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

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.

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?

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.

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

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.

or

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.

"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?

And the Fed isn't printing money.

The monetary base has been stagnant for several years.

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.

anon,

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.

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%!
Fullcarry:
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 shadowstats.com, M3 is growing 17% a year. I'll take shadowstats numbers over Helicopter Ben's any day.

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.

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.''

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.

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.

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?

@ 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.

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.

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.

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!

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.

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.