Epstein's nonsense

Reader comment on: Richard Epstein on Oil Prices

Submitted by Fast Eddie (United States), Feb 22, 2012 10:07

Epstein may be a brilliant guy and very knowledgeable on a lot of subjects, but he obviously knows nothing about how the oil market operates and how prices are determined. In the crude oil marketplace, it is a 'tail wags the dog' arrangement where crude oil futures traded on markets in New York and elsewhere establish spot market prices demanded by sellers. The futures markets have 3 sets of participants, as set up by the U.S. Commodity Futures Trading Commission (CFTC): Small speculators, consisting of pretty much what the name implies; Large speculators, which consists of hedge funds, commodity trading pools, some ETF's and others who run large amounts of speculative money; and the third group, which is theoretically composed of companies who either buy or sell crude oil in large qunatities, e.g., airlines, truckers and other big users, and the oil companies, e.g. Exxon, Shell et. al. and some smaller sellers and middlemen.

The futures markets actually reflected world oil market supply and demand fairly well until about ten years ago, when commodities traders convinced investors that they should take some money that would have gone into stocks and put it into commodities as a hedge against falling stock prices. This resulted in the formation of now-huge pools of money which, among other things, speculate in the crude oil futures by pouring huge amounts of their dollars into contracts for crude which they then 'roll over' every month or two months as those contracts expire. Side by side with these funds are outfits doing Gods work such as Goldman Sachs, Morgan and others who ride the price up until it reaches an unsustainable level. Then, the smarter of the operators quickly dump their long positions and short the market, i.e., bet that prices are heading down, and this often makes the futures market do a 180 turn and plummet.

Take a look at trading in 2008. The commodity pool operators and hedge funds bought tens of millions of barrels of 'paper' oil on the futures markets and drove the price of oil futures from about $60 a barrel to over $140 a barrel in less than a year. Then, by massively shorting the market, Goldman and others drove prices to $32 a barrel in less than another year. The hedge funds make their money via volatility. They don't really care which way prices move as long as they move far and fast. Right now they are moving up fast. And, unfortunately, as in 2008, the tail wags the dog. The 'spot market' in actual crude oil closely follows the futures markets' prices and the result is the wretched run up in gasoline prices the public is subjected to right now.

Put simply, this is a bubble. It probably has further to run. Probably exceeding the $140 hit in the 2008 bubble. And then the bottom will drop out and prices will drop far below $100 a barrel. I have traded in the oil futures markets off and on since the 1970's and therefore know a little something about how the markets work. World crude oil supply and demand, in total, rarely vary more than a few percent from year to year, typically 1 to 3%. It is comical to see people like Epstein (and the TV networks and Krugman and so many others) make supply and demand the cornerstone of their pricing analyses. Krugman tried to make this argument in 2008 in his columns and blog posts and when several of us traders started posting comments that made him look foolish, we soon found that we had been cut off and our comments deleted.

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