The role of Speculation on oil prices

60 Minutes recently did a piece on the impact of speculators on oil prices that is worth some attention.

Did Speculation Fuel Oil Price Swings?, 60 Minutes: Speculation Affected Oil Price Swings More Than Supply And Demand - CBS News: "'Approximately 60 to 70 percent of the oil contracts in the futures markets are now held by speculative entities. Not by companies that need oil, not by the airlines, not by the oil companies. But by investors that...don't actually take delivery of the oil."

Much later:

"Gilligan said. "I tease people sometimes that, you know, people say, 'Well, who's the largest oil company in America?' And they'll always say, 'Well, Exxon Mobil or Chevron, or BP.' But I'll say, 'No. Morgan Stanley.'"

Morgan Stanley isn't an oil company in the traditional sense of the word - it doesn't own or control oil wells or refineries, or gas stations. But according to documents filed with the Securities and Exchange Commission, Morgan Stanley is a significant player in the wholesale market through various entities controlled by the corporation.

It not only buys and sells the physical product through subsidiaries and companies that it controls, Morgan Stanley has the capacity to store and hold 20 million barrels. For example, some storage tanks in New Haven, Conn. hold Morgan Stanley heating oil bound for homes in New England, where it controls nearly 15 percent of the market. "

Interesting. I should warn you that the video is not ground breaking (for as anyone knows speculation obviously played a role in price swings), but worth including as it shows how far investment banking has gone from traditional investment banking and it has some good insights in the market for oil.

When renting a ship to anchor it offshore makes sense (and cents!)

Contango and Backwardation are two terms that confuse many students. But with today's oil markets giving us an historic (and memorable!) example of contango, I trust many more will remember it going forward.

First the fast definitions: (want a better definition? see Investorwords.com)

Contango: when futures price is higher than spot price
Backwardation: when spot price is higher than futures price

Now the story. Oil prices have fallen sharply. In the short term there is more oil than we need. Of course producers will likely adjust (and the economy recover) so most future market participants beleive that oil prices will go up in the future. So why not buy now and hold on to it? Well one problem is that it is not a trivial thing to store oil for long periods of time.

Bloomberg.com: Contango Pays Most in Decade as Shell Stores Crude:

"...traders who bought oil at the $40.81 a barrel on Dec. 5 could sell futures contracts for delivery next December at $54.65, a 34 percent gain."

Now of course there are costs involved (cost of capital and storage costs)

"After taking into account storage and financing costs investors would earn about 11 percent, according to Andy Lipow, president of Houston consultant Lipow Oil Associates LLC."

But where do you store so much oil? With storage facilities in Cushing Oklahoma and elsewhere filling up, companies are renting tankers to anchor off shore holding the oil.

Again from Bloomberg:

"Royal Dutch Shell Plc sees so much potential in the strategy that it anchored a supertanker holding as much as $80 million of oil off the U.K. to take advantage of higher prices for future delivery. The ship is one of as many as 16 booked for potential storage instead of transporting crude, said Johnny Plumbe, chief executive officer of London shipbroker ACM Shipping Group..."

Want to learn more about the contango and backwardation? Check out this teaching video from Bionic Turtle.

Regulators Back Away From Changes to Commodity Hedging - New York Times

Regulators Back Away From Changes to Commodity Hedging - New York Times:

"All the farm industry speakers expressed concern about whether banks, in the midst of a tight credit market, would continue to provide the farm industry with the credit it needs to meet the higher costs of maintaining their hedge positions.

The commission was told about a “very solid” grain elevator in Kansas that lined up a $15 million line of credit last fall to finance margin calls on its hedged positions and has just learned that it will actually need $80 million in credit for this season."

Given it is coming up on finals, I bet an interesting question would be to draw the payoff diagrams that the grain elevator likely has.

How (and why) to invest in commodities

When we speak about diversification we always provide lip service to investing in assets with low correlations, but since most take this to mean different stocks (equities) we sometimes mention other assets but few know how to invest in these other assets such as commodities.

Because of that lack of knowledge SmartMoney looks at ways that investors can invest in commodities without having to trade actual commodity contracts.

Funds Allow Small Investors Access to Commodities (Pimco Commodity Real Return, Oppenheimer Commodity Strategy Total Return, Fidelity Select Energy, Excelsior Energy & Natural Resources) | SmartMo:

Let's begin with the why, as in "why would you want to buy commodities":

Shortest version: because they have a lower correlation with equities (see Greer 2000). Thus even if they offer lower expected returns, they can lower overall portfolio risk.

From SmartMoney:

"with the increasing globalization of the world you can't get diversification by just going outside your country. It's all about getting outside of equities.'"

The Smartmoney article goes on to suggest three ways to do this without actually buying the commodities.

1. Buying equities--for instance buy oil companies or sector mutual funds that buy equities.
2. Buy Exchange Traded Funds (ETFs) that invest in commodity indexes. (for instance see Powershares.com)
3. Buy mutual funds that buy commodities.
   

Senate Report on Amaranth Advisors

Given the news of Bear Stearns' hedge fund troubles, it is ironically coincidentally that the Senate's report on the collapse of Amaranth Advisors was released today.

A look around at some of the reporting:

From NY Times' Dealbook:

"After a nine-month investigation, a bipartisan Senate subcommittee is expected to issue a report Monday detailing how a single hedge fund, Amaranth Advisors , dominated the North American natural gas market last year, causing high prices and extreme volatility that ultimately led to the company’s stunning collapse."

From CNNMoney:

"U.S. regulators were powerless to stop "excessive speculation" by Amaranth Advisors LLC because the giant hedge fund exploited an unregulated electronic exchange to "dominate" and "distort" natural gas markets in 2006, a U.S. Senate panel said....U.S. regulators were powerless to stop "excessive speculation" by Amaranth Advisors LLC because the giant hedge fund exploited an unregulated electronic exchange to "dominate" and "distort" natural gas markets in 2006, a U.S. Senate panel said."

From the Houston Chronicle:

"The hedge fund at times last year controlled 40 percent or more of the natural gas contracts traded on the New York Mercantile Exchange, and as much as 75 percent in one month, according to the 135-page report by the Senate's permanent subcommittee on investigations....In order to avoid trading limits it faced on the New York Mercantile Exchange, Amaranth shifted its activity to the InterContinental Exchange Inc., an Atlanta-based electronic futures exchange that is free from such constraints, the report found."

And from Bloomberg:

"The report also calls for closing the so-called Enron loophole, which allowed Amaranth to do more business on electronic trading systems such as Intercontinental Exchange Inc. after being forced to reduce its positions on the New York Mercantile Exchange, where benchmark gas futures trade.

``Amaranth did not manipulate the market, and nothing in the subcommittee's report concludes otherwise,'' Dan Webb, an attorney representing Amaranth, said in an e-mailed statement. Webb said the firm agreed with a minority staff opinion in the report that Amaranth was responding to market changes rather than influencing prices."

Forbes reports that Shane Lee (the trader who took much of the criticism on the Senate report), contents that he was not to blame:

"Lee said natural gas prices were driven primarily by weather and demand for fuel. Trading would only have an impact on prices in the "extreme short term," he said."

The ICE (the Intercontinental Exchange) also has a response to the Senate Report. After (correctly) saying that many things drive prices and stressing the Friedman view that speculators (if profitable) reduce volatility, the ICE takes issue with much of the report and reminds everyone that they have improved reporting:

“With great respect for the work of the Staff, we believe that the Report does not fully reflect the level of oversight that now exists in the natural gas markets today,” said ICE Chairman and CEO Jeffrey C. Sprecher. “We are pleased to have already implemented, since the end of 2006, a large trader reporting system related to Henry Hub natural gas markets."

So what is next? The troubles at Bear Stearns will almost assuredly add volume to the calls for more regulations.


BTW why is the Senate Report on a Homeland Security website?

Are Commodities Futures Too Risky for Your Portfolio? Hogwash! - Knowledge@Wharton

This article is by Gorton and Rouwenhorst. The quote is from the Knowledge@Wharton April 2006 Newsletter.

Are Commodities Futures Too Risky for Your Portfolio?

"are commodities really that risky? A shortage of data has left that question unanswered. Until now. Using the most comprehensive data on commodities futures returns ever assembled....Gorton and ...Rouwenhorst have reached a surprising conclusion: Commodities offer the same returns as investors are accustomed to receiving with stocks...."

The authors also report that while commodities have about the same risk as stocks, commodities tend to be negatively correlated with the both stocks and bonds and therefore make an ideal investment for diversification purposes.

And besides, who hasn't wanted to say they trade Orange Juice like Eddie Murphy!


Working paper cite:
Rouwenhorst, K. Geert and Gorton, Gary B., "Facts and Fantasies about Commodity Futures" (February 28, 2005). Yale ICF Working Paper No. 04-20. Available at SSRN: http://ssrn.com/abstract=560042


What a day! Two great articles. No wonder finance is so fun! Every day there are new articles to read! It's like a candy store without the calories!

SSRN-Facts and Fantasies about Commodity Futures by K. Rouwenhorst, Gary Gorton

SSRN-Facts and Fantasies about Commodity Futures by K. Rouwenhorst, Gary Gorton

If you talk to most investors, they consider investments as only stocks and bonds. However, other assets should also be considered. For example real estate and commodities can be very useful as ways of reducing risk.

Why are commodities so important? They play an important role in diversifying a portfolio. For instance, Rouwenhorst and Gorton find that "While the risk premium on commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns."

Which of course is ideal from a diversification perspective! :)

Rouwenhorst, K. Geert and Gorton, Gary B., "Facts and Fantasies about Commodity Futures" (June 14, 2004). Yale ICF Working Paper No. 04-20. http://ssrn.com/abstract=560042

BW Online | August 9, 2004 | Oil Prices Could Get Even Worse

Business Week speculates that we could see $50 a barrel oil sooner than we expect.

Why? Demand increases as well as production limits brought about not so much by OPEC but by not having excess capacity in the production of more oil. This lack of capacity is in part driven by lack of investment in the past, in part due to political turmoil, and partially because of OPEC's production limits. With this little excess, any small problem would quickly be magnified and it would lead to higher oil prices.

What would higher oil prices do? For starters, higher prices would slow the economy. For instance, the BBC reports current prices could already be "[shaving] as much as half a percentage point off global growth."
http://news.bbc.co.uk/1/hi/business/3546248.stm

Longer term however, higher prices would also encourage the market-driven development of alternative energy sources. It is for this reason that some in OPEC are beginning to worry.


http://www.businessweek.com/bwdaily/dnflash/aug2004/nf2004086_1412_db039.htm

Hedging: It’s good for you and good for your company

European Airlines Review Hedging As Oil Prices Rise: "Already grappling with stiff competition and deep cost cuts following a slump in global travel, rising fuel costs are the latest blow to the beleaguered industry"



Oil prices are at all time highs (in nominal terms) on both supply (OPEC said they could not pump much more at present) and demand (higher than expected) concerns. Now I am guessing you have heard that from a zillion places. And moreover, I would wager that you probably expected oil prices to fluctuate. So is it just me who is angry every time airlines (this time it was American Airlines) complain about the price of fuel.

Why? They can easily be hedging this risk.

While hopefully their CFOs are all subscribers to the FinanceProfessor Newsletter and read all about the good aspects of hedging when we reviewed the Simkins, Carter, and Rogers paper on airline industry hedging practices. The paper is so interesting we reviewed it a twice. First in 2001 and then again this past spring-the latter review is listed below. But maybe the executives missed those issues (spam filters being what they are and all).

So if they did miss that, and are still not reading this, maybe these constantly complaining executives may happen to have heard of a firm called Southwest Airlines ;) The low cost airline from Texas recently named Gary Kelly as their new CEO. Kelly, an accountant who was formerly the CFO, is probably most famous for his hedging of jet fuel. How well did he hedge? The firm is reported to have locked in oil at $24 and $25 a barrel for much of the next two years. Remember current market price is over $44 a barrel! Gee, I bet that helped his reputation 
It is interesting to see the how other airlines (both in the US and abroad) are dealing with the high jet fuel prices. For instance, Ryanair had hedged much of their fuel only through October. When this fact was admitted, the stock price fell about 3% on volume that was twice its average. “Scandinavian airline SAS plans to announce next week it has decided to resume hedging after being left exposed since the first quarter, while Swiss International Air Lines faces more potential losses after selling hedges to boost cash reserves.”

I will concede that there is truth to the claims that hedging long term risks is more expensive for firms with high financial risks, but the added cost is not a good excuse! So get out there and hedge! You too may end up as CEO.



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Sources:

Articles on Southwest’s hedging
http://www.freep.com/money/business/irep16e_20040716.htm
http://www.ctnow.com/business/hc-southwestair.artaug04,1,6498775.story?coll=hc-headlines-business

Article on other airlines hedging
http://news.airwise.com/stories/2004/08/1091563644.html —VERY GOOD!

For complaints on high jet fuel prices:
From Reuters on July 31, 2004:
http://news.moneycentral.msn.com/breaking/breakingnewsarticle.asp?feed=OBR&Date=20040731&ID=3877152
“``Record-high fuel prices and an intensely competitive domestic revenue environment have made the need for further cost-cutting all the more clear,'' Gerard Arpey, chief executive of American parent AMR Corp. (AMR), said earlier this month.
Continental Airlines (CAL) has said in recent months that fuel prices would add an extra $700 million in operating expenses this year, and it might have to lay off workers as a result.
``The current revenue and fuel environment have overwhelmed our efforts to return to profitability, and we now must achieve significant additional cost reductions,'' Continental CEO Gordon Bethune said when the airline released its quarterly earning in July.


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From the January 13, 2004 FinanceProfessor newsletter:

My chairman Jeff Peterson complained recently that academic publications travel at "glacial speed". The paper is by Simkins, Carter, and Rogers and looks at hedging in the US Airline industry is one such paper. It really is one of my favorites. I saw it presented a few years ago and I thought it was close to publication then, but I guess the glacier has not yet completed its journey as the paper was presented at this year's AFAs. Their findings? Hedging does create value. Using regression analysis, they report that hedging increases firm value by over 10%! How? One hypothesis is that hedgers can better afford to maintain capital spending when jet fuel prices climb. This view is supported by their finding that there is a "positive relation between hedging and…increases in capital investment."
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=325402