Cut and Paste from the Our Town Energy Website:
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Energy Market News
ST PADDY'S DAY UPDATE
How do speculators disrupt the market?
Goldman Sachs made record profits this year and distributed record bonuses. In fact the percentage of net profits devoted to bonuses was almost 50%, prompting one pension fund to sue the company on behalf of shareholders who feel they too are entitled to some of that profit. Goldman, Morgan Stanley and a few other institutions "too big to fail" have made much of that money in manipulating commodities, especially oil. One manipulates the market by altering expectations of either a) supply or b) demand. In the summer of 2009, the big players rented 144 oil tankers to store almost 700 million barrels of oil (30.8 billion gallons of oil) on the high seas. This, in addition to additional storage in rented or purchased oil terminals and storage depots on land. In fact, Goldman Sachs led a consortium in 2006 that purchased 21% of all the ports and associated warehousing, etc in England. Goldman and Morgan Stanley are now big players in 'warehousing'.
Goldman was taking advantage of a situation known as "contango" where current prices (in May, 2009 for June 2009 oil futures) were cheaper than prices for futures for the winter months of 2010 (more on that later). In the summer of 2009, there was a worldwide glut of oil. By purchasing that oil and taking it off the market they actually decreased or tightened oil supply somewhat, although oil supply even today is higher than the five year average. Could the removal of 30.8 billion gallons of oil from the open market affect oil supply and pricing? "Hell, yes", my grandfather would have said.
But why was there "contango" in the first place? Why were oil futures for the winter of 2010 so much higher than oil that could be bought last May for June delivery? Remember 2008 when Goldman Sachs was touting "Buy at $150 per barrel, it's going to go up to $200 per barrel!! It took the King of Saudi Arabia to break Goldman's bubble. King Abdullah insisted that speculators were driving the price as oil supply then was more than sufficient, Goldman Sachs, Morgan Stanley and President Bush (an old oil patch hand) insisted that it was not. The gauntlet thrown, King Saud pumped an extra 2 million gallons a day for a few days and the market crashed, dropping at its low point to about $35 a barrel. Big investment firms like Goldman Sachs and Morgan Stanley have two major arms, the economic forecasting side that tells millions of small investors what Goldman thinks the price of oil will be tomorrow or next June; and the trading arm that gladly takes the money of all these small investors who follow Goldman's advice. These firms do not play on a level playing field with the rest of us. Their computers have special access to the markets and can make almost instant trades, making hundreds, perhaps thousands of trades per day in a particular area. They make money when the market goes up or down.
But how do Goldman Sachs predictions about demand a year from now, based on their 'informed' guesses about economic indicators, oil supply, the strength of the dollar actually change demand?? Fifteen years ago, the only people in the commodities market trading oil were actual producers and wholesalers/end users. Today 75% of all the trades are by banks, hedge funds, private investors and other speculators who do not want the physical oil only the ability to buy and sell the paper at 10% down for a 42,000 gallon contract. The important thing to remember is that it is no longer a market, it's a Casino! The volume of trading far exceeds the actual volume of oil available. When you buy an option for a contract for oil delivery in January 2011, you are buying it from a party like Goldman or Morgan Stanley who does not have that oil but is making a bet to deliver it to you (who have no intention of putting 42,000 gallons of oil in your basement) at that price. The other party is making a bet that he'll make a profit at that price (buying it for less) and you are making a bet that you'll make a profit at that price (be able to sell it for more). Multiply this times thousands of millions of trades. One expert figures that each physical gallon of oil is sold 20 to 25 times. Does this artificial trading demand (not related to actual physical demand for oil) drive up the price of oil? You bet!
Can anyone accurately predict prices based on physical supply and demand anymore? Not really. In the absence of financial regulation, one really has to predict what the speculators will do rather than the market. The only apparent constraint upon the speculators ability to manipulate the market is King Abdullah of Saudi Arabia. He is happy with oil in the range of $70 to $80 per barrel. He has the ability to pump 4 million barrels extra per day and flood the market if speculators drive prices much higher than that. He has telegraphed his willingness to repeat his actions of 2008 if price increases by speculators threaten world economic stability. Ironically, it seems we must rely on Saudi Arabia, a member of a cartel devoted to keeping prices high to keep speculators from driving prices higher. Unlike hedge funds and investment banks, OPEC has an interest in keeping world economies from going into the toilet.