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July 30, 2005

I Just Don’t Get This.

I can’t offer this up as an entry for the Economic Idiot Award as we presented one of those yesterday but I really don’t get what this guy is saying here:

Nevertheless, the threat to refinery capacity was enough to push the price of crude in New York to $60.45, up 51 cents, in early trading. In London, Brent rose 57 cents to $59.33.

Our very first award of this prestigious prize was over the earlier explosion at the same refinery and the way in which a jump in crude prices was ascribed to it. J. Greene provided one answer in the comments to the first award which might be possible although I rather doubt it, as we all know, refineries are at 100% (or something) of capacity already.

So here’s the question again. How does a decrease in the capacity to refine crude lead to an increase in its price? I can see that it will lead to an increase in derivatives, but don’t get the increase in crude. Short term supply of oil is inelastic, so one would think that there will therefore be more oil lying around waiting to be processed and thus (given that it has storage costs) will go down in price.

There’s one  possibility I guess. The unit that blew up refines sludge into higher grades. That might mean an increase in the price difference between light and heavy grades, as it is the latter that has had its refining capacity reduced, and both Brent and the West Texas quoted in New York are light grades.

But the bare statement "refining capacity down, crude prices up" seems entirely wrong to me. We’ll see if I can get a clarification from the journalist.

(And yes, this time I’m acknowledging up front Pootergeek’s wise point, that trying to use economics to track short term commodity price movements is idiotic, a grand way to lose money. What matters is what all the other traders think is true, not what is.)

Update: From the journalist himself:

What can I say? I merely reported what the traders were saying on Friday. I can see the economic logic of your point, but, as you suggest, markets are rarely driven by economic logic.

If I was pushed for an explanation beyond panic buying and irrational speculation, I might say:

(a) The prospect of a shortage of gasoline/petrol increases demand for the types of crude (Brent, Light sweet) that yield a higher proportion of petrol.

(b) Crude is used by speculators to hedge their positions in other oil products.

(c) In theory, the shutdown of one refinery would increase demand, as other refineries bought up supplies to ramp up production and fill the gap.

Obviously that may be less of a factor at present, with refineries running at 97pc capacity or so. Nevertheless, the theory alone may be enough to tempt speculators into the market.

I acknowledge that none of these points really make a compelling case for the price spike. But then I'm not convinced that $60 oil is merely a reflection of the supply/demand balance.

a) I agree is possible (and mentioned it), b) should cause a widening of the gap between derivatives and crude, c) new demand should be exactly equal to the drop in old.

I’ll also agree that this is what traders told Malcolm. My own reading of it is this. Prices rose on Friday for crude. There was a piece of news that day, about the explosion at the refinery. At the end of the day traders are casting around for an event upon which to pin the rise in prices and that refinery story is what was used. At a guess (and yes, I am guessing, completely,) there was in fact no connection between the two events at all, it’s simply another example of backward looking rationalisation. Something  happened so there must be a reason for it, a story to tell, other than that day there were simply more buyers than sellers.

As Terry Pratchett points out, we are Pan Narrans. We’re not just the story telling chimps, we require stories so as to make sense of the world around us. Whether they are true or not.

Further Update: I get nominated for my own Economic Idiot Award! Malcolm writes:

Can I now be bold enough to suggest that you win your own economic idiot award for saying there were more buyers than sellers.

As we all know, the number of buyers and sellers must be equal.

Dare you to put this on your blog.

As I said with the very first such award I was bound to get nominated sometime. Not sure he’s quite got me here. If one person buys a thousand contracts and a thousand people sell one each then we have different numbers of buyers and sellers. But at the deeper level, of course he’s right, the volume of oil bought must be equal to the volume sold.

What we both should have said is that at $59 (or whatever) there was greater demand for oil than supply and at $59.50 (or whatever) the two were in balance, thus the price rise. Mea culpa but not yet a secret masonic handshake and lashings of ginger beer for Timmy! Phew!

July 30, 2005 in Economic Idiot Award | Permalink

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Comments

in transactions there are equal buyers and sellers by definition...that doesnt mean that all buyers demanding to buy managed to buy that day

Posted by: e m butler | Aug 1, 2005 1:32:07 PM

FWIW, an interruption in refining capacity makes futures more valuable relative to physical because it increases the storage cost and thus reduces the "net convenience yield" of physical relative to futures. Hence for stable value of physical crude, you'd expect to see a decline in refining capability reduce the backwardation of the market which would be seen as a rise in futures prices.

All of which would be second nature to an oil trader; he'd just think "refinery fire = buy".

Tim adds: I’ll admit I get lost in backwardations and contangos (is there normally a backwardation in the oil futures market? If the storage costs are higher than the interest rates/futures premium I guess so) but OK, yes, you’ve provided the missing bit. I’ll accept that as an explanation, even if I do get lost in those details.

Interestingly, the journo who wrote the piece didn’t know that either.

Update. Hang on a minute, do I believe this. A divergence in spot and futures because of storage costs, OK. But why would this be seen in the futures market? Isn’t a fall in the spot as or more likely? (it being much the smaller market, for example).

Posted by: dsquared | Aug 1, 2005 2:32:05 PM

Oil is definitely a market with normal backwardation. And you'd see the move in the futures market because it's much more liquid and is a market for genericised "oil"; the spot market is a market for oil in a particular place and time. If you were an independent trader who had managed to sort out a good deal for storage close to the burnt-out refinery, then the trade would be to buy a tanker of oil (spot) that was headed for the burnt-out refinery then sell futures to hedge, picking up the higher convenience yield as a profit. The traders who bid up the cost of oil were betting that nobody was in this position.

Remember that under the classic theory of normal backwardation, it arises because the marginal buyer of an oil futures contract is a speculator (the idea being that hedgers are net sellers of oil futures). Since hedgers are usually people who have their own storage and their own uses for the oil they buy, it's pretty natural that the effect of a squeeze on storage costs would be seen in the futures market rather than the spot; most users of the spot market would, as you suggest in the original post, be blissfully unaware of the refinery fire and nor would they change their plans in response to a small movement in the backwardation of futures.

Posted by: dsquared | Aug 1, 2005 5:19:23 PM

Oil is definitely a market with normal backwardation. And you'd see the move in the futures market because it's much more liquid and is a market for genericised "oil"; the spot market is a market for oil in a particular place and time. If you were an independent trader who had managed to sort out a good deal for storage close to the burnt-out refinery, then the trade would be to buy a tanker of oil (spot) that was headed for the burnt-out refinery then sell futures to hedge, picking up the higher convenience yield as a profit. The traders who bid up the cost of oil were betting that nobody was in this position.

Remember that under the classic theory of normal backwardation, it arises because the marginal buyer of an oil futures contract is a speculator (the idea being that hedgers are net sellers of oil futures). Since hedgers are usually people who have their own storage and their own uses for the oil they buy, it's pretty natural that the effect of a squeeze on storage costs would be seen in the futures market rather than the spot; most users of the spot market would, as you suggest in the original post, be blissfully unaware of the refinery fire and nor would they change their plans in response to a small movement in the backwardation of futures.

Posted by: dsquared | Aug 1, 2005 5:20:51 PM

I raised the exact same question here
http://johnquiggin.com/index.php/archives/2005/06/05/oil-economics/

and got much the same answers

Posted by: John Quiggin | Aug 8, 2005 5:36:14 AM