Thursday, August 14, 2008

Oil Price Decline Bubble?

There seems to be two popular explanations of the recent oil price decline among pundits. One is that this proves that the old price level represented speculation all along. The second is that this represents a shift in fundamentals.

Explanation number one is simply dead wrong. There could be some truth in explanation number two, but it is probably not the entire story. As I've tirelessly tried to explain, a speculative bubble is certainly a possible scenario, but it requires symptoms in the form of rising inventory levels. Because unless demand (and supply) is completely inelastic (which is an unrealistic assumption), any price not representing fundamentals can only be sustained by increasing inventory levels. And there was simply no evidence of rising inventories at any time. It is possible, especially given the limited degree of truth in explanation number two, that had oil stayed at the peak of $147, then inventories would have started to rise. But that is only a possibility, and even if it were true, it doesn't mean that prices like $130 or $140 would be justified.

Explanation number two could have some truth in it, as we see weakening economies in Europe and Japan, something which clearly would hurt demand. Also, the strengthening dollar represents a form of shift in fundamentals for the dollar price of oil (although it represents a negative shift in fundamentals for the price of oil in other currencies), but there are reasons to believe that this rally could be related to the third explanation discussed below.

The third explanation is that the recent decline could be a bubble, triggered by recent short-selling rules. As Merrill Lynch consultant David Bowers explain, the decision by U.S. authorities to enforce a ban on short-selling on 17 banks and financial institutions has set in motion a massive short-squeeze forcing hedge funds to unwind their short positions in these stocks. And since these short positions were used as funding for long positions in oil and other commodities, the unwinding of these short positions in banks also meant unwinding the long positions in oil. The unwinding of these short positions in financial stocks also at the same time forced these hedge funds to buy dollars (as financial stocks are bought back with dollars), which contributed to the dollar rally, a rally which further depressed the oil price.

Combined with the factors I discussed in my recent post about financial market behavioral patterns, this is the explanation for the recent decline in oil. But if the old price wasn't significantly inflated by speculation, and if most of the recent declines reflect speculation, then it follows that the current price could be significantly depressed by speculation. Probably not entirely, but to a very large extent.

The first tentative indication that this could be true came from the significant drops in inventories of petroleum products last week (the week ending August 8). While crude oil inventories only fell 0.4 million barrels, distillates (diesel and heating oil) fell 1.7 million barrel and gasoline fell 6.4 million barrels. Given that these numbers fluctuate a bit from week to week, one week's decline is not conclusive evidence that prices are too low. We'll have to wait and see what happens in the coming weeks. But if inventories continues to fall, then we'll have to conclude that the current price is too low, and that the only speculative "bubble" is the latest decline.


Blogger pej said...

great post!
hope that next week's data will make the reasons clearer.

7:01 PM  
Blogger Enginerd said...

The SEC only created a ban on naked short selling, and gave several days notice before it went into effect. Furthermore, the ban didn't effect "market makers" engaged in market making operations; i.e., big financial firms.

I don't see how the rule would've forced anyone to unwind their positions.

10:38 PM  
Anonymous Anonymous said...

interesting point of view about the USD/Commodity/Financials.
But I think there might be some flaw in your hypothesis about the buy back of USD because of short covering in Financials.
If these hedge funds were long the Commodity and short the Financials then when unwinding this trade they use their USD from their commodity position liquidation to buy back Financials.

10:40 PM  
Anonymous rich t said...

Hi Stefan -- Thanks for another thought-provoking post. I don't quite understand the part about rising inventories being necessary for a bubble. Here in San Diego, during the final blowoff (price) upside in the housing bubble we had extremely low inventory -- this didn't reflect a real, sustainable undersupply, but rather the fact that people were buying 10 homes at a time based on their speculative euphoria. Of course, inventory rose as the bubble began its burst.

Maybe your thought process doesn't even apply to housing... anyway, the point is I am a bit confused by the statement about inventory and i was hoping you could talk me through it or point me at your other writings on the topic (I tried google but didn't find anything).

thanks very much!

6:50 AM  
Blogger stefankarlsson said...

Enginerd: I don't see your point. Whether it was pre-announced or not, it did stop a lot of short selling. And in order to have an effect it is not necessary for all short selling to stop, it is sufficient with some. Furthermore, for reasons I explained in a earlier post, the declines caused by the unwinding of these positions by just some created a ripple effect which caused even those who were still allowed to sell short to unwind their positions.

anonymous: Yes, but someone else had to sell them the USD needed to buy back the stocks. The difference between commodities and stocks is that the latter is a specifically American asset while the former is not.

Rich t: What you are referring to are inventories of unsold homes offered on the market . Oil inventories are more equivalent to the many houses that people held and owned because they believed prices would rise.

I analyzed the issue of speculation in oil markets in this article.

9:17 AM  
Anonymous Tim said...

Hi Stefan - while I completely agree that it's a mixture of factors, I think your third option has to imply that the first explanation has at least some truth to it.

It's just not realistic to say that global demand and supply factors alone, the realizations of which are much more gradual, drove prices up 40%, and then all the way back to where they started, all in the span of three months. Particularly as it has been central bank rhetoric, more than data which was already expected to be weak, that is driving rates and curve shapes, and in turn the weakness in euro, Aussie, and sterling, giving a further kicking to commodity prices.

11:41 AM  
Blogger stefankarlsson said...

No, I don't see how number three follows from number one, because evidence lacks that underlying supply exceeded demand at the higher prices while there are tentative early indications that demand could now exceed supply. As I wrote, while it is possible for speculators to drive up prices above fundamentals, they can't do it without causing inventories to build up, which it didn't during the rally.

Furthermore, with regard to the size of the swings, that is what could be expected given low (but not zero) price elasticity of demand and supply. This implies that even small shifts in demand and supply will cause dramatic price swings, and that moreover speculation driven price swings will only cause minor shifts in demand, although they will cause some swings which can be tracked by inventory changes.

12:18 PM  
Blogger ben said...

stefankarlsson: back to the usd/commodity trade.
If I understand you well you are saying that the financials are american asset while commodities are not.
This doesnt make sense at all as the major currency for quoting the commodity is the USD.
Furthermore the current writedown in the financials is nearly the same in europe and in the us (226 vs 252billion.)

3:34 PM  
Anonymous Anonymous said...

I don't see the market activty that suggests a short-squeeze is going on in the financials.

I can much more believe the rumors in the market that a few large hedge funds are in trouble. It would make sense that they would be liqudating futures positions since they would be the most liquid positions from which to rase cash.

7:27 PM  
Anonymous rich t said...

Thanks for clarifying Stefan... this "Oil inventories are more equivalent to the many houses that people held and owned because they believed prices would rise." is exactly right.


9:32 PM  
Anonymous rich t said...

Thanks Stefan for clarifying...

10:58 PM  
Blogger stefankarlsson said...

Ben: the fact that commodities are quoted in USD is irrelevant. That doesn't mean that you have to hold USD to make a transaction. If say, the price of oil is $120 per barrel and the euro cost $1.5, then buyers of the oil can transfer €80 per barrel from their euro bank accounts to finish the deal.

As for the subprime losses suffered by European banks, they are irrelevant since these banks weren't affected by these rules.

Robert: Well, I don't have any actual data on hedge fund behavior. But given the rather dramatic and simultaneous commodity price bust and financial stock boom that followed in time the ban on certain forms of short-selling, it sure seems like a reasonable explanation.

11:26 PM  
Anonymous Anonymous said...

Sorry, I meant to put a reference to a letter put out by the hedge fund Black Mesa, which warned about some major liquidatons going on. Here it is.

Further, as egnerd pointed out, there was no ban on short selling, merely a techinical change as to when borrowed stock had to be confirmed as borrowed.

Volatile markets do funny things, I can remember when hedge fund operator Niederhoffer blew up one of his funds during the Asian crisis (199?). Of all things AOL started to tank, simply becasue Niederhoffer owned a ton of it and was selling it trying to raise cash and that was his most liquid position.

AS Merrill pointed out hedge funds were long oil/ short banks, but who knows what specific volatility started the great trade close outs?

11:59 PM  
Anonymous Anonymous said...

What do you think now? $40/barrel and falling. What price is the floor?

4:03 AM  

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