Contango Confusion

The Think Progress web site is a Soros-funded mouthpiece for the Obama administration. Someone at Think Progress or its parent, the Center for American Progress, has instructed cub reporter Lee Fang to devote full time to attacking Charles and David Koch and their company, Koch Industries. (It would be interesting to know who gave that instruction, and why.) We have deconstructed several of Mr. Fang’s attacks, all of which have been juvenile. But his latest effort is perhaps his most pitiful yet.
In “The Contango Game,” Fang tries to show that Koch Industries “manipulates the oil market for profit.” Unfortunately, young Mr. Fang has neither the business experience nor the intelligence to understand the issues about which he writes. The result is that nearly every sentence is a howler. Among other things, while a contango market is the main subject of Fang’s post, he doesn’t know what the phrase means.
Fang begins with the claim that oil prices are high these days because of speculation. Whether it is even possible for “speculators”–some call them investors–to have a material impact on the price of oil over time is dubious. While partisans like to blame speculators for rising oil prices–never, however, for falling prices–objective studies, like this one by the Commodity Futures Trading Commission in 2008, have failed to document any such influence.
Moreover, if you don’t like commodity futures investors–sorry, speculators–you are barking up the wrong tree by attacking Koch Industries. Koch buys and sells physical oil; it transports oil; it refines oil. It does some unhedged trading too, but in that field it is a minor player compared to, say, Goldman Sachs. If Think Progress wants to attack petroleum speculators, Goldman Sachs should be in the dock–except that Goldman Sachs is a top contributor to Barack Obama and the Democratic Party.
Our cub reporter continues:

While much of the attention on oil speculators has rested on the backs of investors and commodity traders, the petrochemical conglomerate Koch Industries occupies a unique role in manipulating the oil market.

This is just ridiculous. In the world of petroleum, where Exxon Mobil is number fourteen on the worldwide list, Koch is hardly in a position to “manipulate” anything.

Koch has little business in the extraction process. Instead, Koch focuses on shipping crude oil, refining it, distributing it to retailers — then speculating on the future price. With control of every part of the market, Koch is able to bet on future prices with superior information.

Huh? Koch sells oil to retailers, and “then” speculates on the future price? Isn’t that a little late? One wonders whether these people even read what they write before publishing it.
And what is this about “control of every part of the market”? Fang just made that up. The oil business is highly competitive, and Koch Industries is, in international terms, a small player. Let’s take refining: the U.S. Energy Information Administration publishes data on America’s biggest refineries. Koch owns three of the 141 largest refineries in the United States; its biggest weighs in at number twelve. So how, exactly, does Koch “control every part of the market”?
Young Mr. Fang continues:

In 2008, Koch called attention to itself for “contango” oil market manipulation. A commodity market is said to be in contango when future prices are expected to rise, that is, when demand is expected to outstrip supply.

This is incorrect. “Contango” is not “market manipulation.” On the contrary, it is the natural state of most markets. It simply means that at a given time, the price of a forward or futures contract is trading above the present spot price. This is what you would expect, given the time value of money. Occasionally, for various reasons, this usual condition may not hold; then we have what is called “backwardation.” A contango market has nothing to do with any expectation; rather, if the futures price is higher than the spot price, as is normally the case, it is a contango market.
It is quite remarkable, really, that anyone would try to write a blog post about a contango market without even knowing what the term means. Mr. Fang continues:

Big banks and companies like Koch employ a contango strategy by buying up oil and storing it in massive containers both on land and offshore to lock in the oil for sale later at a set price. In December of 2008, Koch leased “four supertankers to hold oil in the U.S. Gulf Coast to take advantage of rising prices in the months ahead.”

An interesting claim. Koch certainly does buy oil and store it; it is in the oil business. However, I would be curious to know what “big banks” “buy[] up oil and stor[e] it in massive containers both on land and offshore.” In any event, if Koch or any other company has sold oil on a futures contract, it has to produce or buy the oil and store it until the contract comes due. This, apparently, seems sinister to young Mr. Fang. I am guessing his experience in the business world is not extensive.

Writing about Koch’s contango efforts to artificially drive down supply, Fortune magazine writer Jon Birger noted they could be raising “gasoline prices by anywhere from 20 to 40 cents a gallon” at the time.

Pretty much every word of this sentence is false. Contango is the most common market condition, not an “effort[] to artificially drive down supply.” And Fang simply misquotes the cited Fortune article, which claims that “a 200,000 barrel-a-day decrease in supply could raise gasoline prices by anywhere from 20 to 40 cents a gallon.” It did not attribute any such decrease in supply to Koch Industries or any other company.
Mr. Fang continues:

Speaking with the Business Times, Koch executive David Chang even boasted that falling crude prices in 2008 provided an opportunity remove oil from the market for future delivery:

CHANG: The drop in crude oil prices from more than US$145 per barrel in July 2008 to less than US$35 per barrel in December 2008 has presented opportunities for companies such as ours. In the physical business, purchases of crude oil from producers and storing offshore in tankers allow us to benefit from the contango market where crude prices are higher for future delivery than for prompt delivery.

This is a good opportunity to clear away the mists of confusion and explain what was going on in late 2008. Due to the worldwide recession, the demand for crude oil plummeted. Refineries didn’t want any more oil; they couldn’t sell all that they were producing, and their storage facilities were full. At the same time, oil production continued; you can’t turn oil wells on and off like a light switch. Thus, the spot market plunged to a fraction of what it had been months earlier. There was almost no demand for immediate delivery of oil.
At the same time, refineries knew that they would be selling their inventories over time, and demand was expected to pick up. Thus, refineries wanted to lock in future deliveries of oil at reasonable prices. This led to an unusually steep contango curve; that is, the price of oil to be delivered, say, six months in the future was considerably higher than the price of oil to be delivered immediately. Another way of putting this is that there was a huge demand for storage of crude oil. Anyone who had the financial ability to buy large quantities of crude without quick resale, and had access to storage, was able to make good money. That is exactly what Koch Industries and a number of other companies did.
This is not “market manipulation,” it is market satisfaction. Koch sold oil when customers wanted it, at a price dictated by the market. The problem with web sites like Think Progress and smear artists like Lee Fang is that they have zero understanding of economics and zero understanding of business. Thus, pretty much everything they write on these topics is wrong. They cater to an audience of the ignorant.
Let’s wrap up. Poor Mr. Fang concludes with this howler:

A recent presentation from Koch Supply & Trading, the Koch unit devoted to selling financial products, confirms that Koch has taken advantage of a lax regulatory environment to aggressively trade on future oil prices. “The return of speculators to Oil, the ‘macro trade’ is alive and well,” reads slide 36:

The Power Point presentation embedded in Fang’s post was given by a Koch Supply & Trading employee at a conference in Geneva. Its intended audience was prospective clients for Koch’s risk management services. Companies like airlines, for example, need to assure themselves of a future supply of petroleum products, and need to manage the risks associated with price fluctuations. This is a service that Koch Supply & Trading provides. If you actually look at the Power Point presentation, it is an impressive product. It explains Koch’s expertise in this area. The reference to “speculators” had nothing at all to do with Koch Industries, but rather was one line in a discussion of prospects for future price movements.
The basic problem with a site like Think Progress is that its “reporters,” ill-informed, uneducated, inexperienced amateurs like Lee Fang, try to write about subjects of which they have no understanding. Worse yet, they slander the very people who do understand those topics–the people who produce products and make our economy go.
There is another level of irony here. Koch Industries is a classic example of an American company that doesn’t just push paper, but actually makes products. Its business is production, not “speculation.” Think Progress, on the other hand, is funded by one of the world’s most successful speculators: George Soros. Soros has made billions by manipulating markets, without ever producing anything. He is the definitive speculator and market manipulator (in particular, currency markets) of the 20th century. If Soros bothered to read what his minion Lee Fang wrote, he no doubt would burst out in laughter at Fang’s ignorance. But that, apparently, doesn’t bother Soros. He is happy to promote ignorance as long as it advances his own selfish political interests.
UPDATE: A reader writes:

Nice job on the Koch piece. I’m in the business, and you explained it all very well. The Koch presentation about speculators (the “macro” people) is about the flow of money into specific commodity markets. The flows are large enough to make the markets move against the fundamentals in the short run.
In other markets, for example soft commodities (ags), contango is referred to as “carry,” the source the phrase “the carry trade,” which is mainly used in reference to interest rates and FX. Everyone has the opportunity to buy the nearby and sell deferred. The difference between the two needs to cover the cost of storing and financing the inventory, which in the Koch case includes the daily cost of chartering a ship to use as storage, which is in the tens of thousands or hundreds of thousands of dollars per day. If contango/carry didn’t exist, no one would have an incentive to hold inventory.

FURTHER UPDATE: “Think Progress” is rapidly becoming the punching bag of the internet. For another fun devastation of a remarkably stupid Think Progress post on Koch, Governor Walker and Justice Prosser, see Professor Bill Jacobson. These people are really making it too easy; George Soros may want to demand his money back.
MORE: Another highly knowledgeable reader writes:

Your comments on contango are exactly right. Koch and the other market participants REACTED to extraordinary contango pricing in the market; they did not just wake up one day and decide to inventory oil on spec to create the contango conditions. The contango trade is possible because spot prices DROPPED….compared to longer term pricing in the first instance. The image implied that Koch somehow “artificially” removes supply because they inventory oil is itself ludicrous. They don’t “remove supply”— they buy oil for immediate delivery at spot prices….the market price today…that anyone can get and that clears current supply. And in the future, to realize on the trade, wouldn’t they on this logic have to dump their inventory then “artificially” creating “excess” supply…and driving prices down? If the claim is that Koch and others are “artificially” reducing current supplies which tends to raise spot prices, it would thereby cause spot and future prices to converge and eliminate the point of the trade!
The idea that Koch “occupies a unique role in manipulating the oil market”…and has “control of every part of the market…with superior information”….with NO, zero, nada oil production of its own is laughable on its face, as you note. This is an arbitrage trade; by definition not “speculative” if you’re long the crude and short the forward. Your price spread is locked in risk-free…it’s only “speculative” if you’re missing one leg of the trade. Koch and — horrors! — some banks or financial institutions who also did the same trade actually went out and leased ships and storage facilities? Well, so what? In fact, the very existence of the leases for storage of physical product is evidence that the forwards are not speculation just as the existence of forwards means that the storage of physical product is not speculative.
The utter stupidity of this “journalism” is summed up in the breathless conclusion. “Is Koch again buying up supply in expectation of higher crude prices during the summer or beyond – as many analysts have predicted?”…well, duh!…Koch itself, as the article notes, is NOT a producer of crude oil…they are a refiner and buyer only. So, OF COURSE they are “buying up supply” if they believe — quite reasonably, as the article itself suggests — that prices in the future will be higher! What else would they or any rational user of crude oil do?
Obviously this moron doesn’t know the difference between hedging and speculation. Indeed, the very source cited concludes that expected future higher prices, quoting the U.S. government’s Energy Information agency, are due to….”continuing strength in worldwide liquid fuels consumption.”….in other words….market fundamentals!….not “speculation.”
The article is absurd….nonsense on stilts….hysterical propaganda obviously intended as prolefeed…nothing but a collection of question begging assertions, non sequiturs and shamefully misrepresented citations to frighten and outrage the ignorant who, like the author, evidently have no concept whatsoever how any of these businesses and markets actually operate.

That pretty well sums up Think Progress.
OKAY, ONE MORE, from reader Craig Pirrong:

I wrote the book on manipulation (The Law, Economics, and Public Policy of Market Power Manipulation, Kluwer, 1996). I’ve also published 10 scholarly articles in economics journals and law reviews on the subject. My next book (Structural Models of Commodity Price Dynamics, Cambridge UP, forthcoming) is all about the determinants of contango, backwardation, storage, etc. Based on 25 years of scholarly research and market experience, I can say that Fang the Farcical knows not the first thing about either manipulation or commodities pricing. You would think that Soros could have found a junior assistant trader to teach Fang the basics. But then there wouldn’t have been a story, would there?

Lee Fang, RIP.

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