Speculation: how oil prices (often) happen in the real world  Over the last couple of days, there has been a bloodbath in the oil market -- a "flash crash" as they call it. Today, prices are dropping further. What is going on? Well, the traders in the casino whom we've been discussing the last several months are taking their winnings off the table in a seriously panicked way and stampeding out the door. Oil is now in the mid-$90-a-barrel range. If this keeps up, gasoline will fall back from $4 a gallon here in the United States.

I raise this because of the news, but also because elsewhere we are seeing pushback from those who argue -- as similar individuals did the last time we had a price runup, in 2008 -- that not trading (speculation) but supply and demand are the motive drivers of oil prices. These folks' refrain goes like this: "People who say traders are behind the whole runup in oil prices are wrong wrong wrong, besides being paranoid and conspiratorial."

What's the problem with this argument? Nothing on its face -- after all, how can any one single factor be responsible in every case of a particular outcome? The law of averages tells you the dice won't come up sevens every time. But when you look underneath it, it falls apart. Why? Because its formulation is faulty. Speculation isn't always responsible for price swings. But often it is.

Back in 2008 -- and now -- a debate raged over steep increases in oil prices. Traders from Goldman Sachs and elsewhere, along with many observers, asserted that this was all about supply and demand (actually they use the code word "fundamentals"): There in fact were traders buying and selling cargoes and futures, but they had no or little ultimate impact because (gobbledygook alert!) "for every buyer, there is a seller," and "futures prices cannot be persistently high without the support of physical fundamentals." On the other side of the debate were lots of screamers using epithets against speculators (spit, spit), in addition to ordinary commodities analysts and reporters who simply watched the action before them, compared that with the movement of prices, and made their own assessment: Psychology drives the price of oil futures up, and down. Traders are aware at all times of supply and demand, but it is what they expect next that propels their trading, and hence prices of futures. After that, their decisions converge directly with what buyers pay in the physical (spot) market.

Again, let's use a betting metaphor. A group of men and women are sitting in a casino playing poker.  The pot grows larger as each player discards and picks up new cards, betting in rounds along the way. The question: What is causing the pot to grow? The bettors or the cards in their hands?

The first crowd -- the traders and absolutists -- will say it's the cards (the fundamentals): no cards, no bets. The second crowd will say, sure there are the cards -- no one would bet without their presence; but in the end, it is the bettors whose hubris, knowledge of their own cards, guesswork about others' cards, susceptibility to bluffing, and experience in the game drives how much they do or don't put on the table, and thus how large the pot grows.

Listen to Frank Cholly of Lind-Woldock, speaking after yesterday's selloff with the Wall Street Journal: "It's a mass liquidation. I think it's just hedge funds got scared and everyone's running for the door right now. It just seems to be contagion." Now listen to Douglas Hepworth of Gresham Investment Management, who spoke with the Financial Times:  "You want to be the first one out the door because the trip down can be even faster than the trip up."

Finally, watch this video featuring Liam Denning of the Journal, and Oppenheimer's Fadel Gheit, the dean of Wall Street oil analysts. Then look me in the eye and tell me traders and their day-by-day speculation are not singular and dominant factors in the oil price.

As for the morality of all this, are speculators bad people? No. Should they have to pay more to bet in the casino? Yes. Would that higher fee-per-bet cause a catastrophe to "the liquidity of the market," as the gobbledygook purveyors will argue? No.

Read on

To keep power, give it away: The autocrats of the petro-driven Middle East are discovering that ushering in democracy is not an altruistic act, but desperation politics -- if they want to stay in office, there is a good chance they must dispense with the strongman act and accept truly elected representation. For Ali Abdullah Saleh, the president of Yemen, that realization came far too late; he has at most days to go in office, and possibly just hours. What about Syrian President Bashar al-Assad? Possibly next to Saudi Arabia and Iran, Syria is the unlikeliest place in the Middle East for regime change. Today, his troops fired on protesters after Assad attempted to assuage public unhappiness by promising to end 48 years of martial law. Yet more unrest there seems probable as thousands poured into the streets regardless, and reports are of some protesters grabbing away guns from authorities. Libya is the conspicuous outlier -- short of a palace coup, Col. Moammar Qaddafi looks likely to hang on.

My colleague David Rothkopf took President Obama to task this week for a supposedly fuzzy approach toward Libya, but I don't grasp his mystification. The best U.S. course is to allow Middle East events to take their course and not put an American imprint on them, even when they reach nail-biting stage. In the case of Libya, the U.S. rightly held back as long as possible with the idea that perhaps, perhaps the rebels might yet turn back the Qaddafi tide, but when Benghazi was about to be overrun, stepped in to create a level playing field (there is a preference for another Libyan leader, but the policy is not to explicitly overthrow Qaddafi, but to make it as much a fair fight as possible.). The U.S. rightly is not going to install the opposition, but take away the regime's air, armor and artillery advantage. Equally incomprehensible, also here on the pages of Foreign Policy, Bruce Ackerman has declared Obama an imperial president. On the other side, the chest-beaters would like Obama to be more "decisive." Guys -- take a little course in the exercise of influence and power; better yet, take a look at the nature of what's going on in the Middle East. This era is not the time to kick down the door, guns blazing.

The rare earth blues: The Chinese are clamping down ever harder with market hindrances against exports of rare earth elements from the country, this time by raising tariffs on the 17 types of minerals. This has been an issue since last September, when Japan's arrest of a Chinese trawler captain revealed Beijing's ultimate soft spot (which we had thought was Tibet, followed closely by Taiwan) by triggering China's rare earths embargo on the entire global market. But is there a crisis for the high-tech industries and armaments manufacturers who rely on them? This week, I participated in a panel discussion at the Heritage Foundation on the subject. The consensus was that, while there is a current squeeze and prices have almost doubled since last year, a combination of recycling and the fast development of new supplies will resolve it within three or so years. Australia, India, Kazakhstan, Mongolia, not to mention Alaska and California, are all acting in concert to develop new supplies.  

Read on for more on this week's news. 

Read on

Japan/Libya/Bahrain: trader heaven (or hell) One of the main canards of times such as this is that the markets hate uncertainty. The truth is that traders and investors are in a heavenly time. It's pretty simple - if you are a bettor (which is what oil traders, for example, are), you make money only if the price changes on the volumes you buy. When they do shift either up or down -- and keep doing so -- you win (assuming, of course, that you bet on the correct direction). The last 24 hours have been absolute nirvana for the shrewd trader (though not so much for the laggards). Oil prices were down, then they shot up after Col. Moammar Qaddafi threatened to pursue his enemies into their closets (there is something apparently chilling about that closed-in image; or perhaps it's the shoes?) and the United Nations Security Council voted to bomb him. We were well back up into the $100s-a-barrel prices. Now, after Qaddafi appears to have blinked (deciding perhaps that he prefers not to risk a possible indeterminate period of time confined to a spider hole with a long beard), oil prices have plunged. On each of those movements -- if you were a well-hedged trader -- you have earned big, big bucks. Of course, there are many losers too. Regardless, this is what traders live for -- the profit potential in uncertain times.

Big Oil and the calculus of friendship: Paolo Scaroni, the agile CEO of Italy's Eni, who manages to maintain relations no one in Big Oil can match -- with Russia's Vladimir Putin, with Kazakhstan's Nursultan Nazarbayev and, of course, with Libya's Col. Moammar Qaddafi with -- is bristling at the international sanctions slapped on Libya. Scaroni calls the sanctions "shooting ourselves in the foot."

There is some fear that Eni, along with BP and Exxon, could face contractual problems with Qaddafi, Bloomberg reports. But that isn't how oil deals have really worked in recent decades. Instead, governments have generally honored oil contracts from one regime to another, of course with some possible renegotiation.

So what is Scaroni really up to as he calls on Europe to abandon the sanctions against Qaddafi? Perhaps he is emitting a friendship code intended for others, such as Putin and Nazarbayev, a message that he is not a fair-weather friend.

Coal: When pressed, even the choosey loosen up. Being health-conscious, you thought you'd never eat another cheeseburger -- until you were starving that one day, and McDonald's was the only place open. So it is with electricity producers. Many nations have been moving away from coal-fired electricity, since it's so dirty and spews out so much CO2, but now Japan's dual natural disasters have shaken up those preferences. Coal may be back in a big way, reports the Wall Street Journal (though, for the record, the Journal is also hedging its bets. In addition to today's optimistic coal piece, the paper ran separate optimistic natural gas and nuclear energy stories).

Here is how the dots connect: Japan, having to replace nuclear-produced electricity, is going to buy a lot more coal, and also liquefied natural gas. Some of the LNG is being diverted from Europe. That has made LNG more expensive in Europe and elsewhere as markets tighten. At the same time, Germany has at least temporarily shut down seven nuclear reactors. Put together the higher LNG prices, and the closed German nuclear reactors, and you get more European demand for much-cheaper coal. Make the same calculus in Japan and elsewhere, and you get the larger picture -- more coal demand.

If this is right, much of the clean-air progress made in recent years appears likely to be set back in the coming months. Yet one would be remiss to ignore the shift of public sentiment, and hence political support, in recent years toward a cleaner environment. If that holds -- and that's my bet -- then there may be added use of coal in the short- and medium-term as the market resolves the current uncertainty over nuclear power, but there will also be a mighty hindrance toward a wholesale shift to coal. Instead, there is reason to expect more momentum coming to the natural gas future that we've been discussing.

The Gazprom State: Outbreak of pragmatism. But does Nabucco win? Not to equate Russian gas policy with Col. Moammar Qaddafi's war footing, but are we seeing a case of forced practicality? Qaddafi, after threatening to enter the closets of his enemies in Benghazi, has had a change of heart now that he might be bombed by France and the United Arab Emirates. As for Russia, it's making more noises about reversing a long-standing war-footing in Europe, fought on the battlefield of natural gas pipelines. As we discussed last week, Gazprom, Russia's politically inclined natural gas giant, has sought to reinforce its hold on the European market (where it supplies some 30 percent of the gas) by connecting up a gigantic new pipeline called South Stream. The United States and Europe have countered with Nabucco, their own proposed pipeline starting at the Caspian Sea. At stake, according to the latter folks, is the political independence of eastern and central Europe. But Russian officials are offering more details on possible plans to scrap South Stream and instead ship its gas to Europe in the form of liquefied natural gas.

In our videotaped interview last week with South Stream CEO Marcel Kramer, he said that he was in the dark about any such change of Russian plans. But now a couple of Russian government officials say South Stream may face an "insurmountable" political hurdle in Turkey, and so they are seeking economical alternatives toward accomplishing the same aim, but with LNG.

On first glance, this would appear to be a possible victory for Nabucco. But not so fast. First, Nabucco still doesn't have sufficient gas to be built, mainly because the Turkmen -- as they have done since the 1990s -- won't get with the program and commit to gas shipments and a pipeline. Second, what is the effective difference if Russian gas goes to Europe via pipeline or LNG? True, a pipeline suggests a more permanent marriage. But these days, divorce is mighty common. LNG provides the Russians a lot more flexibility in terms of markets.

Perhaps the Nabucco folks will go LNG as well?

As O&G readers know, I've been in Houston at CERA Week -- the Davos of the energy industry, hosted by oil historian Daniel Yergin -- for the past five days. So in today's wrap, the highlights of the conference:

Emergencies drive the market: The news over the last 24 hours punctuated the general message of CERA Week: Bad economic news sent oil prices down, unrest in Saudi Arabia's oil-rich Eastern Province pushed them back up, then the 8.9 magnitude earthquake off Japan's coastline pushed them back below $100 a barrel. Finally, the oil price settled just a bit down, just over $100. The message: the market is incredibly jittery, and is holding pretty close to $100 a barrel regardless of the news.

As oil analyst Ed Morse told me, oil was probably overvalued prior to the Middle East unrest. But the turmoil there has fundamentally changed the political calculus, and with it the oil market for around the next decade and perhaps longer. A risk premium is going to remain in the price, especially since real trouble struck Saudi Arabia yesterday, as I wrote. So gasoline prices, too, are going to stay relatively high (that's a Paris gas station pictured above). All in all, as Christophe de Margerie, the CEO of France's Total, said, the oil industry is in a serious fix.

But what's notable is how muted the response has been in the market. Step back and look at the absolute price movements so far since the turmoil in the Arab world began. If we had just one of these events back in the spare-capacity-short year of 2008,we would have seen huge price movements -- $10 and $20 a barrel. Instead, we are getting shifts of two or three dollars one way or the other. One reason is that there is global surplus production capacity of 3 or 4 million barrels a day that can be brought to bear; another is that, in the short term, the United States and Japan can swamp any sudden oil shortage by releasing millions of barrels of oil from their strategic reserves. These petroleum reserves -- totaling 1.6 billion barrels around the world -- cannot create long-term price stability, because traders will always bet on spare capacity in an emergency. But they can smooth out the bumps.

The next emergencies? Where are the predictable next bumps? Today's planned Day of Rage in Saudi Arabia became, as the Washington Post called it, a day of rest, and we cannot foresee natural disasters. Yet, some are attempting to quantify what is possible. Among those is Bloomberg, which has ranked 20 possibly troubled countries in a Combustibility Index. Of those, 18 are in the Middle East, but interestingly none of the big oil producers top the list.

The five most combustible countries, in descending order, are Libya, Sudan, Yemen, Syria, and Egypt. The bottom five among these combustible states, again in descending order, are Saudi Arabia, Morocco, United Arab Emirates, Kuwait and Qatar.

For the quants among you, the biggest component in the Bloomberg equation is repression, which accounts for 50 percent of the weight of the variables. (To calculate that, among the factors are the size of a country's military per capita, how a ruler came to power -- whether by vote, coup or assassination -- plus how long the ruler has been in power, and whether the ruler came from the military.) The other 50 percent includes GDP adjusted for purchasing power parity, unemployment, median age, income inequality and access to information.

Electric car realities: Another takeaway from the conference is how technological advances are shifting the energy equation, and geopolitics along with them. Among the technological changes are in transportation. I spoke with two big players in the electric-car space: Britta Gross, director of global energy systems for General Motors, and Steven Koonin, the U.S. undersecretary of energy for science. Both of them described the multi-year realities of creating a plug-in hybrid and electric-car industry. Gross said that one reason the GM Volt is currently so expensive is the carmaker's strategy of creating a "wow" factor for buyers -- carving out a market by loading up the Volt with exciting gizmos. When the next generation of the Volt comes out -- perhaps in five years or so -- it may have a lot fewer such electronics, Gross said, which will much-reduce the sticker price. In addition, the cost of parts will probably be less because there may be more competition among suppliers. Here are Gross' remarks:

Koonin, looking at the market from the perspective of a government goal of reducing oil consumption, said that much will be gained by simple efficiencies: 25 percent less gasoline will be used when cars are lighter and engines more efficient. He said that years from now, plug-in hybrids will penetrate a much larger segment of the market and cut more oil consumption. No one is certain that advanced batteries will ever be good enough to make a purely electric car commercially competitive, he said, but the performance of hybrids may mean that they won't be necessary. Here are Koonin's remarks:

Possible Putin shift in pipeline politics: For much of the last decade, Russia and the West have fought a pipeline war in Europe. Russia has sought to tighten its natural gas supply grip on Europe -- Russia's Gazprom supplies about 30 percent of Europe's gas -- by building yet another big pipeline into the continent, called South Stream. The West, led by the United States, has offered up a rival pipeline, called Nabucco, that would carry gas from the Caspian Sea states of Azerbaijan and Turkmenistan into Europe, and hence reduce the continent's dependence on Russian gas. This may sound mighty arcane, but the combatants of pipeline politics treat the game quite seriously.

In any case, Russian Prime Minister Vladimir Putin yesterday added new confusion to the state of play. He suggested that Russia may not build the pipeline after all, but instead a liquefied natural gas terminal that would ship Russia's gas to Europe by tanker. In an interview today, South Stream pipeline director Marcel Kramer told me that he has received no new instructions, and that he is proceeding with his existing orders to make the $21 billion pipeline work. He is attempting to get a final investment decision on the pipeline by the middle of next year so that it can be built by the end of 2015. Here is a clip from our conversation:

How to moderate oil prices: Vladimir Putin, Hugo Chávez and Mahmoud Ahmadinejad, plus the leaders of a bunch of other oil-producing states, are benefitting from high oil prices. But not motorists, and so we are being treated to the latest round of American politicians insisting that the White House open up the brimming, 727-million-barrel U.S. Strategic Petroleum Reserve. Sen. Jay Rockefeller (pictured above), the great-grandson of John D. Rockefeller, is the latest voice advocating the liberation of this sea of oil in order to bring down gasoline prices. His colleague, Sen. Jeff Bingaman, who chairs the Senate Energy Committee, says the following: "Between the lost production in Libya, the crude oil dislocation associated with additional Saudi production and the prospect of further turmoil in the region, we are now unquestionably facing a physical oil supply disruption that is at risk of getting worse before it gets better."

No, we are not facing what these two senators suggest, which is a supply shortage. Even if we were, the huge reserve would not influence gasoline prices. The single factor that would calm the markets would be more surplus production capacity, in other words not more oil, but the capacity to produce more oil. When traders are bidding up and down the price as they earn paper profits, then cash them in, they are not leveraging the perception of a supply shortage. They are trading on the perception of a lack of surplus capacity to produce more oil -- they are betting that the chaos in Libya could spread to one or more additional OPEC states, remove more oil from the global market, and reduce spare production capacity to a sliver, or even erase it completely. When there is no spare capacity, it portends a battle for resources.

So simply putting more oil on the market, as these senators suggest, would have almost zero impact. In fact, Michael Levi argues that invoking the petroleum reserve could have the perverse impact of spooking the market, much as Saudi King Abdullah did a week ago by promising $36 billion to the country's suffering masses. Levi asserts that releasing the reserves could "validate fears in the market --after all, it would signal that the United States government was worried."

Traders watch videos such as the one below, and rub their hands with glee. The politics and the panic are part of this volatile casino.

The Chinese are not suicidal: The Chinese have given us the latest evidence that some of the major presumptions regarding their fixations aren't as valid as some think. Zhou Shengxian, China's environment minister, said pollution could hinder Chinese economic growth and social stability. That was after Prime Minister Wen Jiabao said the country would aim for slower, cleaner GDP growth over the next five years -- not the double-digit rates of the last quarter-century, but more like 7 percent.

We have suggested that China may continue using a lot more coal -- it currently accounts for half the world's demand for the fuel -- but that, for the very reason cited by Zhou, its demand will not rise at the breakneck rate that is conventionally suggested. Simply put, the Chinese Communist Party is not suicidal; it wants to continue in power, and if pollution gets out of control, there could be serious public unrest. Less-than-projected coal consumption in China carries a lot of implications, such as lower-than-presumed CO2 emissions and generally a cleaner country going forward than the received wisdom suggests.

… but they are still pretty territorial: China has demonstrated yet again that territory is a red line. Two Chinese patrol boats appear to have ordered a Filipino oil exploration vessel to leave an area of the disputed Spratly Islands in the South China Sea. The confrontation was ended when a Philippines military aircraft swooped over. The Spratlys are a long-time source of antagonism among several nations that claim them -- Taiwan, Brunei, Malaysia,  and Vietnam, in addition to China and the Philippines. The Chinese call them the Nansha islands, and appear likely to continue pressing their case that they have "indisputable sovereignty" over them, as a spokesman for the Chinese Embassy in Manila said.

Libya falls squarely into the central aim of this blog, which is to identify and follow the geopolitical impact of energy events. Libya is fundamentally an energy event. After decades of ostracism because of his terrorist attacks and links, Col. Moammar Qaddafi was re-embraced by the international community in 2003, led by the United Kingdom and the United States, for one primary reason -- he said he would open his oilfields to their companies. Oh, there was the renunciation of terror, too -- no trivial matter -- but then-British Prime Minister Tony Blair reversed Britain's stand on the Libyan-ordered Lockerbie airline bombing specifically to shoehorn BP, Britain's biggest company, into some monstrous new oilfields. The same went for the rest of Europe and the U.S., where ConocoPhillips, Hess and Occidental also got oil deals.

Eight years later, we observe the geopolitical impact in the spectacle of Qaddafi provoking an unnecessary civil war, and roiling world oil markets, all so he can continue his almost 42-year rule. The energy-geopolitical takeaway -- political and financial compromise with a certain class of petro-tyrant can rebound back on you profoundly, destabilize a region, and shake up economies, all while tarnishing you with the same brush. One also doesn't know if, in the end, the deals themselves will all hold up.

Read on

The Saudis' power to calm: We all know by now that oil prices have soared not specifically because of Libya, but because traders are worried about what happens next. In particular, they are worried about Saudi Arabia -- whether it can truly step up to the plate with big volumes of oil to compensate for a shortfall elsewhere, even if it itself falls victim to the unrest roiling the Middle East. To be more precise, the question on many lips is: Will or will not the Saudis announce an increase in oil production in order to calm roiling global markets? I discuss this topic today on the Brian Lehrer Show at WNYC.

The answer is that they may already have quietly done so.The Oil Daily is reporting today that Saudi Arabia has lifted production to 9 million barrels a day, which if accurate would be about 4 percent, or 400,000 barrels a day, higher than its most recent reported volume. That's a serious uptick in production -- sufficient, one would think, to persuade traders that the kingdom in fact possesses the capacity and will to tamp down market volatility when it's called for. It should be sufficient to lower prices well into the low $90-a-barrel range. It should be, that is, if the Saudis actually tell the market that it has done so. Instead, the Saudis are going around simply asserting that they will step in as soon as they are truly needed.

Is this just the Saudis playing coy? No, writes the Oil Daily: "Saudi Arabia has been quiet about its output hike, most likely because of the political sensitivities in the region and the internal dynamics of OPEC, where members are expected to produce at target levels." In other words, if Saudi Arabia wishes to remain the uber-alpha male in OPEC, it must not be unilateral or bumptious, but navigate the shoals of the cartel with diplomacy.

Okay, I get that. But doesn't that defeat the purpose? If the market doesn't know that you've added the volumes -- which otherwise would be like apologizing to your wife for an egregious mistake by writing it on a piece of paper and putting it in your pocket -- why bother? I suppose there are just things about the Saudis that we are doomed never to grasp.

Speaking of Libya's impact, readers emailed me the nifty charts below. In the first chart, produced by the International Energy Agency, you can see that Ireland is the most exposed country in the world to Libya, which supplies almost a whopping quarter of its oil. Italy is next with about 22 percent reliance on Libya. Indeed, Europe in general is on the hook. As for the United States, it's relatively inoculated -- Libya satisfies just 2-3 percent of its demand.

In this chart, produced by the Russian news agency RIA Novosti, you can see Libya's export reliance. It by far sells the most of its oil to Italy -- almost a third of its export total. Ten percent of its oil goes to China, and 6 percent to the United States.

The fallacy about China's oil companies: One prevailing wisdom about China's global resource grab is that it's all a centrally devised plan. So that when China's oil companies hand out big loans to Brazil, Russia and Kazakhstan in exchange for oil supply and access to fields, they are effectively following Communist Party orders. Not so, says the Paris-based International Energy Agency.  In a new report, the IEA says that not only do the China National Petroleum Co., Sinopec and the rest operate autonomously and commercially, but they also have added volume to the world supply of oil and gas. Julie Jiang, who co-wrote the IEA report with Jonathan Sinton, said, "These are far from puppet companies operating under control of the Chinese government, as many have assumed. Their investments in recent years have been driven by a strong commercial interest, not the whim of the state." At the Wall Street Journal, James Areddy called the report "eye-catching."

Out one door, through two more: World power is shifting from west to east, and so is BP's portfolio of assets. Over the last month or so, the British company has announced $15 billion in operational tie-ups and share swaps with Russian and Indian oil companies, including a $7.2 billion deal this week with India's Reliance Industries, headed by Mukesh Ambani, one of the richest men in the world. At the same time, BP is reducing its foothold both in the United States and at home in the United Kingdom. All of this has followed BP's disastrous oil spill in the Gulf of Mexico last year. For BP, the strategy is a bet that, by gambling in Russia and India, it can increase its reserve base by about a third, to some 80 billion barrels of oil and natural gas, according to a Citibank estimate cited by the Financial Times.

Let's look at the bigger picture: Will Wall Street eversee BP the same again after the Gulf of Mexico, and bid up its share price astraders did for almost all the other major oil companies this week? Probably. Butit could be a long time. Production in Russia's Arctic region is a long way off -- perhaps a decade. So for now the value of these deals is largely notional.