So why are gas prices rising?

The full title should be:
So why are gas prices rising? The coming oil price bubble CRASH... the other cause of the food crisis... and why the "free" market sucks.

I decided to do a non political article, although obviously economics impacts politics. Iraq war, oil, gas prices, "it's the economy stupid", to name just a few old canards...

And this is as topical as you can get.

So, why are gas prices rising? Why is the price of an oil barrel breaking a record price almost daily now?

Here's the media's view:
nytimes.com, from 2006: China's Oil Needs Are High on U.S. Agenda.

The competition for access to oil is emerging high on the agenda for President Hu Jintao's visit to the White House this week. President Bush has called China's growing demand for oil one reason for rising prices, and has warned Beijing against trying to "lock up" global supplies.

Aha, China is an emerging economy and needs more and more oil. Supply and demand - the more people want something, the more the price of that something goes up.

Lets go to the BBC: What is driving oil prices so high? article from 2 January 2008:

This was triggered by concerns about violence in Nigeria and Algeria as well as the delay of the elections in Pakistan.

The assassination of the former Pakistani Prime Minister Benazir Bhutto increased oil prices because stability in Pakistan is important to US policy in the Middle East.

Threats to oil workers and facilities in Nigeria have cast a long-term shadow over oil supplies from the world's eighth largest oil exporter.

Suspected militant attacks on Wednesday in Nigeria's main oil city, Port Harcourt, heightened concern over the potential for further disruptions in shipments.

Aha, it is politics and warfare in Africa. Funny, as long as I can remember, there was always strife and warfare and atrocities, civil wars, genocides happening in Africa. And the price of oil never came close to $100 in my lifetime...

Demand is at an all-time high, fuelled by the continued breakneck economic expansion of the Indian and Chinese economies.

With more than a billion people in each country, and both economies growing fast, manufacturers and consumers are sucking in energy at an ever-increasing rate.

OK, China and India need more and more of the stuff.

This analysis is so simple, so easy, so...

False?


Here is another theory on what is really going on, from Michael W. Masters, Managing Member / Portfolio Manager, Masters Capital Management, LLC.

Source quoted herein: Mr. Masters testimony before US Senate, dateline May 20, 2008. The hearing was before the
Committee on Homeland Security and Governmental Affairs in the United States Senate.

This testimony was not really reported on TV, on any US channel (as far as I know - maybe I missed it on CSPAN). After all, it makes much more sense to run a story about Americans bitching about how high the price of gas is (CNN is the king of this - every 5 minutes they will have another American idiot on TV speaking on camera that, yes, the price of oil is high, and, shockingly, they don't like it!).

So, China and India and the upheaval in Africa, in Nigeria, is to blame for the high price of oil, right?

Lets listen in to Mr. Masters testimony before the Senate:

I have been successfully managing a long-short equity hedge fund for over 12 years and I have extensive contacts on Wall Street and within the hedge fund community.

Itʼs important that you know that I am not currently involved in trading the commodities futures markets. I am not representing any corporate, financial, or lobby organizations.

I am speaking with you today as a concerned citizen whose professional background has given me insight into a situation that I believe is negatively affecting the U.S. economy.

While some in my profession might be disappointed that I am presenting this testimony
to Congress, I feel that it is the right thing to do.

OK, Mr. Masters seems legit and after all, he was just speaking to the Homeland Security Committee in the US Senate. Masters continues:

You have asked the question “Are Institutional Investors contributing to food and energy price inflation?” And my unequivocal answer is “YES.” In this testimony I will explain that Institutional Investors are one of, if not the primary, factors affecting commodities prices today. Clearly, there are many factors that contribute to price determination in the commodities markets; I am here to expose a fast-growing yet virtually unnoticed factor, and one that presents a problem that can be expediently corrected through legislative policy action.

Mr. Masters claims that it is Institutional Investors that are one of the, if not THE primary cause, of the high price of oil. Which leads to one, ugly word as the cause of all this: speculation. Free market, to all you Ron Paul fan boys.

Commodities prices have increased more in the aggregate over the last five years than at any other time in U.S. history. We have seen commodity price spikes occur in the past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today, unlike previous episodes, supply is ample: there are no lines at the gas pump and there is plenty of food on the shelves.

There is no underlying cause for the price of oil to be so high. None. No logical reason WHY it is so high.

If supply is adequate - as has been shown by others who have testified before this committee - and prices are still rising, then demand must be increasing. But how do you explain a continuing increase in demand when commodity prices have doubled or tripled in the last 5 years?

Obviously, it is all the fault of China, India, and those damn Nigerians warlords... right?

What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

Got that?

This is not complicated, but I will explain this in layman's terms.
People with money - BIG money, as in millions and millions of dollars, punds, euros - are always looking to invest into different markets, different methods and vehicles to make more money out of their money.

All those 401K managers, all those hedge funds managers, all the big powerful banks are looking for places to invest their millions, their billions of dollars and and to have as big a guarantee of getting a return as they can.

Banks got burned by loaning money to idiot Americans (calling a spade a spade here) who should never have gotten a loan, and should never have used it to buy a house. They were too poor to afford it, and their loan was a terrible scam - a subprime, or better yet an adjustable mortgage rate (which always adjusts to the detriment of the person who took out the loan and to the benefit of the bank - shocking, I know).

So banks, big banks, transnationals, looked to invest in something that will guarantee their returns.

And so, according to Masters, "Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant."

Interesting, to say the least, don't you think so, dear reader?

But but but... How can they feel so cocky about investing into oil as opposed to the housing bubble market?

After all, all those people who loan the money got REALLY burned on the housing bubble?

Mr. Masters explains further who invests:

These parties, who I call Index Speculators, allocate a portion of their portfolios to “investments” in the commodities futures market, and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as “Index” Speculators because of their investing strategy: they distribute their allocation of dollars across the 25 key commodities futures according to the popular indices – the Standard & Poors - Goldman Sachs Commodity Index and the Dow Jones - AIG Commodity Index

Index funds.

The funds about which I wrote an article, telling everybody to invest in them and not try to beat the system (the article is in here, if you want to read it - good stuff if you are an investor).

So now all those 401K, all those hedge funds guys, all the banks, they all invest in oil. And very possibly, to pump up their profits, the so called "safe" index funds which are supposed to follow the market, have a bigger share invested in oil than you might think (depending on how aggressive a manager is and how a company defines an index fund - just calling it one does not make it so - there is a lot of bait and switch naming conventions in the financial world).

Where did these guys come from and how come they started to invest in this?

In the early part of this decade, some institutional investors who suffered as a result of the severe equity bear market of 2000-2002, began to look to the commodity futures market as a potential new “asset class” suitable for institutional investment. While the commodities markets have always had some speculators, never before had major investment institutions seriously considered the commodities futures markets as viable for larger scale investment programs. Commodities looked attractive because they have historically been “uncorrelated,” meaning they trade inversely to fixed income and equity portfolios. Mainline financial industry consultants, who advised large institutions on portfolio allocations, suggested for the first time that investors could “buy and hold” commodities futures, just like investors previously had done with stocks and bonds.

You can buy commodities futures, and hold them, just like you would buy a bond or a stock.

Now, historically, a commodities future, such as one for oil, was a very short term investment, if you could call it an investment.

Here is how it used to work, before this "buy and hold" mentality took hold.

This is crucial to understand it all, so pay attention to the next paragraph (please).

Source: BBC article :

Alistair Dickie, director of UK-based grain market consultancy HGCA, pointed out that technological innovations have made commodity markets accessible to a wider range of investors.

"There is a philosophy that says that commodities are counter- cyclical to the stock markets, and electronic exchanges have reduced the transaction costs of trading in them," he said.

Speculative investors in farm commodities typically buy futures - contracts entitling them to buy the underlying product at a specified price on a specified date.

These contracts were originally designed to protect buyers and sellers from weather-induced price fluctuations, but are now traded in their own right.

This allows investors to cash in on a rising market without the expense and inconvenience of owning tonnes of grain or coffee.

Did you get it?
Point 1 - commodities are counter-cyclical to the stock markets, which means that when the markets are down, these commodities are... going up.

"Speculative investors in farm commodities typically buy futures - contracts entitling them to buy the underlying product at a specified price on a specified date".

This is how things used to work.
A commodity buyer, dealing with a farmer, would go to the said farmer and say: "I will buy your crop of wheat next year at this set price of X amount of dollars per bushel".
The farmer haggled with the commodity trader, and then a deal was struck, and the farmer went to work to know that no matter what the price was next year, he would sell his wheat for the price of X dollars per bushel.

Now, if there was a glut of wheat supply, the farmer would become better off than his competitors, because his price is guaranteed.

But, if there was a shortage of wheat, the farmer would lose money.

But either way, the farmer's price was GUARANTEED, which is THE key here.

This guarantee allowed to farmer to buy and/or repair his equipment, hire workers, buy fertilizer, because no matter what price the wheat will reach in a year's time, he is GUARANTEED an X amount of dollars per bushel.

This commodity trading was done on a season by season (or year to year) basis - very short term.

The trouble starts when the mentality of speculative investing, of "buy and hold" reaches this market.

This next sentence is key - please re-read it and understand:
The demand for oil now is not necessarily created by a demand for oil - but by a demand for oil commodities futures.

Got that?
I am not saying that China and India, with their growing economies, have no effect on the price of oil. I am saying that they are not having THIS MUCH effect.

This is speculation.

This is your free market at work, Ron Paul fan boys.

If you read my article on the Global Food Crisis, which is a real crisis in the world, with millions of people priced out of buying their normal food, I have put the standard explanations of Australia having a few dry seasons in a row, with other countries also having weather related problems.

But the key paragraph in my Global Food Crisis article was this, the more I think about it:

Robert Zeigler, director-general of the International Rice Research Institute, said it could be months before the market got a clear sense of how high prices could go. "The whole market could become paralysed. Who's going to sell rice at $750 a tonne when they think it's going to hit $1,000?"

Free market. Speculation. Banks, investors - they are as much to blame for the global hunger as the weather and global climate change is.

And the same logic is at play with the oil futures.
Lets listen in to Mr. Masters testimony:

In the popular press the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE (Department of Energy in USA -AG), annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculatorsʼ demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!

Did you get that?

"The increase in demand from Index Speculators is almost equal to the increase in demand from China!".

Again, it is not the demand for ACTUAL oil, the black goo, that is driving the prices up so high (although it is rising, per standard market rules of supply and demand). It is the demand for oil futures, a commodity market, in other words for a shitty piece of paper.

Masters again:

In fact, Index Speculators have now stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve over the last five years.

Staggering, isn't it?

Lets repeat it, because it is worth repeating:
"Index Speculators have now stockpiled, via the futures market, (...) eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve over the last five years".

Masters then shows me that, yes, speculators are partly to blame for the global food crisis also:

Let’s turn our attention to food prices, which have skyrocketed in the last six months.

When asked to explain this dramatic increase, economists’ replies typically focus on the diversion of a significant portion of the U.S. corn crop to ethanol production. What they overlook is the fact that Institutional Investors have purchased over 2 billion bushels of corn futures in the last five years. Right now, Index Speculators have stockpiled enough corn futures to potentially fuel the entire United States ethanol industry at full capacity for a year. That’s equivalent to producing 5.3 billion gallons of ethanol, which would make America the world’s largest ethanol producer.

Turning to Wheat, in 2007 Americans consumed 2.22 bushels of Wheat per capita. At 1.3 billion bushels, the current Wheat futures stockpile of Index Speculators is enough to supply every American citizen with all the bread, pasta and baked goods they can eat for the next two years!

One question you should be asking yourself here, if you are a critically informed reader.

How can the speculators be so sure that the price of oil will stay up, or rather, that the price of an oil future will continue to rise? After all, didn't these people get burned off the housing bubble? Didn't they learn anything?

Answer that, Americangoy, and don't try to skip over that question anymore!

Well, OK!

Masters believes that it is mostly the index speculators, who operate thusly:

When an Institutional Investor decides to allocate 2% to commodities futures, for example, they come to the market with a set amount of money. They are not concerned with the price per unit; they will buy as many futures contracts as they need, at whatever price is necessary, until all of their money has been “put to work.” Their insensitivity to price multiplies their impact on commodity markets.

In other words, the index investor does not care about the price per share or a future - he will buy them for as much money as he has. This is how your 401K plan operates, and you should be familiar with that. Think of your 401K plan allocating yours, your neighbors, and your co-workers money, and your whole company's money, and other corporations' money, into a big oil futures fund. That's millions, billions of dollars that is pumped into the oil futures market and which are used to buy those futures without any regard for the price.

After all, like I profiled in my article about index funds, these people buy and hold and wait - forever.

But but but... I didn't answer the question about how the index investors (and in my view, many other types of predatory investors by now) are so cocky, so sure that the price of oil will not fall, that there will be no oil bubble?

Answer that 50 billion dollar question already, goy, otherwise this makes no sense!

OK, OK, fine fine.

Masters:

One particularly troubling aspect of Index Speculator demand is that it actually increases the more prices increase. This explains the accelerating rate at which commodity futures prices (and actual commodity prices) are increasing. Rising prices attract more Index Speculators, whose tendency is to increase their allocation as prices rise. So their profit-motivated demand for futures is the inverse of what you would expect from price-sensitive consumer behavior.

Got that?

In the strange and fucked up world of index speculation, the more a price increases the more attractive it is for the speculators. Because the more money is poured into a commodity futures market, the more the price will rise.

I know - if you are a Ron Paul "classical market theory" devotee, this runs counter to everything you believe in. I suggest, if you haven't already, to get yourself a strong alcoholic drink, and then go outside and look at how the real world works, as opposed to how you think it works or should work. I suggest you take a whole bottle of a strong alcoholic beverage with you when you take this drastic action which will change your life. Or perhaps a case of bottles. Something strong...

Masters again:

You can see from Chart Two that prices have increased the most dramatically in the first quarter of 2008. We calculate that Index Speculators flooded the markets with $55 billion in just the first 52 trading days of this year.19 That’s an increase in the dollar value of outstanding futures contracts of more than $1 billion per trading day.

Doesn’t it seem likely that an increase in demand of this magnitude in the commodities futures markets could go a long way in explaining the extraordinary commodities price increases in the beginning of 2008?

Sorry folks, no chart 2 - go to the original article linked (a PDF document) to see it.

But re-read what Masters is saying here, por favor:
"(...)prices have increased the most dramatically in the first quarter of 2008. We calculate that Index Speculators flooded the markets with $55 billion in just the first 52 trading days of this year.19 That’s an increase in the dollar value of outstanding futures contracts of more than $1 billion per trading day.

Doesn’t it seem likely that an increase in demand of this magnitude in the commodities futures markets could go a long way in explaining the extraordinary commodities price increases in the beginning of 2008?"

It does, indeed.

Masters continues:

There is a crucial distinction between Traditional Speculators and Index Speculators:
Traditional Speculators provide liquidity by both buying and selling futures.

Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets.

Remember my example of how commodity trading used to work, the one with the farmer and a wheat future trader? The one where the futures trader guaranteed the farmer a set price for his wheat for the next year?

Well, that is past now. Thanks to the global free markets, and how easy and profitable it is to trade in futures (as opposed to actual products), to trade in pieces of paper, the index investors to allow your 401K to grow, to allow the banks to have guaranteed profits next year, and next year, and next...

They never sell the futures.

And, using the simple "free" market economic theory that Ron Paul devotees believe, when the speculators buy and hold oil futures, that decreases the supply of oil futures. And you know what happens when the supply is decreased?

Masters again lays it down:

It is easy to see now that traditional policy measures will not work to correct the problem created by Index Speculators, whose allocation decisions are made with little regard for the supply and demand fundamentals in the physical commodity markets. If OPEC supplies the markets with more oil, it will have little affect on Index Speculator demand for oil futures. If Americans reduce their demand through conservation measures like carpooling and using public transportation, it will have little affect on Institutional Investor demand for commodities futures.

The speculators decisions to buy and hold oil futures are not affected by price controls, by OPEC producing more oil, by reducing taxes on gasoline.

The speculators don't give a shit about all that - they have your 401K or a bank or whatever hedge fund money, and they will invest it in the oil futures - no matter the price of oil that day.

Masters nails it here:

Index Speculators’ trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.

Got that?

They invest more and more money into oil futures, and then hold those futures (remember, the market is set up so that commodity futures were short term investments, if you could even call them investments, and they were NEVER meant to be traded in the glorious free market), and then wait for the inevitable price to rise of these futures.

Two words come to mind - pyramid scheme.

Yes, it is that simple.

The financial world is very simple, except the people in the know do not use regular words and simple language to explain simple concepts to us laymen - otherwise, we might find out what is really going on and take action.

Say, like calling your local congressperson...

Masters:

Think about it this way: If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged.

I am not sure that Americans will by now be outraged by anything. We Americans are the sheep, ready to be sheared, ready to be dumped upon, spat upon, worked to death in our jobs, which cease to provide us medical benefits, which fire us before our 401K kicks in (if a job even has that plan, as many of them no longer do).

But Masters' analogy here is a good one: except that Americans are too docile by now to take any action whatsoever.

Instead of an ending...
But of course, the oil prices cannot just keep climbing without the world's governments not taking actions. USA, Europe and Asian economic powers will, they WILL, take action. Because the free market is not so free, and in the real world the big boys - transnational corporations and governments - dictate the rules of the game.

And so the price of oil (and food) WILL come down, new rules WILL be put in place to prevent this rampant speculation and leeching off of the market, and your 401K, which has invested heavily in the oil and other futures...

Well, it might take a hit.

But, looking at the big picture, I would much rather have half the world not starving, and gas prices come down to reasonable levels, than allow this insanity to continue.

Hope you are on the ball when this happens.

AG

Bonus Material: Proof?
english.donga.com:

Billionaire investor George Soros yesterday blamed speculators as largely responsible for driving crude oil prices to record highs.

In an interview with the Daily Telegraph of the United Kingdom, Soros said the weak dollar, ebbing Middle Eastern supply and record Chinese demand can partially explain hikes in energy prices, but that the crude oil market has been significantly affected by speculation.

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

His comments go against the opinions of other experts who deny that speculators have significantly fueled oil inflation.

Haha, I love the "His comments go against the opinions of other experts who deny that speculators have significantly fueled oil inflation". By "other" experts, they must mean the experts on TV, on CNN and FOX, right?

But why would the experts on this matter, who actually trade in commodities, and who make money for themselves off the rising price of oil, tell the truth? Wouldn't they shoot themselves in the foot?

upi.com:

Oil speculators may be partly to blame for skyrocketing U.S. gasoline prices, analysts say.

The price of crude oil has more than doubled, increasing $70 a barrel in the past year, and some experts say speculation could account for up to $30 of that, the Houston Chronicle reported Sunday.

To help reduce the affect speculators have on the price at the pump, some are calling on Congress to probe the role commodity market players such as the nation's pension funds, endowments and other institutional investors play in determining the price of oil.

Institutional investors' interest in oil "is accelerating and emboldening the price rise," said Mark Lapolla of Sixth Man Research, an Atlanta financial research firm. "We just can't quantify it."

"The price of crude oil has more than doubled, increasing $70 a barrel in the past year, and some experts say speculation could account for up to $30 of that".

Houston Chronicle:

A key Democratic lawmaker Tuesday called on federal regulators to examine more closely the role speculators — particularly large institutional investors such as pension funds and university endowments — may be playing in the rising price of oil.

Officials of the Commodity Futures Trading Commission, which oversees conventional U.S. commodity exchanges but not electronic energy trading, have argued that market fundamentals of supply and demand account for the run-up. But large institutional players including the Teacher Retirement System of Texas and the University of Texas investment arm recently have put billions into oil and other commodities as a hedge against a balky stock market.

Some analysts blame such speculation for part of oil's record run this year to $100 a barrel and well beyond.

I realize that for some people, if they haven't seen it on CNN or FOX it must not be true nor important. And for those people, reading a blog (with a point of view which then are proved by examples) and then agreeing with it is anathema, almost goes beyond belief that a blog can be more informative than a cable news channel.

Well, I am sorry, buddy.
If you don't get your news from BBC online, from Reuters, your op/ed from the Guardian and Ha'aretz, and instead rely on CNN, FOX and other TV news, you, buddy, are an idiot.

You and this president deserve one another.

Bonus Material 2: When did this commodity insanity start?
villagevoice.com

In June 2000, Senator Gramm co-sponsored the Commodity Futures Modernization Act, a measure aimed at deregulating certain kinds of futures trading, but not energy futures. That bill never made it to the floor, and thus quietly died. Six months later, on December 15, Gramm curiously turned up as co-sponsor of a bill with the same name, the Commodity Futures Modernization Act, which did deregulate energy futures and which, without undergoing the usual committee hearings and preliminary votes, was immediately attached as a rider to an 11,000-page appropriations bill. It passed and was signed into law by President Bill Clinton six days later. Few lawmakers had likely perused the rider carefully, if they even knew it was there. And at any rate, Enron had given to the campaigns of over 200 legislators.

Thanks to a reader at Daily Kos.