as about the unhappy things that excess money tends to get up to. Krugman was opinioning the other day about how ain’t real inflation becuase we don’t have a “wage-price spiral”. Okay, we’ve got a “price-price sprial.” Why should that make a person so jolly?

  7. Benign Brodwicz writes:

    Oil price will come back down when the Idiotic Central Bankers (ICBs) of the world unite to fight “wage-price spiral inflation,” and all that “liquidity” (debt) currently chasing real assets deflates like it is doing in Real Estate in many countries… but the Fed will not let the Investment Banks suffer illiquidity, oh no. The best play is Volatility, I’d guess, over the next several years.

  8. I agree with anon &MK. Oil is going to get more [200-300%] expensive over the next 10 years. If the $’s fall is doing it, then all commodities should rise at the same rate, but oils broken out from that.

    I don’t think the falling dollar would invalidate Steve’s trick. Just short oil, and go long a basket of other commodities &currencies.

  9. Fullcarry writes:

    I don’t understand why people resist the simplest explanation. Those who have the Oil to extract and swap for dollars already have too many dollars that are losing value. They have no incentive to extract and sell more Oil for dollars. It is just that simple.

    The solution to getting Oil prices down is to make buying and swapping for dollars more profitable, ie raise rates.

  10. Anon writes:

    Take away the alphabet soup from the primary crooks err.. dealers and watch oil fundamentals return to normal.

  11. An idea from Turkey writes:

    We know that the senate will approve nuclear car motors in the begining of 2009. This oil bubble is to sell in future markets. However the world is suffering with high commodity prices specially food. The prices are going higher with oil price. In Turkey the bond interest rate is today 22% annual for lenders. But the physical econmy collapsed. There is no money in circulation and the government is cheating with inflation. Producers are also suffering. Agro products are too expensive cause of high cost of fertilizing and irrigation. Draught is an additive to the prices as well. We dont know what to do now. The real problem is hunger here. Not head scarves or secular politics. Please wake up.70 million people is starving.

  12. Nemo writes:

    Hi, Steve. Why even bother with the futures? Just announce your intention to sell at the futures price (or better) when it ultimately expires. Then one of two things will happen:

    a) The contract settles above the original futures price. Thus you make more money than if you had sold the futures contract.


    b) The contract settles below the original futures price. Congratulations! You pricked the “bubble” without selling a single barrel.

    Either way, you are strictly better off than if you had entered into the futures contract…

    If your primary goal is to prick a (hypothetical) bubble, and your secondary goal is to do so at a minimal loss, then there is no advantage to using futures; simply sell into the spot market.

    I have to admit, I find this idea oddly compelling. We have spent decades building up the SPR at very low prices; now perhaps we should use it to ease our transition into a post-petroleum world…

    Just a thought.

  13. SW:

    I ignore what the nitwits in Congress say. Look at: rice, wheat, soybeans, copper, lead, zinc, iron ore, etc. All in “bull markets”. Why? These are manifestations of the bear market in dollars. If Congress wants oil to fall, tell Helicopter Ben: stop the printing press. Stop buying Wall Street paper. No more JPMorgan bailouts, etc.

    Your “short plan” might depress oil for a few days, nothing more.

    I agree with Fullcarry and have said so at my blog. Would you rather have oil in the ground, or 30-year Treasury paper yielding 4.71%?

  14. anon writes:

    “Oil in the ground” doesn’t explain it.

    There hasn’t been a material decline in production in the past six months. Why should prices double?

  15. anon writes:

    The dollar also doesn’t explain it.

    Both the Euro price of oil and the real price of oil in dollars are up substantially.

  16. anon writes:

    And the Fed isn’t printing money.

    The monetary base has been stagnant for several years.

  17. zerobeta writes:

    I like the idea. It’s very interesting, but I still think we should just let the bubble run its course. Even if it triples from here, only good would come out of it anyways – albeit a whole lot of pain on the way up. The only sustainable thing that would bring down the price of oil would be a viable alternative.

  18. Fullcarry writes:

    anon 3:00

    Prices are set at the margin. Norway, Saudi Arabia and most Oil producers are swimming in dollars. They have zero incentive to start exploration programs right now to produce more Oil.

    Also the FED isn’t printing money but real rates are negative because overnight rates are being pegged at 2%. So what is the incentive to own dollars? The huge trade and current account deficits? The looming over the top budget deficits? Or is it the wonderfully transparent banking sector?

    You are fooling yourself if you think this is about Oil. Its about the Dollar and all the other paper currencies formally and informally pegged to it.

  19. anon writes:

    Let me get this straight:

    Oil prices are set at the margin … but its not about oil … and oil has increased in price by 100 % in 6 months because the Fed has reduced annual interest rates by 3.25 % …

    O.K. Seems reasonable.

  20. Fullcarry writes:


    If only the real world were linear. Things don’t break until they break and then its very hard to put back together. I think the world has reached that break point. Demand for dollars is collapsing. I understand the speed of this change has you perplexed but there were also many years of dollar abuse by the FED without any consequence. We could very well now be paying the price even if the FED started acting responsibly.

  21. anon writes:

    I’m perplexed mostly by why you think the collapsing dollar has driven up the Euro price of oil.

    Oh, right. Non-linear.

  22. Anon:

    All paper currencies are suspect. The dollar right now is weaker than the euro. Vietnam just devalued the dong. The paper currency “price”, in all paper currencies, of real assets is rising as too many currency units are being created and have been created. Vietnam’s current inflation rate is 25.2%!


    You are correct, there are “discontinuities” in the price functions. We apparently had one in August. If the Fed isn’t printing money, explain negative real interest rates? According to, M3 is growing 17% a year. I’ll take shadowstats numbers over Helicopter Ben’s any day.

  23. Anon:

    All paper currencies are suspect. The dollar right now is weaker than the euro. Vietnam just devalued the dong. The paper currency “price”, in all paper currencies, of real assets is rising as too many currency units are being created and have been created. Vietnam’s current inflation rate is 25.2%!


    You are correct, there are “discontinuities” in the price functions. We apparently had one in August. If the Fed isn’t printing money, explain negative real interest rates? According to, M3 is growing 17% a year. I’ll take shadowstats numbers over Helicopter Ben’s any day.

  24. Harald Korneliussen writes:

    Fullcarry: Speaking from Norway here, we are opening up for drilling in some areas that were previously off limits due to low value and ecological dangers (Barents sea and Lofoten, very good fisheries). The notion that politicians should not want to stuff as much as possible into the oil pensions fund is ridiculous. And exploration here (or SA!) would be only slightly more useful than exploring Manhattan to search for uncontacted tribes.

    In mature regions such as SA, the USA and North Sea, exploration would cost more than the oil you could hope to find by it.

    I thought markets had woken up to the hard facts, but it looks like there’s a good way to go.

  25. anon writes:


    If all paper currencies are suspect, fine. I’m aware of that. So state the oil problem that way. Don’t state it in terms of the dollar alone. We might have a decent discussion if we acknowledge the facts.

    Speaking of which, the Fed most definitely doesn’t print M3.

    And my doubts remain whether the presumptive thesis is based on the dollar or all currencies. Because I don’t hear an explanation from anybody that hangs together properly.

    But good on you IA to identify a discontinuity correctly (as opposed to a non-linearity).

  26. anon writes:

    Billionaire investor George Soros and Stephen Schork, president of Schork Group Inc., say oil is ready to tumble because prices aren’t justified by supply and demand.

    “There’s nothing different between this mania, the dot-com mania, the real estate mania, the Dow Jones mania of the 1920s, the South Sea bubble and the Dutch tulip-bulb mania,” said Schork, whose Villanova, Pennsylvania-based firm advises the Organization of Petroleum Exporting Countries, Wall Street firms and oil companies on the outlook for energy prices. “History repeats itself over and over and over again.”

  27. groucho writes:

    Follow the money….follow GS. Nature is lazy….wall st is lazier.

    The new wall st model is “originate to repo”. The liquidity is coming from the TAF in the US and the ECB’s LTRO.

    Of course, this liquidity is not going back into CDO’s. For now commodities is the lazy man’s way to riches. IF(a BIG if), the FED cuts off the primary dealers in September, bye bye oil bubble.

  28. Steve,

    I don’t think the forcing the delivery of the physical oil thing really matters.

    For example, suppose I own huge depots of actual physical oil? I have 100 million barrels stored in my depot. And, I decide to follow your plan, and sell all 100 million barrels forward 1 month in the future, for $140/barrel, with a contract that says I can force the buyer to take physical delivery of my oil.

    A month later, let’s suppose that the current price (called the spot price, for lay-readers, because it’s the price you have to if you want to buy the oil right now, “on the spot”) is only $135/barrel. In that case, the speculator who signed (or agreed to on his PCs) the forward contracts a month ago to buy the oil for $140 is in bad shape. Because due to the forward contract they agreed to, they are now legally required to buy 100 million barrels of oil from me at a price of $140, even though the current market price is only $135.

    Normally, I wouldn’t force them to actually buy the oil and take delivery of all 100 million barrels at $140, and then just buy back the 100 million barrels in the current market for only $135 (making $5/barrel, for a total profit of $500 million).

    It would be a waste of time and transportation costs to empty my depots and then just fill them up again. I’d just let the speculator pay me $5 for each of the 100 million barrels he agreed to buy at a price $5 less than the current market price.

    One might ask, what if I just left my depot empty? Why might I not chooes to do that? Well, why build a depot in the first place if you’re going to just leave it empty. You built it because you could profit from using it.

    One way is that you can use a depot to act as an oil wholesaler, who serves the purpose of keeping an inventory handy to make sure that if demand for oil-using goods is higher than expected, the production will be able to ramp up and not grind to a halt because the inventory of the oil input ran out. And now the producer has to wait idly until more arrives from across the ocean.

    Another reason I don’t want my oil depot to be empty is that if it’s full, or mostly full, I have oil to sell to different producers in relatively small regular quantities, and I make transactions fees off of those sales. If the depots are empty, I make no transaction fees, plus, when my regular customers called for delivery’s, I’d have to tell them I’m empty, disrupting their operations. This would make me look unreliable and problematic, so I might lose some of my regular customers.

    Thus, I don’t want my depots to sit empty, so if I did force the buyer in the forward contract to actually take all of my 100 million barrels of oil, I’d just have to buy 100 million barrels back again, and I’d have to pay transactions and transport costs on top of it. Why would I incur those large and unnecessary costs? Normally, I wouldn’t. And that’s why these forward contracts never involve physical delivery (unless you aren’t just speculating, you actually really need the oil for production or retail sales at gas stations, etc.) .

    But suppose I want to try Steve Waldman’s test, and I do actually force delivery. How will this make things different? The speculator is a speculator, not an oil depot owner. Thus, he will have to either: a) sell the oil right away on the spot market, and have it delivered to the new owners, or b) pay some depot owner to store it for him.

    Suppose he does a. He sells the 100 million barrels on the spot market. All other things equal, that would push the current (or spot) price of oil down. But, if I, the depot owner, then have to, at the same time, buy 100 million barrels to refill my depot, then that would completely negate it. And requiring physical delivery would have no effect on the price of oil (although it would waste a lot of money on useless transportation of oil).

    Next suppose the speculator does b. He hires a depot owner to store his 100 million barrels.

    But what if all of the depots are full? Well, in a well functioning economy, all of the depots, normally won’t be full.

    Suppose they were? Depots are important because supply of oil and demand for oil aren’t totally stable and predictable. If weather is good tanker ships of oil would arrive early and they would want to dump off more oil than is normal at that time. If all of the depots were full, there’s a problem, and tanker owners would be willing to pay a very high premium to any depot owner who has excess storage space. They don’t want their tankers to have to sit idle waiting for depot space to open up.

    Thus, it’s smart for depot owners to keep a little excess capacity for those situations. Having a little excess capacity is valuable. It allows you to take up slack during unusaully heavy times. In addition, it helps customer loyalty, when regular customers can always depend on you to store their oil.

    So the speculator will be able to find depots to store the 100 million barrels of oil that Steve Waldman forced him to take physical delivery of. But then those depots will be too full, and they will want to sell some on the spot market, in equilibrium, about 100 million barrels. So it’s hard to see how this will affect the price of oil much.

    Now let’s look at what else could happen. Suppose that I, the depot owner who sold forward the 100 million barrels of oil, decide that after I force the speculator to take delivery of my 100 million barrels of oil, I will just leave my depot empty, unutilized. I don’t buy back 100 million barrels of oil in the spot market, because I really want to try to force down the price of oil. If I do this, then every day I lose fees for the use of my depot that I could have charged. It just sits empty, wasted. This is certainly not profit maximizing behavior, so essentially it would never happen.

    But the government is not in business; their goal should be, and despite problems, mostly is, to maximize social welfare. So, if the social cost is not too great, they would like the social benefit of lower oil prices.

    Now suppose they though that it was worth it to sell forward 100 million barrels from their “Strategic Reserve” depots, and not replace them, and force delivery.

    This would push the price of oil down just by increasing net supply, but it would have nothing to do with speculation, and it would work essentially just as well if they just sold it today on the spot market, as if they sold it forward to a speculator and then forced him to take delivery.

    I just don’t see how forcing a speculator to take physical delivery really matters – He sells the X barrels, but then the depot owner who shipped it just buys back X barrels so that his depot doesn’t get too empty, so that he can’t satisfy his customers and charge fees.

    Requiring physical oil delivery just shifts oil around. It just shifts the oil to different depots, but it doesn’t affect the total supply, and so it doesn’t affect the price. It just wastes a lot of money unnecessarily transporting around oil from depot to depot.

    Again, if there is speculation, there must be hoarding, withholding supply from the market to drive up price. And that would mean a rise in inventories, but a very trusty source, Princeton’s Paul Krugman, says he can find no excessive inventories, and he’s challenged others to prove it to him if there are.

  29. Speculation in the futures market on the price of oil (without hoarding) is just betting (although it can normally be used to hedge risk and as a nice forecast of what the future price will be.).

    100 million Americans can each place bets of $1,000 on what the price of oil will be in a month. And a month later they will see the price of oil and 100 billion dollars will change hands between the winners and losers, but this will happen independently of the market price of oil. That price will depend only on the supply of oil to sell and the net demand for oil to take delivery of and actually use, or put in storage — and there appears to be no excessively high amount of oil in storage.

  30. Another reason why forcing a speculator to accept physical delivery wouldn’t really matter is this:

    Suppose a speculator agreed to buy 100 million barrels of oil one month from now in a forward contract. And you forced him to take delivery of the oil, rather than just paying/getting the difference between the forward contract price and the actual price that ends up one month later.

    You seem to be assuming that the speculator because he’s not an oil industrialist will just sell all 100 million barrels right away, pushing the current price down (maybe way down if it’s bubbled up).

    But the speculator doesn’t have to sell the 100 million barrels just because you forced him to take delivery. He could just arrange to have it stored at a depot, and he could sell it in small amounts over time. This is like what wealthy individuals and organizations often do when they want to sell a large amount of a companies stock.

    Bill gates wouldn’t just sell 100 million shares of Microsoft all at once. The market wouldn’t be liquid enough to absorb it all at once and the price would drop substantially. Instead, he would sell it in relatively small chunks over time.

  31. Richard — That’s a lot, but I think you are missing some things.

    1) The bluff-calling depot owner, in this case the SPR, has stocks much, much larger than would be required to force specs to take delivery. The depot-owner does not face a convenience yield opportunity cost for having an empty depot.

    2) The speculators cannot arrange to take delivery themselves. They are not permitted to by the exchange. They have to persuade some other party to relieve them of their obligation to accept delivery, whatever the price. It’s an empirical question how much that will cost them. It depends what people with tanks are actually willing to pay to bear the risk of holding large quantities of oil. If, as Krugman suggests (and I don’t necessarily disagree, this is a test), there is little oil currently stored but a great deal of storage capacity, and those in the industry believe oil not to be overvalued, then the specs would be able to find people of relieve them of their obligation. However, if storage capacity is dear or those in the industry unwilling to bear the risk of holding, then they’d have to pay a large price. You suggest that they could rent storage, that is find a third party to accept on their behalf while the risk of ownership would remain with the specs. These would have to be off-exchange agreements, and the oil storers would face counterparty risk, so storage would be expensive for the specs.

    3) If you buy the prevailing (Michael Masters) speculation story, the specs are dunb financial intermediaries, not strategic players with the capacity to actively and creatively seek solutions to a sudden problem. They have a bunc of CFA types in an office buying and selling futures and treasuries, and no expertise or connections with the actual physical mandate. Their funds are chartered to trade futures, not physical commodities. As an organization and legal matter, they’d not be able to scour the planet for idle tankers and storage facilities and arrange trucks and pipelines to manage the delivery of physical oil. It is simply beyond their capacity.

    4) The whole point is that oil and other commodities are very different from Microsoft stock or other financial assets. In a textbook, there is always slack storage and stored commodity, logistical details don’t exist. But force delivery of millions of barrels of crude, and textbook simplifications will fall apart. There have been times and places where natural gas prices have gone negative, where for logistical considerations unsold gas had to be burned off for lack of storage capacity given the physical realities of production. If the SPR were to force delivery of a very large quantity of physical oil, I think it very unlikely that prices wouldn’t spike downward sharply. Some players would simply be caught with their pants down. The only way this wouldn’t happen is if other, more knowledgable and capable players compete to purchase the oil. Which might happen, in which case Krugman’s thesis would be borne out, and we will know that this is not a bubble at all, but something else, whether a loss of confidence in dollars, an informed increase in people’s valuation of oil, or very tight physical supply. I’m not claiming this would burst the bubble if there is no bubble to be burst. But if it is a speculative bubble, it’s have a pretty good shot of taking it down. So this would be a nice test.

  32. Steve,

    But why would a speculator sign a contract that forced him to take posession of the oil?

    Wouldn’t he at least want details in the contract like, if he has to take posession of the oil, he will have the option of letting the oil will stay in it’s current depot, with a guaranteed the right to rent the depot space for the fair market rate?

    I’m sure it’s true that a lot of speculators don’t know much about oil, or even futures contracts, but after decades of such contracts, wouldn’t the standard one have evolved to cover these things in response to people getting into pickles in the past?

  33. Richard — Nobody signs a contract. They just buy standardized futures on exchanges, and presume there will always be liquidity. To ask why is like to ask why banks offer demand deposits against far more cash than they keep, when there is the possibility (and occasional historical fact) of getting into a pickle that way. Usually it works out, so people do it, but sometimes people get reminded that not ensuring you can keep all the promises you make can get you into trouble. Perhaps that’s useful. (Note that banks overpromised and got into pickles long before they included Fed liquidity support as an implicit option in their contracting.)

    If you believe Michael Masters and the congressional critics he has “informed” (and again, I don’t, but if that’s the working hypothesis let’s test it), then price rises are being driven by paper speculators in public futures markets who cannot take delivery but maintain huge open positions. My suggestion amounts to staging a run on this “paper oil bank”, explicitly to hurt the players Masters suggests are distorting the market. If they’re there and driving prices like he says, they’ll hurt and hurt bad. If there’s plenty of interest in physical oil at these prices (more per Krugman), than commercial players will buy up the bear-raid oil, prices won’t much move, and specs will be fine. It’s a test.

    Anyway, it’s a weird world, huh? I do it too, by the way. I buy and sell futures on which I cannot deliver, under which there will be a foreseeable margin call near expiration such that I may have to liquidate at a bad moment. Normally this isn’t a problem, because you roll forward in liquid and well arbitraged futures markets. If you are selling low to escape today’s prices you are buying forward at the same low price plus interest and cost of storage. But if there were a flood of physical delivery in an expiring contract, the roll might be expensive (the expiring contract price might fall faster than next futures prices). Moreover, the price of the whole curve would spike south, testing the stomach of those who think oil is a one way bet. The tale would be told by whether the downspike is short lived. If speculators really believe in these valuations, they can hold through the turbulence, maybe taking a hit on the roll, but they’ll mostly recover. If people run for the hills, well, then bubble popped.

  34. groucho writes:

    @ the G-8. Note Paulson only one saying real supply/demand @ play(just like housing)

    “There were disagreements over what’s driving the surge in commodity prices. Lagarde and Russian Finance Minister Alexei Kudrin argued investors are buying oil and food as a hedge against the dollar’s drop. Paulson downplayed the link by noting oil’s gain outpaced the dollar’s decline since 2002.

    Oil Output

    The U.S. Treasury secretary also refused to blame speculators for higher prices, saying “all the evidence” points to tight supply and robust demand.

  35. groucho — “nothing to see here… move right along…”

  36. Steve,

    I did some research on physical delivery rules for forward contracts. The delivery rules seem to be firmly standardized, and not at the discretion of the seller to, say, demand physical delivery of the oil to the speculator buyer’s home!

    Ok, what did I find: John C. Hull of The University of Toronto writes some of the most popular undergraduate and Ph.D. books on derivatives. On page 31 of his book, “Introduction to Futures and Options Markets”, 3rd edition, 1998, he writes, “In the case of a commodity, taking delivery usually means accepting a warehouse receipt in return for immediate payment. The party taking delivery is then responsible for all warehousing costs.”.

    On pages 17-18, Hull implies that the futures contracts (which are all standardized, as opposed to forward contracts which can be customized, but are for larger and presumably sophisticated participants) give the option to the buyer to just pay his losses or accept his gains, and not accept delivery. So to force delivery, it looks like you would have to change longstanding exchange conventions, obviously not likely.

    The full NYMEX rules for Light “Sweet” Crude Oil Futures Contracts include at the buyers option delivery, “By in-tank transfer of title to the buyer without physical movement of product; if the facility used by the seller allows such transfer, or by in-line transfer or book-out if the seller agrees to such transfer.”. So a speculator buyer doesn’t have to be sophisticated about delivery and storage. He can just have the oil kept where it’s at and sell it slowly without dumping it.

    What about pricking a bubble (if there is one) by the government dumping oil on the market from its strategic reserve? I recall the government making sales before to try to prick prices and it never working.

    A general issue is that historically bubbles don’t prick from a single event. It’s sustained action or bad news that changes the psychology. A U.S. government sale of oil from the strategic reserve would be thought of as a very temporary blip. Even if the government kept it up for a week, there’s still a question of how large the reserve is and their staying power.

    Yale economist Robert Shiller discusses how bubbles deflate slowly in his outstanding book, “Irrational Exuberance”, 3rd edition. A quote:

    Despite the suggestion inherent in the phrase speculative bubble that there may be a dramatic burst-a stock market crash-speculative bubbles and their associated new era thinking do not end definitively with a sudden, final crash…People today remember the stock market crash of 1929 as occurring in one or two days. In fact, after that crash, the market recovered almost all of its lost ground by early 1930. The significance of 1929 is not the one day drops in October, but the fact that that year marked the beginning of the end: The beginning of the three year period that reversed much of the stock market gains of the 1920s.

    Sorry to be so disagreeable here. I really do like your blog a lot, although you may not hear so much from me in the future. My main motivation for starting blogging was to learn more about it to help in building and promoting a personal finance website for the University of Arizona and the state of Arizona. Now I’ve learned the basics, and am starting to get pretty busy also.

  37. Richard — The conditions of delivery are absolutely standardized! And you absolutely can force delivery! Forcing delivery is the default. If you sell a futures contract and do not close your position prior to expiration, someone is required to accept delivery!

    Different futures contracts may include different sorts of options that constitute acceptable delivery. As you suggest, for any given contract, there may or may not be some provision for temporary warehousing to ease transactional frictions associated with delivery. Note that in the NY light sweet crude contract you describe, “in tank transfer of title without physical movement of the product” is not solely the buyer’s option. It requires that the seller cooperation (by virtue of the seller’s choice of a facility that provides for that). Buyers absolutely cannot rely upon having that option, and especially cannot rely on having that option in a cost effective way (facilities will charge storage costs, and temporary transactional storage won’t be cheap). Speculative buyers, unless they have explicitly planned for taking an operational role, absolutely cannot “just have the oil kept where it’s at and sell it slowly without dumping it”. These storage facilities aren’t gas stations. A spec who tried to call somebody’s bluff and take the oil this way would get killed, by storage costs in the best case, by an insistence that they find someone to take the oil in the worst.

    Of course, this could never happen, because all trades are made via an exchange’s clearing member, and traders will not be permitted by the clearing member, which is liable for its client’s obligations to the exchange to make or take delivery unless the client has demonstrated an operational capacity to do so. In the history of the planet, I’d challenge you to find one instance of a pension fund, commodity ETF or retail mutual fund that has ever accepted delivery on a commodity position.

    Going forward, this is likely to change, a bit. Given the commodity boom, some sophisticated financial players are going operational. I would not be surprised to hear that commodity hedge funds have already strengthened their bargaining positions by making operational contingencies to make or take delivery on their positions. There are rumors of Wall Street firms buying oil storage facilities these days, and I’d not be at all surprised if those were true. But the current physical capacity available to miscellaneous investment funds to make and take delivery, storage and transport capacity, is nowhere near what would be necessary for specs to accept delivery. If speculators seriously want to hold oil because they are certain prices will rise, they will ride out downspikes and respond to getting forced out by hedging with physical storage capacity. They’d have to bear higher transaction and storage costs, and commit to a longer term of investment, to make this worthwhile. If that’s what they want to do, more power to them, that implies that the collective judgement of the investment community really is that oil is underpriced, and we should shift some of today’s supply to tomorrow. Remember, nonmomentum speculation is a good thing. But players riding a bubble or trend without a firm conviction that the market is underpricing present and near future oil relative to long future oil won’t have the stomach to start operational oil storage firms. My suggestion above is a test, only a test. There ain’t nothing wrong with speculation, if it’s driven by informed independent judgements of the investment community, and not an unreliable information cascade or thoughtless extrapolation.

    BTW, there ain’t nuthin’ wrong with being disagreeable. It’s called arguing, and it’s fun, as long we’re disagreeable politely. It’s been fun having you around, and you’re always welcome, time permitting.

  38. Oh, also.

    I want to add that, if the gov’t were to try this, it absolutely would be crucial that the oil sales be made forward, via standardized futures contracts, and not on the spot market.

    The point is to insist that speculators live up to contracts on which, in aggregate, they cannot perform. That’ll force futures prices down very sharply with great certainty. Spot sales would naturally be limited by the storage and transport capacity of those willing to take. No one would be caught with their pants down, which defeats the purpose of the exercise. If SPR starts selling spot rather than future, that will do nothing more than harm taxpayers, who probably paid a high “ask” price filling up the SPR and would end up selling for a low bid, made lower by SPR’s own selling. Spot markets are fragmented and opaque, and without futures positions in place ask a backstop for leverage, a large-quantity seller is likely to just get raped.

  39. Oh yet again… To answer my own challenge, I’d not be at all surprised to hear that retail ETFs that are in fact physical storage companies, like GLD or SLV sometimes buy via futures markets and take delivery. I’m referring to funds that generally synthesize a commodity position via financial futures (which account for the vast majority of commodity fund positions outside of precious metals), not tradable storage companies like GLD.

  40. Steve,

    There’s still a lot of this that I don’t see.

    1) The NYMEX rules, under 200.14, Part B, state “At buyer’s option, such delivery shall be made by any of the following methods:” and the second method, which can be chosen at the buyer’s option is “By in-tank transfer of title to the buyer without physical movement of product; if the facility used by the seller allows such transfer, or by in-line transfer or book-out if the seller agrees to such transfer.”.

    So the buyer appears to have the option of just leaving the oil in storage where it is. If the speculator buyer left it in storage for just a few weeks, releasing it slowly on the market, I don’t think the storage costs would be that high. If storage depots were that expensive (per barrel), I don’t think the economy would have produced so many of them.

    2) It still appears that you can’t really force speculator buyers to take delivery anyway. You said yourself they have the right to close out their positions before the delivery date (To the less expert readers, closing out means just taking the opposite position, so for example if the speculator has a futures contract to buy 1 million barrels of oil on August 1st, 2008, he just buys a contract to sell 1 million barrels on that same date, and the whole thing is finished. He doesn’t have to deliver or accept any oil.).

    Hull notes the details of this in his text, “Introduction to Futures and Options Markets”, 3rd edition, on page 31.

    There are three critical days for a contract. These are the first notice day, the last notice day, and the last trading day. The first notice day is the first day on which a notice of intention to make delivery can be submitted to the exchange. The last notice day is the last such day. The last trading day is generally a few days before the last notice day. To avoid the risk of having to take delivery, an investor with a long position should close out his or her contracts prior to the first notice day.

    Of course, the speculator buyers might not be paying attention, or not be concerned, and miss the deadline to close out, and perhaps be caught having to take delivery, but this is unlikely to be a mistake they’ll make again. So, it appears this would just be thought of as a temporary blip, and wouldn’t burst the psychology of a bubble, a la the arguments of Shiller.

    3) I don’t see how even if you forced them to take delivery this could overwhelm the storage capacity. Suppose it’s like this: There are 10 billion barrels of storage, with 8 billion of it already used up. The specs have contracts to buy 5 billion barrels. One might initially think, oh, they can’t store it all because there’s 8 billion already in storage; if you add another 5 billion to storage that’s 13 billion barrels, and there’s only storage space for 10, so they’ll have to dump the other 3 on the market forcing down the price.

    But the thing is, those 5 billion barrels they buy don’t appear out of thin air. They come from the existing storage of 8 billion. It’s just ownership of that 8 billion barrels in storage changes hands. The storage space won’t get overwhelmed unless more oil starts coming over on tankers, and/or the owners of that oil stop selling it and start hoarding it (the real key to a speculative commodity bubble,) and/or consumption goes down.

    4) If the U.S. government bought heavily on the spot market and was able to drive the price far down, that would still badly hurt the speculators from the futures contracts they bought in the previous month, the previous 3 months, etc.

    If the U.S. government instead went into the futures market and sold huge amounts of oil forward, say 1 month, driving down the forward contract price, they’d still lose a lot of money if the price in a month was still high. They’d only get away ok if there really was a bubble, and this pierced the psychology of it (but again Shiller says with good logic and empirics that it takes sustained action and /or events, that aren’t viewed as temporary, over months at least, to pierce a bubble), or if it thwarted a speculative attract (which is different from a bubble).

    Krugman has a great story in his book, “The Return of Depression Economics” (pages 126-9) of how in Hong Kong in 1998, a group of hedge funds waged a simultaneous speculative attack on both the Hong Kong currency and its stock market. The Hong Kong government unexpectedly fought back by buying up not just its currency, but its stocks, and devastated the speculators!

  41. Richard — “Forcing delivery” in this context means not letting people out of their contracts without their having to take a terrible hit on price. Only a small fraction of futures contracts are delivered, because people ordinarily close out positions. But for every seller (closing a long position) there has to be a buyer, and no one can force a buyer to enter the market to let a seller close. You’re falling for the illusion that you’re supposed to buy into, and that I also fall for as a speculator, that the market is always out there and liquid and so I can always exit my position at a reasonable price. But no one can force a buyer to let me out when I want to get out. If there is a large seller unwilling to do anything but deliver, longs who cannot take delivery will have to close their positions somehow. In order to do so, they will have to be willing to sell at very low prices to whatever buyers are out there who can accept delivery (including potentially the SPR itself, which might set a price beneath which it would forego delivery).

    By the way, no spec “misses” notice days. They are trading through clearing members who will automatically close their positions prior to, because clearing members do not want to be liable for failure to perform on the part of their clients. Only parties who clearing members have deemed capable of making or taking delivery have the option of not closing prior. The risk of “forced delivery” is not that somehow oil will show up at your front door. It’s that you’ll be between a rock and a hard place, having committed to something you cannot perform (collect physical oil), and you’ll take desperate measures (or an intermediary will take desperate measures for you) to close your position. You’ll take a dramatic price cut, when all is said and done, and that is the point.

    If the SPR wanted to, it probably could force an serious crisis on the exchange, whereby the contracts it intends to deliver upon absolutely exceed any party’s capacity to accept delivery, and whereby it refused to close at any price. In that case (and there have been cases where fulfilling futures contracts turned out to be physically undoable), the exchange would intervene and change the rules. But SPF wouldn’t push it so hard, that wouldn’t be the point of the exercise. It would choose a price beneath which it would let those stuck like bugs escape, i.e. it would force delivery rather than accept any price above X, with X very low but not less than zero.

    Your logic about storage is mistaken. It’s true that the aggregate storage in the universe has to be sufficient to accomodate the delivered oil, since it was stored before. But the SPR wouldn’t make its salt domes available to third parties, nor would other facilities that don’t ordinary lease, except at exorbitant prices.

    It is simply not the case that an ordinary speculative long can do what you suggest and store oil to sell off slowly. We can fight it out with boldface if you want: “At buyer’s option, such delivery shall be made by any of the following methods: …By in-tank transfer of title to the buyer without physical movement of product; if the facility used by the seller allows such transfer, or by in-line transfer or book-out if the seller agrees to such transfer.” Those clauses effectively give the seller control over whether mere transfer of title is an option. It’s the buyers option if the seller has set it up that way, which means it’s only really an option by mutual consent. We’d have to look deeply into the array of suitable facilities in Cushing, OK in order to know how likely it is that any given buyer could let the oil sit in storage. Since buyers don’t know who the sellers are (they transact via the exchange), they could not in aggregate rely upon having this option. And even if they could, they’d have to pay for storage, in facilities and at prices intended for transient holding not efficient long-term inventory, facilities that could likely be overwhelmed by the SPR. Again, this is simply not a real option for existing pension funds, mutual funds, and futures-based ETFs. Longer-term, it could be. Commodity funds would evolve the capacity to take oil, if they come to believe that liquidity in futures market sometimes dry up. But it would very much limit speculation if spec funds had to maintain contingency plans to take all or a substantial fraction of the oil they contract for.

    (In practice, I think the exchanges ordinarily try to match counterparties according to mutual convenience at delivery time. That is, under ordinary circumstances, a party who needed oil to sit for few days would find a counterparty capable of enabling that. But the capacity to accomodate that kind of thing is limited, and could be overwhelmed.)

    (Browsing prospectuses, some of the big public ETFs — the entities most likely to evolve to take physical, since they are large and specialized — outline directly how they trade and when they roll, futures only and totally price insensitive. That is, by charter DBO is required to roll on the first 2nd to 6th business day of the month prior to delivery, regardless of price. If there is little buying interest, because a big player has already sold forward to all who might possibly want except at very low prices, DBO would just roll. USO is more flexible in its description of how it invests, but makes no contingency for taking physical oil, mentioning futures and options, potentially traded on foreign as well as domestic exchanges, but not physical storage as an “oil interest”.)

    I agree with you that something known by the market to be a one-time thing would be of limited effectiveness. For this to work, the government would have to do it once (without warning), and then maintain “constructive ambiguity” about the possibility it might do it again. The point would not be to drive down oil prices permanently. Maybe the high prices are the right prices. The point would be to break information cascades with unpredictable sharp downspikes, and to ensure that people speculating on oil are not terribly leveraged but are doing so out of informed conviction, that prices are not just as an emergent feedback effect among traders.

    As you suggest, the outcome of these kinds of games in unpredictable. I don’t know whether a bubble would be popped, or whether China’s petroleum reserve would just take the oil at what it considers to be a good price going forward. If a bubble did pop, the scheme would be profitable for taxpayers, if not it might be costly (although only if prices continue to rise at higher than the risk free interest rate). The point here is to set up a test. If you think that oil prices might be too high, I suggest that this is a far better way of testing that than banning pension funds or ETFs from speculating, which strikes me as both misguided and inequitable.


  42. I would also add, that if the government unloaded a huge amount of oil in the spot market just a couple of days before the end of the settlement date for some futures contracts, they could potentially drive down the spot price and hurt a lot of specs.

    But if the government instead sold a lot of oil on futures contracts, they would push down the current buy price, but that would only hurt specs who wanted to sell their contracts before maturity. The specs who held their contracts to maturity (and seeing the government doing this I would think that the vast majority would), would only pay if the difference between their futures contract price and the spot price at maturity was positive. So they only get hurt if the spot price gets driven down on that settlement day (or just before).

    It doesn’t seem like you are going to really hurt the specs unless you drive down the spot price just before, and on, a settlement day.

    A simultaneous strategy would work, if it wasn’t illegal market manipulation. The government could do this: Sign lots of futures contracts with specs to sell oil in August 08, for the current futures price of about $136. Then, just before the settlement day, August 30th, they could unload a huge quantity of oil on the spot market to try to push the price way below the $136 strike price of the futures contracts they had signed with the specs.

  43. I think it’s hard to play in the spot market, because it is not centralized and less liquid. The ability of buyers to take limits the volume at which you can sell, forcing you to sell low without affecting prices for anyone other than local transactors. Futures specs who cannot take are in a bind in a way that physical purchasers, who may choose to take or not, are not. There are no more specs, in current markets, in the month before settlement day. They’ve all closed and most have rolled forward.

    (That’s overbroad, there may be some people planning to take and store for speculative purposes, but not many. We’re gonna have to agree to disagree here about whether specs would take delivery seeing someone flood the market. Obviously I’m not persuading you, although I’m pretty certain I’m right given current physical and institutional arrangements.)

    (In a hypothetical frictionless world, things could be different. In theory, buying and rolling futures should be equivalent to hiring efficient storage full stop, to the degree that it is not balanced by unhedged speculators taking the opposite bet.)

    The question of market manipulation is tricky here: If SPR thinks oil is over priced, it ain’t market manipulation to sell high with intent to repurchase at better prices (selling short from a long position). Normally, knowing that a good faith trade will alter the market doesn’t make it market manipulation… but this is a pretty radical suggestion.

    The strategy you suggest, sell forward high, then drive spot down immediately prior to settlement, ands up being pretty similar, to the degree that spot is well-defined. If, as you think, specs can hold, then they could take and hold through the spot downspike, taking a per loss on the purchase but expecting the price to bounce. If they can’t take and hold, if they cash settle (contrary to real practice), they take a loss, but to the degree the next forward contract has been driven down with spot, they can buy cheap forward and ride it up. The long-term loss is only the cost of roll, the degree to which spot has fallen faster than the next contract forward for parties that want to buy and hold.

    One “nice” thing about selling forward is that the specs needn’t notice they’re in trouble until its time to roll. If the physical seller drives prices down just a bit and substitutes for spec sellers who would have taken higher prices, spec buyers just view themselves as getting a good deal when he positions are first taken. They get in trouble when they start trying to roll, and find that more longs want to roll forward than shorts willing to close positions at anywhere near the price they bought.

    Re “forced delivery”, I think the right way to describe it is that sellers can force the delivery of their oil, although no one can force any particular buyer to take. No particular buyer is “forced”, though sellers “force”. In the aggregate, buyers must take what seller insist on delivering, so those who don’t want to take end up paying for the privilege.

  44. Steve,

    This is an area where the institutional nity-gritty is important. I’m not expert in it, and not being expert in it I had a lot of questions on this post. You’ve answered many of them, so thank you. You’re right that the phrase, “if the facility used by the seller allows such transfer, or by in-line transfer or book-out if the seller agrees to such transfer” could be a big out (or maybe not, that’s another piece of important nity-gritty I don’t have.)

    Certainly, the U.S. strategic reserve could effectively shrink global storage space if it wanted to, by emptying its reserve a lot and leaving it empty.

    There’s just a lot of important nity-gritty here that’s assumed away in most models. Thanks for the fill in’s. As far as time, I really have to go. Everytime my girlfriend sees me typing to you she gets more upset.

  45. Your girlfriend is much more important than this crap… send her my apologies and live a lot.