The Real Reason Behind Oil's Dramatic Plunge
"Current [oil] prices are supported by supply and demand fundamentals. The commodity markets are not behaving in a way that a speculative bubble would suggest." — Goldman Sachs Energy Report, Bloomberg, June 30, 2008
"There was an enormous amount of speculation pent up in energy markets, and it wasn't just the supply-demand equation." — Michael Cembalest, chief investment officer, JPMorgan Chase, in an e-mail to wealthy investors, Washington Post, Sept. 18, 2008
It was only a few months ago that global economies were frightened by the prospect of $200 oil. Yet at the time this column went to bed on Oct. 22, the price of a barrel of crude had slipped 54% from its peak in July, to below $67 a barrel. What made the cost of oil rise so dramatically, and why has it fallen so equally dramatically? And in the intervening months, did we really need to shell out almost $4 a gallon for gas, forcing many families to choose between food and fuel, crippling the traditional summer driving season, sending the price of commodities soaring, and nearly destroying Detroit?
In a word, no.
If the world's financial system hadn't come quite so close to a complete meltdown over the past few weeks, the collapse of the energy market and gasoline prices worldwide most certainly would have led every day's nightly news. We haven't seen that, but by now we should at least have come to understand that Goldman Sachs' (GS) energy division has taken a title from Enron. When it comes to discussing energy with the media, Goldman Sachs is either the world's most clueless organization or its most misleading.
Then again, as with everything else that's going wrong right now, we can ask Washington—the Bush Administration and Congress equally—why they allowed the oil futures market to get so completely out of control. Just as government inaction protected the Wall Street guilty, a situation that could cost taxpayers trillions of dollars to make right, government inaction allowed the amount of speculation in oil to grow obscenely massive.
I can think of only one reason why the outrage we're hearing isn't from a public that has finally realized we've been had for years on oil pricing. That's because the oil market collapse will be seen as "saving" consumers and industry billions of dollars; the collapse in housing and our financial systems is doing just the opposite.
Squeeze Play: Speculators Tipped Their HandIf there was one day that proved beyond a shadow of a doubt that speculators were in charge of the energy markets, it was Monday, Sept. 22. On that day the price of oil shot up by more than $25 a barrel, then settled back to a mere $16 gain. At its peak that day, oil was at $130 a barrel. Immediately, Goldman Sachs sent its clients a note claiming that the massive jump in oil pricing was the result of a serious lack of oil. Of course, this same Goldman Sachs in May had forecast that a superspike in oil futures could push the price of oil to $200 a barrel in the near term.
The rest of the industry understood what had taken place on that day: a "squeeze play." A trader or traders had placed the wrong bets on oil and then been forced to cover the positions. (This also happened earlier this year.) Typically it involves going short and selling contracts in the hope that prices for oil will decline. But just before the contracts expired, the trader(s) would be forced either to buy back the previous shorted position or be forced to actually take possession of the oil.
You read that last line right. Either pump up the price of oil to cover your bad bets, or it's, "Where would you like the tanker to park until you can unload it?"
That is the classic definition of speculation: traders flipping paper looking for profits. Actually dealing in real crude oil is not in their script.
The national media, however, reported simply that there had been a massive spike in oil futures prices. To be fair, it's hard to explain how the futures market can be manipulated by speculators in an eight-second TV sound bite.
Many analysts, who had acted like cheerleaders for ever-higher oil prices during the last 18-month runup in prices—from over $50 a barrel in January 2007 to the peak of $147 a barrel in July 2008—now were more than willing to be quoted the next day on that $26 superspike in oil. Even they admitted that it appeared to have been a squeeze play from betting wrong on oil.
Craig Pirrong of the University of Houston's Global Energy Management Institute understood the implications of speculators' tipping their hand that day to save their financial skins. He was quoted in Bloomberg saying, "It's just stunning this could happen, given the recent scrutiny in Congress and among U.S. regulators concerning the crude oil markets."
Outing the Long Con
In my first column for BusinessWeek.com on the energy situation (BusinessWeek.com, 4/1/08) on Apr. 1, I showed the discussions about a serious shortage of both oil and gas to be manifestly, absolutely false. In subsequent columns (BusinessWeek.com, 4/23/08), I pointed out that, on the contrary, oil supplies had been increasing—and that demand destruction for oil and finished products such as gasoline were increasing by an even larger percentage, which meant that the massive runup in oil pricing was unsustainable.
At some point, as the facts became more widely known, the great lie could no longer be supported. That's not to say they didn't try: Energy Secretary Sam Bodman gave almost weekly quotes on oil supply problems that seemed to legitimize the price hikes that speculators were actually driving. Not to put too fine a point on it, President Bush, a former oilman, also gave credence to the speculators' positions on a regular basis.
But all the time the government's own data showed something completely different. On Apr. 1 we had more gasoline refined and on hand than we've had at any time since late 1992. Because that was true, all summer our refineries ran at approximately 10% below their operational capacity—and yet gasoline demand still dropped faster than the gas supplies could be cut.
That's when the big boys in the business started a full-court press in the media. Defending the price structure for both oil and gas as legitimate, they derided any speculative "bubble" as simply a misguided fantasy of ill-informed journalists.
By May I was pointing out (BusinessWeek.com, 5/13/08) that Iran was sitting on tankers full of oil with no shipping instructions; that Saudi Arabia was enlarging oil discounts; that refinery runs were down to 85% of capacity; and that our own Energy Dept. was saying oil use in America was down by only 190,000 barrels per day. After that column appeared, the Energy Dept.'s Energy Information Administration altered its demand destruction estimate to 400,000 barrels per day, then upped it to 800,000—and now it appears we are using 1.5 million barrels of oil a day less than our recent historical average.
Here's the point: If the government had publicly admitted the extremely high rate of oil demand destruction that was taking place all year long—the U.S. stockpiled 33 million extra barrels of oil from Jan. 1 to May 1—oil never could have climbed to $147 a barrel. That simple truth would have deflated the oil bubble right then and there. Instead, as I pointed out in April, Secretary Bodman claimed supplies were tight and falling.
By the fourth week of September, gasoline inventories—after a five-month run of reduced refinery output —had finally hit a 41-year low. The price of gasoline on the futures market that day settled at $2.6973 a gallon.
By the first week of October, MasterCard Advisors was showing that gasoline demand was down 9.5% from the year before. But the story hadn't ended yet: In spite of oil's fall from its July peak of $147 a barrel, lack of demand had the price of gasoline plummeting even faster. The Oil Price Information Service sent out an e-mail alert on Oct. 7 stating that refineries on the Gulf Coast were now losing $5.45 on every barrel of crude that they were turning into gasoline.
Clearly, when the nation is sitting on a 41-year low for gasoline supplies on hand, while at the same time many refiners are losing money making gasoline, then the demand destruction for gasoline is still far greater than anyone has yet imagined. Tom Knight, director of trading for Truman & Arnold Energy in Texarkana, Tex., wrote me on Oct. 17 that there was anecdotal evidence that their gasoline business was off by around 10%. So with the nation's oil inventories growing from 292.2 million barrels on July 4 to 308.1 million barrels this past week, while gasoline inventories fell from 211.7 million barrels to 193.7 million, it's rather obvious that something serious has been wrong with the entire market. In spite of the falling inventories the price of gasoline on the futures market sank from $2.69 to $1.554 during the same six weeks.
Whose Side Are They On?
Now, what if Washington had stated what they knew were the facts behind the oil market this year in a timely fashion? Think of the billions and billions of consumer dollars—which could have forestalled or at least softened whatever consumer recession the nation is in—that instead went into the pockets of speculators. After all, Americans have paid a minimum of $240 billion in excessive oil profits, almost $100 billion more than they received in this spring's economic incentive check.
Instead of protecting the public, Washington has actively protected that oil market for years by giving inaccurate statements to the media. Yet anyone could have looked at the publicly available charts, as I did, and seen that oil and gasoline demand has been falling far faster in America since August 2007 than it has been increasing in Third World countries. Washington protected the speculators during the rise in oil and gasoline prices just as it did Wall Street.
The only redeeming epilogue to this story is that in the middle of this month, Goldman Sachs revised its forecast for oil downward again, now saying prices could fall as low as $50 a barrel. That's a long way from the $200 it forecast this May. The spirit of Ken Lay lives on.