Reply #13: Soros: Skyrocketing Oil Prices a Bubble (the spirit of Enron lives on)

[ozymandius]

Veteran investor George Soros, in an interview with the Telegraph, describes speculation as a significant factor in the recent spike in oil prices. However, he doesn't expect prices to break until there are signs of economic weakening. Later in the post, I'll provide some information that suggests how traditional supply/demand forces could have been swamped by the volume of futures trading.

First, from the Telegraph:

Speculators are largely responsible for driving crude prices to their peaks in recent weeks and the record oil price now looks like a bubble, George Soros has warned....

In an interview with The Daily Telegraph, Mr Soros said that although the weak dollar, ebbing Middle Eastern supply and record Chinese demand could explain some of the increase in energy prices, the crude oil market had been significantly affected by speculation.

"Speculation... is increasingly affecting the price," he said. "The price has this parabolic shape which is characteristic of bubbles," he said.

.....

Mr Soros also warned that the Bank's inflation report represents a "Faustian pact", obliging it to keep interest rates high to control inflation, even as the economy is starting to slump.

There are two arguments made against the speculation thesis. One is arbitrage: if oil was too high, someone would go short the future and buy oil in the cash market cheaper, and earn the arbitrage profit.

The problem with that logic is that price discovery happens in the futures markets; there isn't another venue for setting the price and thus arbitraging it against futures. Worse, a substantial amount of that trading is either over the counter (hence not reported to US futures regulators) or on the ICE exchange in London (ditto).

The two most important visible markets are NYMEX and ICE, and far and away the two most important types of crude (in terms of price discovery and setting global prices) are West Texas Intermediate and North Sea Brent. A June 2006 US Senate Permanent Subcommittee on Investigations report on “The Role of Market Speculation in rising oil and gas prices,” found:

…there is substantial evidence supporting the conclusion that the large amount of speculation in the current market has significantly increased prices....

Until recently, US energy futures were traded exclusively on regulated exchanges within the United States, like the NYMEX, which are subject to extensive oversight by the CFTC, including ongoing monitoring to detect and prevent price manipulation or fraud. In recent years, however, there has been a tremendous growth in the trading of contracts that look and are structured just like futures contracts, but which are traded on unregulated OTC electronic markets. Because of their similarity to futures contracts they are often called “futures look-alikes.”

The only practical difference between futures look-alike contracts and futures contracts is that the look-alikes are traded in unregulated markets whereas futures are traded on regulated exchanges. The trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron ....

http://www.nakedcapitalism.com/2008/05/soros-skyrocketing-oil-prices-bubble.html