Lex Oleum

Another discouraging bit of political football around energy in the NY Times, May 24, 2011. Every time the price of oil goes up, some people seem to reflexively think it must be a conspiracy by evil speculators. Funny, this group doesn’t seem to have an explanation for why the price sometimes goes down, nor any apparent curiosity about what happens to “speculators” who are long in oil when that happens.

On Tuesday, federal commodities regulators filed a civil lawsuit against two obscure traders in Australia and California and three American and international firms. The suit says that in early 2008 they tried to hoard nearly two-thirds of the available supply of a crucial American market for crude oil, then abruptly dumped it and improperly pocketed $50 million.

So the accused “tried to hoard nearly two-thirds of the available supply of a crucial American market for crude oil”, then “improperly pocketed $50 million”. Pretty alarming, isn’t it?

Here are some basic facts:

• The average daily trade volume in the American market is 20 million barrels, give or take.
• The US Strategic Petroleum Supply, the largest storage capacity in the world, can hold about 700 million barrels, or only about 30 days’ volume on the US market.
• The average daily dollar volume on the American market, at $100/bbl, is $2 billion; the world volume, about $8 billion.

Does it seem plausible that any individuals could privately hoard “two-thirds” of the US supply? Or, if they could somehow do so, only make $50 million on the deal? Or, even if they could somehow make that “improper” profit, that it could have any measurable effect on the market price? I think the regulators’ argument depends for its plausibility on the supposed reader’s lack of basic numerical skills.

Well, let’s give the regulators the benefit of doubt, and read further.

In the case filed Tuesday, the defendants — James T. Dyer of Australia, Nicholas J. Wildgoose of Rancho Santa Fe, Calif., and three related companies, Parnon Energy of California, Arcadia Petroleum of Britain and Arcadia Energy, a Swiss company — have told regulators they deny they manipulated the market.

Aha! Now I get it. It’s a Wildgoose chase. Am I reading The Onion, not the New York Times?

In a matter of a few weeks in January 2008, the defendants built up large positions in the oil futures market on exchanges in New York and London, according to the suit, filed in the Federal Court in the Southern District of New York.

Now, a futures position could be either long or short – the article doesn’t say. My guess is, they were going short on the futures, as a hedge against their current purchases. Thus the future positions were actually a bet that the market price would fall. This is a fairly standard investment approach.

At the same time, they bought millions of barrels of physical crude oil at Cushing, Okla., one of the main delivery sites for West Texas Intermediate, the benchmark for American oil, the suit says. They bought the oil even though they had no commercial need for it, giving the market the impression of a shortage, the complaint says.

Here we get to the meat of it. The usual attack on “speculators” centers on this very point: they have “no commercial need”. And “the market” got a (presumably false) “impression of a shortage”. Surely, the reasoning goes, this can’t be good.

However, that oil did not sit around indefinitely. It was most assuredly sold (within weeks or days) to people who did have a “commercial need”, and were glad to have it, and it was sold at the spot price prevailing on the day of sale. If that price turned out to be higher than the price at which the so-called speculators bought it, then they would make a profit; if not, they wouldn’t.

Now, what about that impression of a shortage?

At one point they had such a dominant position that they owned about 4.6 million barrels of crude oil, estimating that this represented two-thirds of the seven million barrels of excess oil then available at Cushing, according to lawsuits.

So now we have gone from “nearly two-thirds of the available supply” to “two-thirds of the seven million barrels of excess oil”. Hmmm…

The capacity of the tank farm at Cushing is 46.3 million barrels. So the defendants owned about 10% of that, which just doesn’t seem too alarming. I am not at all sure what the article means by “excess oil” – does that refer to oil which is in storage but not immediately spoken for, or perhaps to unused storage capacity available at the beginning of the supposed escapade? It sounds a lot like “excess profit”, something which exists very much in the eye of the beholder.

The traders repeated the buying and selling in March 2008, and were preparing to do it again in April but stopped when investigators contacted them for information, the suit says.

Between January and April, average gas prices rose roughly to $3.50 a gallon, from $3. It was not until later in 2008, after the defendants had ceased their reported actions, that oil prices soared higher — reaching $145 that July. By the
end of the year, prices had fallen back to around $44. The Texas oil is now around $100.

After reading this, I downloaded the average monthly price history for the year in question (easily available from http://tonto.eia.doe.gov):

Note that, from January to March, the period during which Mr Wildgoose and friends were supposedly goosing the market for improper gains, the price did indeed rise from just under $93/bbl to just over $105, about a $12 increase. However, after they stopped, in the ensuing two months the price rose to over $125, a $20 increase! And it jumped another $8 the next month! Wouldn’t such data lead a reasonable person to doubt the speculation theory?

Over this 90-day period from January through March, about 1.8 billion barrels traded on the US oil market, for a dollar volume of about $180 billion.

According to the government, the Wildgoose cohort bought and held 4.6 million barrels. Neglecting storage costs (which must surely have been sizable), that is an investment of about $460 million. On this, they made $50 million, a little over 10% of their investment. That is hardly an outrageous profit – the average profit for all US manufacturers in 2010 (not a particularly great year, if you don’t recall) was 8.5%. So Wildgoose went to a lot of trouble, and ran the risk of attracting unfavorable government attention, in order to make quite a mediocre profit.

Relative to the total market volume over the period in question, the Wildgoose cohort owned at the most a quarter of a percent of the oil traded, and their profit was less than one thirtieth of the dollar volume. The reported profit of $50 million is only about 2.5% of the daily US dollar volume, and a little over half a percent of the world oil trade daily dollar volume.

To summarize, the government theory is that Wildgoose and friends drove the price up by buying, and were then able to profit by selling. However, as I have shown, the amount of oil they purchased was miniscule by comparison with any measure of sales volume or storage capacity. Furthermore, the oil price went up more after they stopped than it had while they were active.

The most humorous thing of all is this: looking at the price history over the full course of 2008, if the government hadn’t intervened, and Wildgoose and friends had kept playing the oil market until later in the year, they most likely would have taken big losses, much larger than the relatively small profit they actually cleared.

So the truth is that the government, by stopping them, locked in their profits! Who should be investigated now?