How does demand for derivatives influence the physical commodity price?

[soupcxan]

Some have argued that the increasing price of oil has been due to increased demand by pension funds and other institutional investors over the last five years, as commodities have become an "asset class" of their own. However, while these buyers may purchase futures contracts, they never actually take delivery of the physical goods. So I understand that if aggregate demand for oil futures increases, the price of the futures will increase. But the underlying demand for the physical product hasn't increased nearly as much as the price over the last few years (maybe a few refineries have increased output, but it's not like they've built 100 new refineries). So supply and demand for physical crude haven't changed much over the last year, but demand for contracts on crude have increased substantially (while supply has remained the same).

Given all that, how can demand for the financial instruments affect the price of the underlying commodity this much? It's not like the pension funds are storing crude in huge tanks somewhere. When their contracts mature, where is the oil going?

 

[d]

i too find this puzzling, and would appreciate an explanation of how futures contracts impact actual spot prices. that said, what we observe is that the quantity demanded and the quantity supplied is about the same, but the spot price has increased substantially. if the supply curve is vertical (or nearly so), this would suggest an increase in demand (the entire curve, not the particular quantity)

 

[ERD50]

However, while these buyers may purchase futures contracts, they never actually take delivery of the physical goods.

But, if they don't actually take delivery, they need to buy back the contract, right? That's how it works if I sell a put on a stock (if it drops below the strike price) - I either buy back the contract before expiry date (at a loss), or I will take possession of the underlying asset (and hold it at a loss). Futures are different, but must work in a similar way.

I guess this is no different than the housing bubble? As long as prices are rising, you can buy in and sell at a higher price. If they drop - well, what happens if there is no money to back up the contract? I don't know, but something tells me somebody will be looking at my wallet again

HaHa is very knowledgeable on this stuff, maybe he will chime in...

-ERD50

 

[ladelfina]

Here is one person's take on it.. someone writes in here:
James Howard Kunstler
(Daily Grunt, 6/27/08)

You may recall that a few weeks ago I wrote regarding my theory that a substantial chunk of the increase in the price of oil was due to speculation to offset bad debt portfolios by the larger east coast investment houses. What puzzled me was how this worked: because once the futures are bid up and the margins made, then the price of crude at the head assumes the previous month’s futures price! The short answer is that a kind of ratcheting mechanism is at work: once the price is bid up, it stays there until it is bid up again the following month.

It’s reported that the level of oil futures market activity by these investment houses is significant, with at least 10 percent of the futures market controlled in any one month. With each market manipulation, their margin per barrel is probably around $5.00. So if you take 10 percent of 85,000,000 barrels a day times 30 days in an average month times $5.00 you get a total of $1,275,000,000 in margin. With each month of these shenanigans, these banks can offset upwards of 12,000 subprime mortgages. Not a lot given that there may be upwards of 2,000,000 of these ticking time bombs, and considerably more if the banks fail to walk the razor’s edge they’ve defined for themselves. At this rate, it will take over ten years to offset the bad debt portfolios and only if few of those who have investment accounts make withdrawals. At the rate of +$5.00 a month, the price for a barrel of oil in 2018 would probably be over $900. It will never get there!

So each month, the investment houses pay out cash to those with account holders who demand it, offset bad paper and then go back to work the futures market with what’s left and what they borrow for 30 days from the Fed. As long as they work quickly, they can keep ahead of the game, at least until the price of oil destroys the underlying economic base. It’s reported that with Americans now paying around 11 percent of their income on energy, we are getting pretty darn close to the end of these shenanigans: in the 1973-74 time frame, the tipping point was reached when Americans had to pay more than 12 percent of their income for energy. When oil gets to $150/barrel in two to three months we’ll be past that point.

Another thing to note: a fair amount of funds in the investment accounts are withdrawn annually in the July-August time frame so that middle class parents can pay college tuition. This is one of the reasons why the market always drops in value in the late summer.

If you consider the combined effects of both the limits to oil futures manipulation and the annual July-August tuition dip and you have some of the makings of a perfect storm.

I think that we very well could be witness the effects of gravity on some very big shoes within the next two months.

 

[audreyh1]

Very interesting Ladelfina. The oil price has just gone up so fast that there have got to be shenanigans behind them (remember California crying about market manipulation in early 2000s - sure enough Enron was pulling a few fast ones and causing a lot of public pain).

It'll be interesting to see how this plays out.

One thing though - if the oil price does drop suddenly, the other equity markets will rally big time.

Audrey

 

[ladelfina]

Oh, if it's not clear, I should point out that this is not Mr. Kunstler talking.. it's someone who wrote in to him.

 

[d]

"The short answer is that a kind of ratcheting mechanism is at work: once the price is bid up, it stays there until it is bid up again the following month." this explanation doesn't explain it, since the vast majority of futures contracts are also sold prior to actual delivery. what are the "mechanics" of ratcheting mechanism?

 

[FIRE'd@51]

But, if they don't actually take delivery, they need to buy back the contract, right?
-ERD50

Actually, if they don't want to (or can't) take delivery, they must sell the contract, which will tend to depress the price. However, if they want remain long the oil, they will roll the position forward by buying the next month, so any price depression by selling the front (expiring) contract is offset by demand for the next month's contract.

 

[brewer12345]

Actually, if they don't want to (or can't) take delivery, they must sell the contract, which will tend to depress the price. However, if they want remain long the oil, they will roll the position forward by buying the next month, so any price depression by selling the front (expiring) contract is offset by demand for the next month's contract.

US commodity derivatives are generally cash settled, AFAIK. Choosing to take delivery at "strategic" points in time (designed to cause a short squeeze) would almost certainly attract the attentions of the US CFTC (regulator). My understanding is that market convention in London is more friendly towards taking physical delivery than in the US.








Actually, I am lying. The Elders of Zion, the Gnomes of Zurich, 18 guys in lower Manhattan, 3 guys in Omaha, and my dog* collectively control the global derivatives market for their own profit and amusement. The rest of you are along for the ride. <insert sound of evil laughter>


* I will not tell you which of my dogs is the one.

 

[Finance Dave]

One thing though - if the oil price does drop suddenly, the other equity markets will rally big time.

Audrey

Boy would that be nice...the opposite of a double whammy....a double bonus. Two years of 20%+ returns and I may be able to rehire early.

 

[d]

In its Medium-Term Oil Market Report, the International Energy Agency (IEA) said there was little evidence speculation had distorted prices over both the longer and shorter term, although it noted a lack of data on inventory levels, as well as on financial market participants.

IEA,7/1. given their take on the subject, those who blame speculation, especially through futures, really need to provide an explanation of how the futures are supposedly impacting the spot price! i'm certainly willing to entertain the possibility, but no satisfactory explanation has been put forward to explain just how that works.

 

[brewer12345]

IEA,7/1. given their take on the subject, those who blame speculation, especially through futures, really need to provide an explanation of how the futures are supposedly impacting the spot price! i'm certainly willing to entertain the possibility, but no satisfactory explanation has been put forward to explain just how that works.

I am undecided on whether speculative activity is driving oil prices via the futures market, but I will make two observations:

1) Almost every large institutional investor in the US has decided in the last 5 years that adding some commodity futures exposure to their asset mix would be a good idea. Even a dummy like me can figure out that this pobably has had some effect on prices, given the magnitude of capital involved.

2) I don't know if this is specifically the case in the oil market, but there are plenty of markets where the derivatives price the physical asset, rather than the other way around. Treasuries, corporates, even the junk market (via credit default swaps) are all driven by moves in the derivatives, with the physical markets dragged along behind. So it wouldn't be ahuge shock if this were the case in the oil market as well.

 

[Marquette]

I've been discussing oil and peak oil off and on for about two years now with my friend Joe. Joe is probably the most intelligent person I know, an over-the-top conspiracy theorist, and passed the Series 3 because he was bored. I'm not sure if any of that makes him any more or less qualified to speculate on state of things along with the rest of us, so I thought I'd let him participate by proxy.

Well, these are two different issues. Spot and futures price *should* converge as the contract comes due. I would say with a product that can be stored and *still* has a futures contract (gold) I can definitely see the futures price (as an indicator of speculator activity) driving the spot price. However, with oil, 90%+ of that oil is used as fast as it comes out of the ground (correct?), so in a way it is perishable (demand/need is too great) and the speculator activity would be massively dampened by the real spot activity. I mean, you can't just *sit* on oil, your economy runs on it. The closeness of the two prices could be a result of many things, and in any case is "normal" as the contract comes due (minus delivery costs). One thing that could explain these two prices "pre-converging" so to speak is simple supply/demand. Oil *can* be stored but there is a finite supply (say for the month of August) and we generally want to use most of that oil in August... so people who need oil in August will buy the future at today's price (with or without fear of a bubble) and since it *can* be stored... there is no downward pressure on the price. If oil were extremely perishable... I would imagine the spot price would stay lower than the month-out future. I mean, it won't *go bad* but the trucks must roll. Oil is strange.

Futures contracts are "marked to market" daily. You pay (or receive) the difference between your August sweet oil contract and today's sweet oil spot price. In august, you have the option to settle the contract by taking physical ownership (or enforcing the sale) of the oil. So (minus delivery/holding costs) the prices almost always converge.

Traditionally, hedgers want the price to stay the same, and speculators want it to change. Hedgers want to be able to predict the price in the future for forecasting... and what better way than to "pre-pay" for your hog bellies without taking the cashflow hit or "pre-sell" before your wheat is ready? A price lock-in is essentially what a futures contract is to the hedger. The speculator is purely a gambler. The hedger doesn't really *care* (not necessarily) if they lose money on the contract because the spot price went *down*, they are busily making muffins with their wheat, or driving their trucks, or whatever.

Now, if there *is* a bubble, the speculators could be simply dominating the market. Basically the trading volume could be swinging over to more and more speculator-speculator action. To me and my limited knowledge, this might be a bubble indicator. Also, if the hedger has "given in to temptation" and has decided to not simply hedge but play speculator as well... either by overbuying contracts or holding/hoarding the physical asset... then that might be bubble behavior too. All this should be measurable.

If people in the futures market who regularly deal in the physical asset (and are therefore able to) start holding/hoarding, then this would (to me) be an inversion of the traditional role a futures market plays in the economy.

If people aren't holding/hoarding, or if the supply isn't being artificially lowered (tampered with), I don't see how there can be a bubble in oil. Because if people are, in fact, paying the "bubble" spot price, *and* then actually consuming the good, well, then that's just good old supply & demand. If you are willing to pay $8USD/gallon (as they are in europe) and then burn that gas... well, you are setting/proving the demand price. If supply is being tampered with (lowered), then that would drive prices up in a bubble-like way. I'm not sure I'd call that a bubble though.

I mean people only drive up bubble prices because they think they are going to hold the goods (tulips, houses, stocks) for a little while and turn around and sell it for more. Is this happening in any significant quantity in the oil market? My impression was, it is not.

But George Sorous says it *is* a bubble
George Soros: rocketing oil price is a bubble - Telegraph

"Speculation... is increasingly affecting the price," he said. "The price has this parabolic shape which is characteristic of bubbles," he said. 'We face the most serious recession of our lifetime' The comments are significant, not only because Mr Soros is the world's most prominent hedge fund investor but also because many experts have claimed speculation is only a minor factor affecting crude prices.

I mean, that's it, right? Prices are going up like nuts, but if the futures market is functioning normally, then, no. No bubble.
So... are they functioning normally? Has the trading volume patterns shifted? Have traditional roles changed? Because if all Soros has is his parabola (well, HALF a parabola) then maybe he's wrong, or lying.
In other words, if people are paying these bubble prices and using the oil to drive their economies... then when the bubble pops it will be a GOOD thing. The only people who will suffer are the speculators. We *need* and are *using* all this oil.

Are there any historical parallels?

And I'm convinced that the oil companies are keeping gasoline low here in the states because of the election. All this is weird and uncharted territory.

This is no bubble.

(sorry this is so long, didn't have time to make it shorter)



joe

 

[Marquette]

Since it's a slow day at the office....

I now have a database with gas prices since 1990, sampled several times a month (thanks DOE). I just wrote a query that rolls that up to averages by month.

I also have the US city average CPI-U 1982-84=100 data since 1990

Missing is gas pump data pre-2000

Gasoline Components History

any leads?

edit: and what should I do with all of the data after it's in my database?

 

[d]

still not getting any closer to "how futures contracts impact actual spot prices"

 

[soupcxan]

There was an interesting "economics 101" explanation on the Journal's op-ed page today that argues you can explain the price runup in commodities based on elasticities of supply and demand without blaming speculators:

"Here is a simplified picture of what happened in the past year. The quantity of corn demanded by high-growth countries rose gradually, increasing eventually by an amount equal to, say, 10% of the previous total global level of corn consumption. Since the supply of corn did not increase, the price had to increase enough to reduce corn consumption in other countries by 10%. If it takes a 10% increase in the price to reduce the quantity of corn demanded in the first year by just 1%, it would take a 100% increase in the price of corn to offset the initial 10% rise in the quantity of corn demanded.

In reality, the picture is complicated by the substitution in both supply and demand among different agricultural commodities, and by the role of the corn ethanol program. But the basic explanation holds: With a very low short-run price sensitivity of demand and little scope to raise supply in the short run, even a relatively small increase in corn demand by the high-growth economies can lead to a very large short-run rise in the price of corn."

I came across another blog that agreed with Brewer's explanation. He framed the decision that refiners make as one between buying crude today for $x on the spot market or for $y next month on the futures market. If x > y, buy the futures. If x < y, buy excess on the spot market today and store inventory until next month (you'd have to adjust for carrying cost and inventory capacity). Viewed from that perspective, refiners are subject to the futures prices which could be inflated by increased long-only demand from investors. To my mind, that could explain how high prices persist, but it doesn't tell me how we got from $70 to $140 (at the start of the process, investors push up futures prices but can't affect spot prices, because they aren't buying physical product. So refiners would just keep buying at spot). But if refiners believe that futures are at least somewhat indiciative of future spot prices, they may go along for the ride, as Brewer was saying.

 

[d]

If x < y, buy excess on the spot market today and store inventory until next month (you'd have to adjust for carrying cost and inventory capacity). Viewed from that perspective, refiners are subject to the futures prices which could be inflated by increased long-only demand from investors. To my mind, that could explain how high prices persist, but it doesn't tell me how we got from $70 to $140 (at the start of the process, investors push up futures prices but can't affect spot prices, because they aren't buying physical product. So refiners would just keep buying at spot). But if refiners believe that futures are at least somewhat indicative of future spot prices, they may go along for the ride, as Brewer was saying.

this would suggest inventory builds, which apparently is not occurring.

 

[ladelfina]

I came across something here:
Peak Oil Debunked: 366. FUTURES PRICES DETERMINE PHYSICAL OIL PRICES

Most crude oil is traded based on long-term contracts, and the prices in those contracts are set by a system known as "formula pricing". In this system, the price of delivered crude is set by adding a premium to, or subtracting a discount from, certain benchmark or marker crudes, namely: West Texas Intermediate (WTI), Brent and Dubai-Oman. Generally, WTI is used as the benchmark for oil sold to North America, Brent for oil sold to Europe and Africa, and Dubai-Oman for Gulf crude sold in the Asia-Pacific market (Source1, Source2).

Originally, the benchmark prices were spot prices, but over time problems began to arise due to the depletion of the benchmark crudes:
...
The rapidly declining size of spot markets for the benchmark crudes led to chronic problems with speculators cornering those markets with a technique called the "squeeze":
...
To deal with this problem, many key oil exporters shifted away from the spot market, and began to use futures prices as the benchmark in formula pricing:
...

don't know if it helps

 

[d]

it doesn't help me. reliance on futures prices would not likely clear a current market, and there are no apparent shortages nor surpluses.

 

[boont]

Some Reports Gleaned From The Web

First, the role of the international oil exchanges in London and New York are crucial to the game. Nymex in New York and the ICE Futures in London today control global benchmark oil prices which in turn set most of the freely traded oil cargo. They do so via oil futures contracts on two grades of crude oil West Texas Intermediate and North Sea Brent.

A third rather new oil exchange, the Dubai Mercantile Exchange (DME), trading Dubai crude, is more or less a daughter of Nymex, with Nymex President, James Newsome, sitting on the board of DME and most key personnel British or American citizens.

BRENT IS USED IN SPOT AND LONG-TERM CONTRACTS TO VALUE MUCH OF CRUDE OIL PRODUCED IN GLOBAL OIL MARKETS EACH DAY. THE BRENT PRICE IS PUBLISHED BY A PRIVATE OIL INDUSTRY PUBLICATION, PLATT’S. MAJOR OIL PRODUCERS INCLUDING RUSSIA AND NIGERIA USE BRENT AS A BENCHMARK FOR PRICING THE CRUDE THEY PRODUCE. BRENT IS A KEY CRUDE BLEND FOR THE EUROPEAN MARKET AND, TO SOME EXTENT, FOR ASIA.

In the most recent sustained run-up in energy prices, large financial institutions, hedge funds, pension funds, and other investors have been pouring billions of dollars into the energy commodities markets to try to take advantage of price changes or hedge against them. Most of this additional investment has not come from producers or consumers of these commodities, but from speculators seeking to take advantage of these price changes. The CFTC defines a speculator as a person who does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes.

The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil for future delivery in the same manner that additional demand for contracts for the delivery of a physical barrel today drives up the price for oil on the spot market. As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum.

This 3rd Oil Shock (The first was 1973 when Oil quadrupled from $3 to $12/barrel and the 2nd Oil Shock was in 1979 when the Oil price tripled from $15 to $40 a barrel). This 3rd Oil Shock has been more gradual, with the price quadrupling since 2004 from $30 to $134 today.

The European Weekly July 2, 2008

One way of manipulating the spot (cash) market is by cornering and squeezing it. Under this strategy, a firm will buy large amounts of future contracts and then demand delivery of the good as the contracts become due. By cornering the futures market, the firm has artificially increased demand for the good. At the same time, the firm, which has market power in the cash market, would restrict supply to squeeze the market. The combination of the two can cause substantial increases in price. In other words, the dominant firm can amplify the price effects of withholding supply by becoming a large trader and simultaneously increasing demand.

The best real-world example of such a strategy is the infamous manipulation of the silver market by the Hunt family (and others) who at one time held about $14 billion worth of silver. In January 1979, before the market manipulation, silver was selling for about $6 an ounce. Then in 1979, the Hunts began to buy silver futures and demand delivery (i.e., they cornered the market). At the same time, they bought large quantities of silver and held the physical silver off the market (i.e., the market was squeezed). As a result, in January 1980 silver prices reached about $48 an ounce. Then, the regulators and the exchanges instituted liquidation-only trading. That is, traders were only allowed to close existing contracts; they could not establish any new positions. This forced traders (the Hunts and others) to exit the market as existing contracts became due, so that the manipulators could not continue to accrue large numbers of contracts and were gradually forced to withdraw from the market. The day after the rule was passed, silver prices fell by $12 per ounce, and by March 27, 1980, they fell to about $10 per ounce.

Market corners and squeezes are illegal, but hard to prove. In fact, the Hunts, their co-conspirators, and their brokers were sued, and a $200 million judgement was awarded. The brokers and Lamar Hunt paid about $34 million and $17 million, respectively. The remaining amounts were never collected, because the other parties declared bankruptcy.