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Wednesday, May 4, 2011

Contango

And other issues not commonly understood by consumers about the world oil market
The higher the price of gas at the pump, the more sensitive consumers are to allegations of oil market price manipulation. Most consumers are unaware exactly how any manipulation takes place, but they can't square the doubling of the price of a gallon of gas when the price of a barrel oil doesn't double, so they are suspicious there is a culprit to be blamed. Oil companies become the bad guys as they report high profits.
Well there IS oil market manipulation by the most major of oil traders. AND it isn't even illegal. But it takes tremendous amounts of capital to manipulate the world market price of oil. For a variety of reasons, the best known energy trader manipulating the world market price of oil is Koch Energy, probably because of the Koch brothers high profile participation in the political process.
So what is "contango?" Contango is the strategy of purchasing large stocks of oil and storing it in offshore supertankers and giant containers, creating a shortage or exacerbating a real or perceived shortage in the market. The trading company then it sits on those supplies until oil prices rise.
Ever wonder how gas prices can be $4.50 per gallon in say July 2008, and then drop to $1.90 when President Obama was inaugurated In January 2009 six months later? Crude oil prices dropped from more than US$145 per barrel in July 2008 to less than US$35 per barrel in December 2008.
When the contango hoarders turn their stocks of oil loose on the market at the peak price, it tends to flood the market with oil, especially when consumers have cut back on consumption due to the high price. At the same time all producers pump and transport like crazy to take advantage of the high price, including those in the oil patch. The end result is a glut and cheap fuel at the pump. And consumers end up with fuel price volatility. U.S. consumers tend to think they are entitled to the "glut" fuel prices, rather than the highest price or even an intermediate price.
For those who recall, the Bass Brothers' play on silver in 1977 and 1978 was a form of contango.

But there is another example of "hoarding" on a much larger scale. OPEC has been hoarding oil for 35 years. In 2011 there are more members of OPEC than in 1973 and world wide consumption has accelerated. Yet, OPEC doesn't produce any more oil today than they did in 1973. OPEC is not in the business of just selling volumes of their finite resource, as much as maximizing the price they get for each barrel. The U.S. produces about a third of its oil domestically. We get another third from Mexico and Canada. The final third comes from OPEC. What is not clear to most Americans is that if we double our domestic production, and eliminate the OPEC purchases, we still have not freed ourselves from the world market price of oil. Why? Because Americans do not own the oil produced here, the oil company that makes the investment to find it and produce it owns the oil. The chances of an oil company selling their oil to the U.S. consumers at less than the world market price is slim and none. Yet, I don't hear a lot of talk about nationalizing the oil companies.
Further, when we increase production, OPEC cuts theirs back a like amount to maintain the supply/demand balance. The graph at the following link shows the production of OPEC over the decades: (graph link)
More domestic production WOULD improve our balance of payments situation, but it would quickly eat up our meager oil reserves. The U.S. maximized domestic oil production in 1970 and uses 25% of the world's production while owning less than 5% of known reserves. We ramp up production, OPEC cuts theirs back, and we use up our reserves without saving a dime. So much for “Drill Baby Drill.”
Off shore and ANWR reserves seem like a lot of oil until weighed against U.S. consumption. OPEC sits on 70 - 80 percent of the world's known reserves, to put things in perspective.
There are those who think we are better off to use up others' reserves and keep ours for a rainy day. The Bakken Formation oil shale reserves in the Dakota and Montana ARE huge! Bakken currently produces about 500 million barrels of oil per day.
BUT oil shale development requires large expenditures of water and energy, produces air pollution and carbon emissions and leaves toxic byproducts that endangers the environment, especially the water table. For example, a fully developed Bakken formation could leave the entire Southwestern U. S. with a huge water problem. In addition, the high cost to produce from oil shale in Bakken is only viable when the world price of oil is between $80. and $100. per barrel. Major investment in Bakken on oil shale development has been tentative as investors are afraid OPEC would open their spigots to drive down the price of oil, throwing them into bankruptcy.
While there isn't much we can do about hoarding by OPEC, there have been initiatives to tighten regulations on commodity and derivatives trading. Lobbying against this regulation has been fierce. In fact, the same Commodities and Futures Trading Commission (CFTC) is the same government agency that tried to regulate credit default swaps and collateralized debt obligations on Wall Street. Larry Summers, Alan Greenspan, Robert Rubin and others blocked the efforts to regulate commodities and derivatives by firing the chairman of the CFTC, Brooksley Born, and replacing her with Wendy Gramm. Yes, this is the same Wendy Gramm that was on the board of directors of ENRON when its energy trading speculation and suspect accounting wiped out millions of investors AFTER she had blocked regulation that would have prevented it from happening.
For now, large energy traders continue to benefit from the lack of regulation while U.S. consumers suffer to a greater extent than necessary.
Over his 40 year career David Ruggles has been in every phase of the retail automobile business and has consulted with and done training for hundreds of auto dealers in the U.S. and Japan. He conducted a yearly seminar for one of the world's largest privately owned Toyota dealer groups for eighteen years, and has himself been a dealer for Chrysler, GMC, Mercedes Benz, Ford, Mazda, and Subaru. Author of the Ruggles Report, and a regular contributor to the National Bureau of Asian Research, he blogs at autosandeconomics.com and writes regular columns for several trade publications and The Daily Post online newspaper. He is a member of the International Motor Press Association.