Comment 68: Who are buying crude oil? (June 3, 2009)

Crude oil price has doubled from its December 23, 2008 low. Many observers casually point their fingers at speculators as the culprit behind this stellar rise of crude oil price without thinking who are really the “speculators”. Any one buying crude oil and its derivatives like futures contracts beyond its short term needs of oil is a speculator. For example, an airline company fears that the price of jet fuel will continue to rise for the coming two years, and buys future contracts of crude oil out to two years. The airline company is apparently undertaking an speculative action and is clearly a “speculator”, though some try to cover up the speculative behavior of the airline company by inventing the term “hedging”; the potential of profit or loss for the airline company depending on the future movement of the crude oil price is exactly the same as a pure trader buying those same future contracts. Another example is a refinery fearing the future rise of the crude oil price and buy physical crude oil to fill its storage tanks to their maximumb capacity. The refinery is conducting a speculative action the potential profit or loss from which is exactly the same as a large crude oil hoarder not in any business directly related to crude oil and its products, so the refinery should also be considered as a “speculator”. By digging to the bottom, we may say that the overwhelming majority of players in the crude oil markets are “speculators”. Thus to blame the surging crude oil price on “speculators” becomes almost a meaningless totality. More meaningful approach is to classify the players into two groups, the ones with storage facilities for crude oil and those who do not have the capability to store crude oil. Those two groups behave very differently in their trading pattern, so we can determine which group is mainly responsible for the rapid rise of crude oil price in recent months.

There are milliards of crude oil markets depending on the origin and the quality of crude oil. Throughout this comment we concentrate on the spot and the future prices of WTI (Western Texas Intermediate) crude oil. In the futures market, there is always a series of future contracts expiring at each month. When a crude oil future contract expires, the seller of the contract must deliver a pre-specified amount of crude oil to the buyer of the contract. If the buyer does not have any storage facility for the crude oil, the buyer naturally cannot take the delivery. This means that the buyer must sell the expiring future contract before it actually expires, and roll over to future contracts the expiration dates of which are in future months. If the buyers with no storage facilities are dominating the market, the price of future series that will expire in later months will be substantially higher than the price of the series that will expire in the nearest month, and vice versa. This indication can easily be quantified by looking at the future price spread between the next month series and the nearest month series. This spread is plotted as the black curve in the first graph at the right. When this black curve is high, the buyers without the storage facilities are dominating the futures market, whereas when the buyers with storage facilities are the major force in the futures market, this black curve will be around zero. When a future series expires, by the definition its price should converge to the spot price, so the spot price of WTI is plotted as the blue curve in the graph. The black curve in the graph shows three sharp peaks from December of 2008 to February of 2009 while the blue spot price curve was crawling the bottom. The buyers without storage facilities swamped the market during the period, but they were forced to roll over into the next month series of futures at the last moment very close to the expiration of the nearest month series. They hoped that some big buyer of physical crude oil would appear at the last moment of the expiration date to bail them out. Actually they themselves were the largest buyers of the expiring future series. As they sold the nearest month series to roll over into the next month series in panic, both the nearest series price and the spot price were depressed but the price of the next month series jumped, creating those sharp peaks. When the blue spot price curve had started to rally from the middle of February, those buyers without storage facilities quickly sold out and depressed the black curve. During the second leg of the spot price rally from the middle of April of 2009, this group has become even more bearish and as the consequence the black curve has been pressured down toward zero further. Another way to gauge the action of the buyers without storage facilities is to look at the red USO curve. USO is a trust fund with its shares traded on stock exchanges just like ordinary common stocks. The aim of USO is not to make profits for the holders of its stocks in the crude oil market, but is to synchronize its underlying asset with the spot crude oil price by utilizing crude oil futures and other related derivatives. Thus those bullish on the crude oil price will buy USO shares and those bearish will shortsell the shares. However, the market price of USO is not necessarily equal to its underlying asset value. When players without storage facilities are vastly bullish about crude oil price, they will bid up the price of USO shares so that the gap between the spot price and USO price will shrink and vice versa. In the graph the red USO curve rather lags behind the blue spot price curve further and further as the spot price rallies up, again implying that the players without storage facilities are not enthusiastic about crude oil. From those observations we conclude that the surging crude oil price in recent months is mostly due to the buying by those with storage facilities.

Who are the buyers with storage facilities? They are strategic petroleum reserves run by various governments, oil refineries and other crude oil hoarders. Other crude oil hoarders usually do not have their own land based storage facilities. They often hire super tankers to store crude oil, and park those super tankers all over the place waiting the price of crude oil to rise. Those parked super tankers are easy to spot from satellite pictures. At this moment there is no such report of widespread hoarding of crude oil via super tankers. We thus eliminate “other crude oil hoarders” as the main source behind the sharp run up of crude oil price. Refineries buy crude oil to satisfy demand and/or to hoard crude oil waiting the price to go up, just like other speculators. It is difficult to get global data about what the refineries are doing. We start from the United States where numerous data are open to the public. In the second graph at the right, weekly inventories are plotted as the blue curve. The scale is logarithmic. The monthly consumption is expressed in average consumption per day, and is plotted as the red curve, also in logarithmic scale. The scales of both logarithmic curves are set to be equivalent so that the same size of change in each curve means the same percentage change for each curve. Both the blue inventory curve and the red consumption curve rose in tandem from their September, 2008 low to December, 2008. During that period U. S. refineries bought substantial amount of oil to compensate the sharp drop of purchase due to the shock from the meltdown of Wall Street in September of 2008. However, Since January of 2009 the percentage rise of inventory is almost exactly the same as the decline of consumption. This means that from January U. S. refineries have kept the purchase of crude oil at a constant level, and the rise of inventory has been simply the result of the falling consumption. Therefore, U. S. refinery buying can also be eliminated as the cause of the sharp run up of crude oil price in recent months. We suspect that European and Japanese refineries are probably in the same situation as U. S. refineries. That leaves the potential buyers of crude oil as the refineries in other countries, and the top candidate is the refineries in China since the massive stimulus package from Chinese Government has artificially lifted China's domestic consumption at the moment. The low crude oil price since July of 2008 is definitely the chance for strategic petroleum reserves of non-oil-producing countries to replenish their stock. However, to do so requires large foreign currency reserve and ample unused capacity in the strategic petroleum reserve. This logic again points toward China as the most likely candidate of buying large amounts of crude oil to enhance its strategic petroleum reserve. Thus we suspect the recent sharp rise of crude oil price is due mainly to massive Chinese buying by both its refineries and strategic petroleum reserve. This conclusion is also consistent with the fear of China that they may be holding too much U. S. Dollar denominated assets and will suffer heavy losses if a hyper inflation is triggered by the massive printing of Dollar in the hands of the current U. S. administration.

Another important issue related to the crude oil price is the movement of Euro. In the first graph presented in this comment, Dollar per Euro is plotted as the green curve. In article 11 it has been pointed out that Euro tends to rally following the crude oil price. Some oil-producing countries are not comfortable holding U. S. Dollar in their foreign currency reserve because they are not friends of the United States, and some simply want to diversify their petrodollars. Their natural alternative to U. S. Dollar is Euro. As crude oil price rises, more petrodollars flow into the hands of oil producing countries, more petrodollars are sold and Euro bought, and higher Euro goes against U. S. Dollar. This trend is starting again as shown in the first graph; Euro is moving up following the crude oil price.

In conclusion we believe that it is the buying from China, either from its refineries and/or from its strategic petroleum reserve, is behind the sharp rise of the crude oil price in recent months. On the side of the United States, the inventory accumulation will be cut back if demand does not rebound soon, and it will act as a brake to the surging crude oil price. This observation also indicates that the crude oil price will easily go up to and even exceeds the all time high registered in the summer of 2007 if the global economy does recover strongly as the recent stock market rally and bullish Wall Street sentiment indicate, since then both China and Western economies will be competing for crude oil. As the consequence the gate of the dreaded hyper inflation will be opened, pushing the global economy into another deep recession.