Market Reflections

Thoughts, ideas and musings on current state and evolution of financial markets

What Drives the Market – Supply/Demand, Speculators … or sometimes the Government?

Coming to power Ms. Pelosi promised to take care of the high gasoline prices. By May 2008 she practically doubled them! Facing re-election in few months Ms Pelosi and her compadres in Congress started feverously holding hearings with variety of experts from the industry and around it.

A host of different theories emerged to explain the gasoline prices. The supply demand balance as a reason was strongly defended by the Wall Street bankers. For example, Lawrence Eagles of J.P. Morgan when asked what role excessive speculation played in rising oil prices, answered little to none. “We believe that high energy prices are fundamentally a result of supply and demand,” he said in his testimony. Same position was argued by Mr. Schumer – senator from New York and the voice of Wall Street on Capitol Hill.

For the reference the chart below is compiled from the data published by Energy Information Administration Weekly Petroleum Status Reports. The left scale is for US monthly average retail gasoline price and the right scale for sliding four week average demand change from same period a year ago. Perhaps neither Mr. Eagles, nor Mr. Schumer bothered to read the Energy Department’s weekly reports on petroleum market and were unaware of the real situation with demand side. Whatever the reason, they both were wrong … or were they?


As evident even for an untrained eye, the gasoline demand has been trending down since late winter 2007 – more than 12 months at the time of hearings in the Congress.

Some background of 2008 petro-bubble was discussed in previous week post. The question remaining is, how and why the government let this happen. Speculative position limits enforced by CFTC are designed to prevent big money cornering a market. As opposed to speculators, commercials (companies producing, distributing, storing, refining and consuming oil and oil products) do not have position limits.

As it turns out, the Congress granted position reporting exemptions to special financial instruments – swaps with 2000 legislation. In this case, oil swaps allow investment banks to trade oil contracts on behalf of their clients without position limits. Large pension funds, hedge and index funds invested substantial amounts of new money on the petroleum markets via swaps through Goldman Sachs, J.P. Morgan, Morgan Stanley and Barclays. By this law they were not categorized as speculators even though these funds didn’t have anything to do with oil business. The investment banks benefited and had economic motivation to “forecast” exponentially higher oil prices enticing more funds to channel more money on this market by creating an artificial demand for oil. Some sources estimated that this speculative “demand” exceeded China’s yearly oil consumption. So … in legal sense Mr. Eagles of J P Morgan and Senator Schumer of New York were correct. Just that the “demand” did not come from actual consumers of oil products — gasoline, but from speculative entities.

With the facts on the table, who is to blame for the $4.00+ gasoline prices? Exxon, BP, Shell, Chevron, OPEC, the pension funds, hedge funds, investment banks … or the government in lieu of the Congress? Our laws are in public domain. Everyone can check out on their own who sponsored and who voted for this legislation. Whoever did not enjoy their trips to the gas station at that time may want to consider calling the elected representative they voted in office and ask pointed questions about his/her motivation?

Hearings in Congress resulted in threats from the lawmakers to tighten the regulation, publicity around privately traded oil swaps and scrutiny of CFTC enforcement activity. While the threats have remained only threats so far, CFTC discovered in July few large participants in oil market that were incorrectly categorized (from CTFC news bulletin late July 2008). CFTC revised all past Commitment of Traders reports to correct the problem. Institutional investor’s got scared and liquidated their positions. By some accounts, from mid July until the end of November, roughly $70 billion came out of commodities futures markets from these index funds. Suddenly, everyone “re-discovered” the slumping demand issue. Goldman Sachs discontinued advising their clients on strategies to liquidate remaining long positions on petroleum markets early December 2008.

Who busted the petro-bubble? Government facilitated its emergence and the government action busted it.

The lesson from here: consistent success in commodity futures trading requires not only supply/demand and technical analysis, strong discipline, prudent risk management, great strategy, but also keen interest and focus on potential changes in regulatory and legal environment applicable to the markets one trades. Sounds too complicated for an individual to handle. Well’ it isn’t, but it does require dedication, focus and time. It is full time job, not easy money. If you are looking for easy money, run for Congress: no responsibility for irresponsible laws, vote for your pay raise no matter how the country is doing.

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