GOLDMAN: THE SPECULATIVE PREMIUM IN OIL IS TOO LOW

Interesting findings from Goldman Sachs with regards to oil prices.  This comes from a recent research report from their Commodities Research Team.  In July of 2008 Goldman Sachs famously said the price of oil was not being distorted by speculators.  After a 75% decline in prices they changed their tune and said speculators had in fact distorted prices.  Their retraction said:

“Conversely, speculators bring fundamental views and information to the market, impacting physical supply management and facilitating price discovery. As a result, speculators have a loose relationship with price. In other words, as speculators buy, prices generally tend to rise, and vice versa. Accordingly, speculators also contributed to the extreme price movements over the last two years. For example, new data suggests that speculators increased the price of oil by $9.50/bbl on average during the 2008 run-up. Thus, speculators exacerbated the volatility that was nonetheless rooted in the fundamental imbalance.” (emphasis added)

As I’ve previously stated, I find it hard to believe that there is not a speculative element involved in the price of commodities today.  This is perhaps best seen in “commercial” participants who are now speculating in the markets by hoarding or using various commodities as collateral for financing operations.  Given their 2009 retraction, it’s not surprising to find that Goldman says there is a speculative premium in oil prices currently.  Perhaps more surprising, is their statement that the speculative premium is too small:

“In such an environment, it is not surprising that net speculative long positions in WTI crude oil reached a new record high of 391 million barrels. In comparison, when WTI crude oil prices peaked at over $145/bbl in July 2008, the net speculative long position in the light sweet crude oil contract (future and options) was less than 100 million barrels. We estimate that each million barrels of net speculative length tends to add 8-10 cents to the price of a barrel of crude oil. Given that net speculative length has been about 100 million barrels higher since the political protests spread from Tunisia and Egypt to Libya (Exhibit 2), this suggests that the oil market has been pricing a $10/bbl risk premium into the price of crude oil due to concerns over potential political contagion to other oil producing states in the MENA region. This is consistent with the fact that Brent crude oil has been trading near$115/bbl in the recent period, $10/bbl above our 3-month target.”

“Crude oil prices fell sharply in a broad liquidation on Tuesday as demand concerns raised by the unfolding events in Japan briefly offset the supply concerns arising from the MENA region. However, net speculative length only declined by 15 million barrels, highlighting the strength of the MENA concerns. Further, as we discuss below, we expect that the increased demand for oil due to the loss of nuclear generation capacity in Japan will far outweigh the demand lost to lower economic activity. More specifically, we estimate that230 thousand b/d of combined residual fuel oil and direct-burn crude oil will be required to offset the nuclear generating capacity lost in Japan. We estimate that to lose a comparable amount of oil demand in Japan would require an 8.0% decline in Japan’s economic activity due to the earthquake and its aftermath.

Consequently, we continue to view a containment of the threat to oil production from the political unrest in the MENA region as the primary downside risk to crude oil prices in the near term, with a downside risk from current prices of near $10/bbl. However, at this time assessing the threat to oil production remains challenging, with the ultimate impact of the initiation of airstrikes this weekend by a coalition including the United States, France, and the United Kingdom enforcing a UN-sanctioned “no fly” zone in Libya still unclear. Further,with reports of protests in Syria and Yemen, hostilities at the Gaza/Israel border, and Saudi troops in Bahrain, the risk of political contagion remains.

These developments suggest that the $10/bbl risk premium may prove too modest, and as the world focuses on MENA and Japan, events continue to unfold elsewhere. This weekend brought reports of a 100 mile long oily sheen spotted on the waters off the US Gulf Coast,20 miles north of the site of last year’s Macondo leak. In the wake of last year’s leak,another leak in the deep water would certainly increase the risk of a reduction in supplies from the US portion of the Gulf of Mexico. Fortunately, the initial tests carried out by the US Coast Guard suggest the “oil sheen” is likely caused by large amounts of sediment, and not fresh oil.

Consequently, the balance of risks to our forecasts remains clearly skewed to the upside,with the primary risk to oil prices over the medium term coming from higher oil prices and their potential to slow the pace of economic recovery.”

Source: Goldman Sachs

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • BK

    Cullen, can you help me with something on this issue – given higher oil prices reflect a transfer from consumers to producers, I can certainly understand how rising oil prices can affect consumer demand in other areas. But on the whole, how can higher oil prices cause a recession per se? Until consumers can’t find any more areas to cut discretionary expenditure, then higher oil prices don’t necessarily affect the overall level of spending in an economy. Oil companies are in the same economy that your local green grocer is in! Higher oil prices simply redirects more spending to one area of the econonmy – the petrol pump. Unless oil prices soar to above $200/bbl I think this is a risk this is seriously overrated!!

  • http://www.pragcap.com Cullen Roche

    Think about the transfer of wealth. High oil prices are essentially a wealth transfer from consumers to producers. It’s a persistent drag on consumers depending on the extent to which these profits get trapped. So, Exxon gets rich at the detriment of consumers and they do what? Use the proceeds to hire a few people at best, but more likely they retain the earnings, reinvest and there’s a major lag between the consumer drag and income redistribution. Depending on the size of the shock this can cause disruptions, particularly for a bankrupt consumer driven economy like the usa. It’s oil spikes that are the much bigger concern for this reason. They cause immediate shocks to the system.

  • scharfy

    Americans have more demand elasticity thanks ever2007/2008 price run up. Our use is declining. Its all about China and the EM’s.

    Anybody out there bearish oil? I mean this has to be the most pre-announced bull market ever.

    Color me skeptical..

  • jt26

    Hi TPC, re:”… using various commodities as collateral for financing operations.”
    Just curious what you mean by this.
    I agree with you on the hoarding, the cost to store many commodities have gone down in relative terms, and along with low interest rates, makes the net cost of carry small. Governments are just as bad, as everyone wants a strategic reserve of some sort.

  • http://www.pragcap.com Cullen Roche

    Sure, will follow up…

  • Vangel

    I would agree that the premium is far too low. We are now on the back end of Hubbert’s Peak and the IEA, CERA, and other optimistic institutions have finally figured out that there is no supply side solution to the need for rising demand. Eventually, something will have to break and it is my guess that it will be the USD. My only dispute is with the means of playing the game. Many oil bulls will use the futures route and will have their heads handed to them by the occasional severe pullbacks that force panic selling. A better approach would be to purchase shares in cash rich companies that have actual reserves in relatively safe political jurisdictions. Any opportunity that sees the shares are pulling back due to panic selling should be viewed as a gift that requires additional capital be put into the sector.

  • prescient11

    Goldman is the worst of the worst. They were “granted” an “exception” by a bought off politician’s letter and this just accidentally came up at a hearing.

    Please, watch Goldman for they will tell you which way not to go. I also would be uber-pissed if I was a client on their Euro calls.

  • Hans

    I think Albert Hofmann could give a definitive answer to this subject….