The other day Dean Baker ran a piece on the aluminium market scam that some of the major banks are currently involved in (more info here). I got onto Dean with regards to what he wrote on oil market speculation. He had written that speculation was probably only adding about 10% or less to the price. I think that this is far too low an estimate.
So, I showed Dean the supply and demand graph that I put up here in my piece about oil market speculation. I pulled the graph from a report given to the US Senate. Here it is again:
I regret to say that I never really looked into what this figure represented. I assumed that the EIA had figured out a way to estimate the supply-side and the demand-side of the market with which they could figure out if supply was keeping pace with demand. I thought this to be the case because the supply and demand diverged from each other — which would not, presumably, be the case if this were a simple identity (i.e. if supply always equaled demand given market clearing).
Dean pointed out that this was, in fact, just that identity. The divergence between the supply and demand lines are due to the EIA not counting inventory accumulation as demand. Thus supply and demand are always equal in the above graph provided inventory accumulation is taken into account. I now believe that Dean is correct and that means that the Senate report, in this regard at least, was somewhat misleading.
There is, however, another way of looking at the oil market which might tell us if speculation is adding substantially to price. We can look at the amount of excess capacity in that markets. In theory, price should rise significantly only when excess capacity is tight — otherwise producers could just increase production to dampen the price increases. If excess capacity is tight when price is rising we should look elsewhere to explain the price increases. Here is the relevant graph taken directly from the EIA website:
As you can see I’ve also left in the gloss that the EIA has included with the graph in which they say quite clearly that high excess capacity indicates that OPEC are managing prices.
Okay, so the run-up in prices makes some sense between 2003 and 2008, as the gloss says, because excess capacity was quite low (I am not saying that speculation was not playing a role here, but let’s just keep with the EIA’s own argument). However, from 2009 onwards the price makes no sense. It is quite clear that there is far more excess capacity than there was in, say, 2004-2006.
Another period that doesn’t appear to make sense is the massive run-up in prices at the end of 2007 and the beginning of 2008. The excess capacity was nowhere near historic lows and yet prices rose faster than at any other time in the series.
I’ll end this piece by reminding people that while I have no basis to give an estimate on how much speculation is driving price in these markets, using figures from one of Goldman Sachs’ own internal memos Bart Chilton of the CFTC estimated that there was a ‘speculative premium’ of $23.39 on each barrel of oil at the beginning of 2012; that accounts for almost 25% of price at that time. Chilton also strongly hinted that this might be underestimating the amount because it didn’t include the speculative activities of commercials.
These markets are damn near impenetrable. But the more you pour over the data — and the more you hear about extremely dodgy practices by big banks — the more you come to think that the problem is far bigger than people like Baker are portraying.