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Speculators / Rising prices

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UptonStellington

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To determine if the price change is due to inflation he should have looked at gold ...
Not just gold, but at a variety of other goods and currencies. The price of oil -- expressed in US$ per barrel -- reflects the estimated real value of oil and the estimated real value of the US $. The price is a ratio. Therefore, it necessarily incorporates the value of both oil and US$. Today, the "real" (i.e. currency-abstracted) price of oil is high -- around the real levels of the oil-crisis of the 1970s.

In a previous post, you asked why there was a sudden upshot in the price of oil, hinting that no significant event took place. The war with Iraq, the tension with Iran, growing Asian demand...all these were old news. That premise might be true, but even if no "underlying reality" changed, prices can still change as traders discover that underlying reality. For instance, based on historical patterns, and a bit of updated extrapolation, a trader might predict that demand from China and India will start to flatten at a certain price-level. Fact is, though, there is no good way to know this until it happens. In the 1980's east-Asian per-capita food consumption grew by a huge amount. Today, they want energy. If the price rises to a historical high, how will they re-allocate their Yuan and Rupees? Traders make educated estimates, but sometimes have to change when they find they were wrong. So, the significant fact that probably explains the price-rise is that demand turned out to be stronger than expected.

Some months ago, the price of oil was $100 and the market was estimating that the price would stay around $100 for the next 5 to 8 years (as reflected in the price of futures). Today, the price of oil is around $130, and -- once more -- the market is estimating that the price of oil will stay at that rate going out 5 to 8 years. It appears that the market is currently predicting that supplies will be forthcoming to meet the expected increases in demand in the next few years, but not forthcoming in such large quantities as to bring US$ oil-prices down.

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I didn't get a chance to read this entire thread. But, in summation, blaming speculators or traders for higher prices is blaming them for the exact opposite effect that they have on the market. Actually, we should be saying the reason oil prices are so low right now is because of speculators and traders. Two things:

1. Speculators and traders deal in futures contracts and very rarely take delivery of actual product, so they do not remove any supply from the market.

2. For every buyer in the market there must be a seller.

Number 2 is most important of all, and most people tend to forget it when discussing these sorts of things.

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I didn't get a chance to read this entire thread. But, in summation, blaming speculators or traders for higher prices is blaming them for the exact opposite effect that they have on the market. Actually, we should be saying the reason oil prices are so low right now is because of speculators and traders. Two things:

1. Speculators and traders deal in futures contracts and very rarely take delivery of actual product, so they do not remove any supply from the market.

2. For every buyer in the market there must be a seller.

Number 2 is most important of all, and most people tend to forget it when discussing these sorts of things.

Phenomenal! This is exactly the issue, and exactly when anyone who wants to "speculate" that speculators influence market prices and I ask for them to describe the mechanism by which that happens, no one can.

It is the same thing with "profit taking," the usual explanation you hear on the radio when the market takes an unexpected dip (as in "late afternoon profit taking cause the market to finish down off it's noon-time high.") Huh? Profit taking does not influence market prices. For everyone who sold a stock thinking he'd made enough profit and the stock was overpriced, someone buys it thinking it is good value at that price. For every "profit taker" there is someone who "wants in on the ground floor."

And just as profit taking does not influence market prices neither does "speculation".

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2. For every buyer in the market there must be a seller.

Number 2 is most important of all, and most people tend to forget it when discussing these sorts of things.

Warren Buffet was on CNBC the other day saying the exact same thing. Oil speculation doesn't remove any supply. Its not like guys working on Wall Street are going to have 100 barrels of crude oil delivered to their homes.

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Adrock, I agree that speculators/traders/market-makers/investors...whatever term we wish to use, tend to keep prices down even when the prices are going up. Typically, they are rational, expert moderators of price.

However, the fact that there is a buyer and seller for any transaction is fully consistent with falling/rising demand/ supply. So, that is not the way to argue against the idea that demand/supply falls/rises, thus causing a change in price.

Here's an example: Some fashion-accessories are selling for $50 a piece. There are 1000 produced for sale each month and 1000 customers buy them @ $10 a piece. Then they go out of fashion, and customers aren't buying them. Stock is building up -- they have 3000 units on hand. The sellers decide to slash prices to a sale-price of $2 per piece, and the stock (3000 units is cleared out). Even though the number of units sold goes up, and even though there is a buyer for every unit sold, we still say that demand fell.

Demand is not a single number; it is a willingness and capacity to buy various number of units at various prices. In mathematical terms, it is a series of number-pairs -- typically drawn as a "demand curve". When we speak of "falling demand", we are speaking of the change of this series of numbers, not the final amount that is finally sold at a market-clearing price.

Secondly, the fact that traders do not actually take delivery is not critical in whether they exert demand in the market. At the point at which the trade is made, the fact of whether or not they will take delivery is moot -- it still has the same effect. In the fashion-accessory example, if some fashion-trader were to tell the supplier that he is willing to buy 1000 units a month in the future, that is just as real to the market-demand.

Futures traders do not directly impact today's real supply and demand. However, here too, they have an indirect impact when the commodity is such that it can be held back by a supplier at little cost, and sold at the (known) future price. So, the impact on current supply is not so much in corn, but more in oil and gold etc.

I didn't get a chance to read this entire thread. But, in summation, blaming speculators or traders for higher prices is blaming them for the exact opposite effect that they have on the market. Actually, we should be saying the reason oil prices are so low right now is because of speculators and traders.
Yes, they allow people to plan for the future, by taking on the risk of estimating incorrectly.

Because these traders are willing to guarantee a future price for oil 5-8 years hence, a supplier can use that knowledge to invest in increased production today.

This is more easily seen in something like Corn. A farmer does not have to take on a price risk. Suppose a farmer is willing to plant more corn, as long as he can sell it for over $650 per 5000 bushels. Today, he knows he can sell 5,000 bushels for around $750. However, what if there's a real good crop in 2010, or the government pulls back its Ethanol rules, or many other farmers like him decide to put more land into Corn? Then, the price in 2010 might be less than he expects and he would be in a real fix if it fell below $650.

The existence of market-makers, who specialize in speculating on future prices, allows the farmer to get a quote for 2010 corn. He finds that the market is quoting $690 for 5,000 bushels in 2010 futures. That's lower than today's price, but it is still worth his while. So, he can go ahead and sell futures, and then he is safe planting his corn. The existence of a market where price-risk is bought and sold, means that economy-wide more corn will be planted. Thus, the speculators "coax" forth more future supply, thus keeping the future price lower than it otherwise would be.

Traders impact on prices: In the corn example, when 2010 comes around, "real factors" related to consumption demand and then-available "real supply" will determine the price. If the traders have been accurate in their speculations, they have merely been the agents who predicted that reality. In the act of making their estimates of the future, and putting money behind them, they actually do change the price of futures. If they are right, they are primarily showing what the real factors are going to look like some years hence.

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Seems to me, that for those speculators who have no real interest in the commodity at all it would have been enough to make money if other's believed their prediction was right in terms of a trend just long enough for the buyer to make money as well. And then they get out. It can be just like riding a tide (which I think can be artificially created because it based on predictions/opinions and not reality) and the only thing they have to watch for in terms of their interest is for when the tide is changing directions. Am I wrong?

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I didn't get a chance to read this entire thread. But, in summation, blaming speculators or traders for higher prices is blaming them for the exact opposite effect that they have on the market. Actually, we should be saying the reason oil prices are so low right now is because of speculators and traders. Two things:

1. Speculators and traders deal in futures contracts and very rarely take delivery of actual product, so they do not remove any supply from the market.

2. For every buyer in the market there must be a seller.

Number 2 is most important of all, and most people tend to forget it when discussing these sorts of things.

I had been under the impression that the argument was with the number of people engaging in speculative trading. The number of people bidding for a commodity doesn't affect supply, no. But it does affect demand, raising the price, no?

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Traders impact on prices: In the corn example, when 2010 comes around, "real factors" related to consumption demand and then-available "real supply" will determine the price. If the traders have been accurate in their speculations, they have merely been the agents who predicted that reality. In the act of making their estimates of the future, and putting money behind them, they actually do change the price of futures. If they are right, they are primarily showing what the real factors are going to look like some years hence.

Snerd,

While I agree with the detailed discussion you've put forward to adrock, my only concern with the way you've described it is that to the layman is that it indeed looks as though you've indicated that "speculators" do indeed affect the market price, and can "inflate" it, leading to the argument against speculation. In essence you've accepted the definition of a "speculator".

I prefer to keep the argument distinct so as to not create this confusion.

a. Speculators are not equivalent with anyone trading on the futures markets.

b. Anyone trading in the futures market who has an interest in the underlying commodity or an exposure to it, or information about it, is NOT a speculator.

c. the people in b do affect the price of commodities. But their affect reflects real expectations of performance of the commodity given as much known information about the situation.

d. the people in b are the majority of people trading in these instruments.

e. speculators are people who are gambling, i.e. making bets based upon no new information. These people do NOT impact the price of a commodity in the long term.

The insidious thinking here is that somewhere there is a "natural" price for the commodity, and that people ("speculators") are artificially forcing that price away from it's natural level. And most laypeople see us say that speculation affects the price, and this seems to lend credibility to the idea.

It is possible that price of oil is bid up higher relative to other factors than it has been in the past, but this is not an "unnatural" state. It reflects new context, risks and expectations about the new real risk of obtaining commodities. It is not artifically elevated, it is elevated due to new, real realities in the market.

I have the senate report on speculation that seems to be the starting point of this mess printed out and I'm going to read it on the way to OCON. I can almost guarantee that the conclusion will be based on this sort of "Platonic" ideal price concept.

Edited by KendallJ
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sNerd: I usually agree with you, but I don't feel like we are 100% on the same page here.

The fact that there must be a buyer and seller for every transaction is extraordinarily relevant, as is the fact that said buyers will not take delivery.

Let's assume that 1,000,000 "speculators" gather together and collude to push up the price of oil by buying oil futures. The first hurdle is that those 1,000,000 buyers will need to find 1,000,000 sellers to buy contracts from. After that has been accomplished they face a secondary dilemma: Since none of the speculators will be taking physical delivery of oil (Cushing, OK isn't exactly convenient for hedge funds based in CT and pension funds), they will have to sell their contracts before the expiration date. But in order for the 1,000,000 speculators to make any profit at all, they necessarily have to find 1,000,000 buyers at a price at least above what they paid.

Of course this never happens, because it is in no speculator's interest. Why? Because no profit can be made in this manner. Why? Because there always has to be a buyer for every seller, and vice versa.

An oil company may wish to sell futures when prices rise to lock in high prices. A county educational system may want to buy futures when prices rise because they fear ever increasing gas for their school buses. An airline may want to sell futures when prices rise because they have already locked in profits. Refiners, who essentially live and die by the crack spread, will constantly buy and sell to lock in margins based on where they feel the market is headed. There are so many participants with varying interests in the markets that speculators have a marginal impact, i.e. price moves may be quicker. However, they play the important role of always being on the other side of the trade. Imagine the stock market crash of October 1987 without any market makers.

Another thing to remember is that, as KendallJ pointed out, there is no one "speculator", i.e. some Gordon Gekko type pulling levers and making the price of oil go up and down on any whim he has. Speculators speculate according to different indicators. For speculators who use technical analysis (short term speculators for the most part), one may look at oscillators, another at the 200 day MA, and another at the 50 day MA. Other speculators may prefer to use fundamentals (usually longer term). And still other speculators may prefer some sort of combination of both technical and fundamental analysis, for example a Jim Rogers type.

Edited by adrock3215
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Seems to me, that for those speculators who have no real interest in the commodity at all it would have been enough to make money if other's believed their prediction was right in terms of a trend just long enough for the buyer to make money as well. And then they get out. It can be just like riding a tide (which I think can be artificially created because it based on predictions/opinions and not reality) and the only thing they have to watch for in terms of their interest is for when the tide is changing directions. Am I wrong?

No you aren't. Since speculators do not actually determine supply or demand of the underlying product, they simply place a bet on which way they feel the 'tide is going' so to speak. The only way they can profit is to ride the wave. The reason there are so many buyers and sellers at a given price or time is because each one has a different goal and, more importantly, time horizon.

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By the way, when prices rise to "outrageous" levels, oil companies will typically begin selling contracts to lock in the high price. The revenue gained from this selling action essentially provides capital to increase investment in new production, which, when completed, brings prices down. Don't think for a minute that this phenomenon isn't occuring right this very moment.

Edited by adrock3215
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Another thing to remember is that, as KendallJ pointed out, there is no one "speculator", i.e. some Gordon Gekko type pulling levers and making the price of oil go up and down on any whim he has. Speculators speculate according to different indicators. For speculators who use technical analysis (short term speculators for the most part), one may look at oscillators, another at the 200 day MA, and another at the 50 day MA. Other speculators may prefer to use fundamentals (usually longer term). And still other speculators may prefer some sort of combination of both technical and fundamental analysis, for example a Jim Rogers type.

This is great analysis. Not only is there no one person affecting the price, but speculators cannot affect the price en masse. That is, because a specalator doesn't put new information into the market. All these guys each using their own system each cancel each other out. To the extent that all of these systems might temporarily point in a single direction it is not them that are changing the price, but rather the fundamental traders who are getting and putting new information into the market. They are simply as Sophia says, riding a wave, not influencing it's direction.

Yaron Brook has a very succinct and clear description of what it means to "make a market" in his course "Objective Investing." Speculators do not "make a market."

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c. the people in b do affect the price of commodities. But their affect reflects real expectations of performance of the commodity given as much known information about the situation.

It is hard to see that those expectations are in fact based on real realities (using your term) when commodity producers are stating that there is no shortage right now, won't be anytime soon, and that they have the capacity to meet the projected increase in demand with ease.

e. speculators are people who are gambling, i.e. making bets based upon no new information. These people do NOT impact the price of a commodity in the long term.

The only information gamblers need is that a specific trend in terms of opinions will continue. Short term impact on prices maybe enough for the public to get used to new price points - enough so that you will be able to keep a similar level of demand but now at a new, higher price point. I do think that what people are willing to pay vs. the lifestyle changes they would have to make - has a psychological component of familiarity (like taxes - if they were something new they would "hurt" much more).

The insidious thinking here is that somewhere there is a "natural" price for the commodity, and that people ("speculators") are artificially forcing that price away from it's natural level.

Sometimes the price is what the public is willing to pay and that can be affected. The price is not necessarily a reflection of cost or scarcity (something which you have pointed out to me while discussing drugs). They of course have the right to charge as much as they can get - my point is only that I still see this as a factor.

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It is hard to see that those expectations are in fact based on real realities (using your term) when commodity producers are stating that there is no shortage right now, won't be anytime soon, and that they have the capacity to meet the projected increase in demand with ease.

This is not at all a uniform claim nor is it even close to the concensus. The difference is we are paying attention to what people are saying about it,when two years ago no one cared so we latch onto any old statement made about it. The fact is that I have market sources for instance that you do not see nor have access to (because their services are expensive), who are attempting to triangulate supply/demand, future pricing, on commodities and products you have never heard of and all of those sources reflect unprecedented levels of uncertainty about the future state of each of these markets. My market forecasts are changing weekly, and by unprecendted levels. If there is higher pricing in the market it is because the level of risk is much higher. Futures markets are about risk and information. You are buying to the PR. I know it's tough to see from that perspective, but that does not make that perspective reality.

The only information gamblers need is that a specific trend in terms of opinions will continue. Short term impact on prices maybe enough for the public to get used to new price points - enough so that you will be able to keep a similar level of demand but now at a new, higher price point. I do think that what people are willing to pay vs. the lifestyle changes they would have to make - has a psychological component of familiarity (like taxes - if they were something new they would "hurt" much more).

And this is only a short term effect. Consumers may "get used" to a higher price point, if market prices require a higher risk premium because of uncertainty of supply. However, if that risk premium disappears it will not be consumers the move the price to a lower level, but rather the producers competing for share. It cannot be long term effect because you have to consider supplier behavior as well as consumer behavior. This is why when someone says that 30% of the price of oil is due to sustained speculation it is bunk. Price increases reflect real risk premiums based upon real realities.

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I think the basic problem here is that three different concepts of "speculator" are being discussed. That's why I used the terms "speculator" and "trader" equivalently at the start of my last post.

My concept of speculator is a person who makes estimates on prices of financial assets and then acts to buy/sell when his view is different from the current market price. His rationality does not come into it, though the bulk of such people have to be rational or they will get weeded out over the years. Using this concept, when I buy some share in some company or invest in a 401-K, the act includes an element of speculation.

adRock you seem to be saying that the idea of speculators being people who "manipulate a stock" is an invalid concept. I agree.

Kendall, From your points, I gather that you might be saying that you do accept a concept of "speculator" as being some small sub-set of people who are trading, but trading irrationally -- without interest or enough information. Basically, the concept for which you;re using the term "speculator" is a concept for which I would use the term "irrational speculators". So, the way I use the term "speculator", includes those few hangers on who are "irrational speculators". Adrock also seems to swing to this concept when he speaks of speculators as playing the momentum.

I have seen the term "speculator" is used in all three ways. Essentially we'll be talking at cross-purposes until we gravitate to common terms.

Take my previous post and change every use of "speculator" to "futures trader" and change every use of "speculate about the future" to "make a judgment about the future", and it remains the same.

I suspect that we might disagree on other terms too. For instance, rational traders can "drive" up the price of a commodity. When I use the term "drive up", there is no implication that they drive it up from some unreal price. Quite the opposite. Prices do not simply drive themselves up or down; rather, they are based on the decisions of buyers and seller. When rational traders change their opinions (in net) then the price ends up going up or down. At all times, it reflects the current net expectations of these traders.

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My concept of speculator is a person who makes estimates on prices of financial assets and then acts to buy/sell when his view is different from the current market price.

This is aptly characterized by the title investor. Within the umbrella investor concept, you have your value investor, growth investor, large-cap investor, dividend investor, etc. On the other hand, a speculator is one who is not interested in the current price of the instrument at all. A speculator is relatively short-term oriented, and he only cares about where the price is going and when, not why or how it's going there.

Speculators play volatility and momentum; investors play estimations and predictions.

Edited by adrock3215
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I just grabbed my copies of Security Analysis and The Intelligent Investor to get the father of value investing to settle the score:

An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative...However, the investor must recognize the existence of a speculative factor in his common-stock holdings.

- Benjamin Graham from Security Analysis in 1934

Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.

- Benjamin Graham from The Intelligent Investor

(Anyone who hasn't read both of these books, I highly recommend them!)

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This is not at all a uniform claim nor is it even close to the concensus. The difference is we are paying attention to what people are saying about it,when two years ago no one cared so we latch onto any old statement made about it. The fact is that I have market sources for instance that you do not see nor have access to (because their services are expensive), who are attempting to triangulate supply/demand, future pricing, on commodities and products you have never heard of and all of those sources reflect unprecedented levels of uncertainty about the future state of each of these markets.

Those statements were made recently by some of the biggest world producers. I personally may not have access to such information but I am pretty sure they do. Their business decisions is one of the sources of this information.

And this is only a short term effect. Consumers may "get used" to a higher price point, if market prices require a higher risk premium because of uncertainty of supply. However, if that risk premium disappears it will not be consumers the move the price to a lower level, but rather the producers competing for share.

Yes free competition is what makes the market work. Competition for the maket share of the same commodity (they can however come together and agree to charge the same - isn't OPEC an example of that?) and competition in terms of creating new competing products. It will happen in terms of energy and I think it is the second type which most likely will have an impact on prices.

(This is like taxes - you see it going up but very rarely down. It is a necessity of life and it is not that easy to decrease a demand without replacement).

Edited by ~Sophia~
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On the other hand, a speculator is one who is not interested in the current price of the instrument at all. A speculator is relatively short-term oriented, and he only cares about where the price is going and when, not why or how it's going there.

Speculators play volatility and momentum; investors play estimations and predictions.

Okay, let's work toward delineating a common concept, for the duration of this thread. I'm fine with the above, except for the "not why or how". Even a momentum player is banking on some "why and how", even if this is sort-of piggy-backing on someone else's qualitatively different why or how.

With that qualification, I see your concept of speculator as being as follows: a trader who intends to close his trade in the short-term, and who trades using a view of where the actions of other traders will move the price (i.e., regardless of whether he thinks those other traders are acting rationally or not).

If that's the concept, then I agree that speculators cannot move prices over the medium to long term.

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I had been under the impression that the argument was with the number of people engaging in speculative trading. The number of people bidding for a commodity doesn't affect supply, no. But it does affect demand, raising the price, no?
The number of people has no effect. Roughly, the amount of money behind any demand is the important, not the number of people behind it. One man who wants to buy 100 pizzas exerts just as much demand as 100 men each wanting to buy 1 pizza.
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The number of people has no effect. Roughly, the amount of money behind any demand is the important, not the number of people behind it. One man who wants to buy 100 pizzas exerts just as much demand as 100 men each wanting to buy 1 pizza.

Another thing about futures is that you only need a small percentage of the money in order to be a player (which is not the case with stocks). Wouldn't that further inflate the demand?

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Another thing about futures is that you only need a small percentage of the money in order to be a player (which is not the case with stocks). Wouldn't that further inflate the demand?

No because the commusurate risk is huge! The idea that you only need a little ante and so many people play is not right. In the equities markets the chance that you lose your principal entirely is low. That is, if I invest $1, the market may go down and I only lose 0.10$. In the futures market, you "invest" $1 (it's really more of a bet) and you stand to lose the whole thing. This keeps most true speculators out.

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Those statements were made recently by some of the biggest world producers. I personally may not have access to such information but I am pretty sure they do. Their business decisions is one of the sources of this information.

Don't confuse their statements with their business decisions. They are not he same thing. Also, if you take a uniform survey of statements you'll see all across the board, and by people who know as well, I'd bet you would see as much variability.

Like this guy:

Additionally, price increases due to inflation have nothing to do with supply / demand. Meaning prices will go up regardless what is said about supply positions. You threw off my claim last time even thought 1/2 of contribution could be due to that.

Edited by KendallJ
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Additionally, price increases due to inflation have nothing to do with supply / demand. Meaning prices will go up regardless what is said about supply positions. You threw off my claim last time even thought 1/2 of contribution could be due to that.

Inflation is a significant component but not the full answer.

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By the way, when prices rise to "outrageous" levels, oil companies will typically begin selling contracts to lock in the high price. The revenue gained from this selling action essentially provides capital to increase investment in new production, which, when completed, brings prices down. Don't think for a minute that this phenomenon isn't occuring right this very moment.

How much investment in refining capacity have you seen? If the refining capacity is limited, then increasing the flow of crude does not help much.

ruveyn

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