Speculation watch

The economics blogosphere is abuzz ... is the oil price being driven up by market fundamentals or by some sort of manipulative activity?Paul Krugman has a short theoretical piece here challenging the speculator-spotters to come up with a story that fits the facts.Tom Palley thinks it is specualtion.I have argued that it is speculation of  a very specific type. And this is my answer to Krugman's challenge, posted as a comment on his NYT blog:Paul, I agree with the mechanisms described in your note (indeed, my own piece on speculation relies on arguing that the storage signature is difficult to spot because it comes mostly in the form of spare capacity in Saudi Arabia and possibly Russia).Your second question is why the future and spot prices are not in contango if this kind of storage is going on. My view here is that we need to take into account the market power of SA and Russia (both are "residual monopolists" - take out their production, and there is insufficient capacity to meet world demand at _any_ price) to understand the difference between the future price as traded on exchanges and out-turn prices as determined by the interaction of supply, demand and market power.Portfolio buyers pile into long only commodity funds and push up the exchange-determined future price. Aramco uses the future price as just one of its inputs in its optimal production schedule models. It is just one input, because: a) it understands its market power, and b) it has a bunch of OPEC-related and US-related political objectives to satisfy.The "effective future price" Aramco uses in "storage" decisions is not the exchange-traded price, but is certainly affected by it. The exchange traded price spiraled to extraordinary levels - way above the limit entry price (about $75/bll) - because of portfolio adjustments. Aramco saw that a) the sky did not fall in, b) that it had probably lost the entry-limitation game anyway, in that investment is now going on at the kind of level that will drive prices back to $75/bll in 3-5 years and c) anyway it could not alone guarantee a price fall back to the limit price given Russia's residual monopoly position. When Gazprom talked of oil at $250/bll, Aramco knew that Gazprom in the short term could choose. This has led Aramco to a view that a quick, relatively short-lived (2 year?) dash-for-profit is the sensible option. Hence the repeated and unexplained delays in brining on the new fields for light and heavy oils (Indeed, one might think that Aramco is managing the spot price to be around the future price.)The test of this theory is whether Aramco is indeed withholding capacity. Although credible statements and numbers are hard to come by, Saudi Arabia repeatedly states that it has spare capacity, but is not seeing demand _at_this_price. This, to me, is as good as an admission that it is exercising market power to keep prices high.In other words, the exchange traded price that you want to see in contango is not the right shadow price to be looking at because SA and Russia will exercise their market power in the spot market and possibly in any OTC contracts they are signing.