Saturday, June 28, 2008

The Role Of Speculation & Governments In High Oil Price

On LRC today I analyze the role of speculation vs. government policies in causing the high price of oil and other commodities.

8 Comments:

Blogger Sophist said...

I'm sorry to say and this is by no means an ad hominen attack, but your analysis is completely wrong and potentially biased.

You are wrong on so many counts on how the futures markets work, how price discovery works and how speculators can cause bubbles that I feel it is pointless to even begin rebutting your statements.

With all respect of course...

I can only one possibility to you, out of the many that exist.

it is quite possible that speculators in the crude oil market lose money. However, they may be making many times what they lose in intermarket trades, like carry trades and shorting equities.

This is a very complicated issue and be sure speculators are very sophisticated. Your simplistic description of how futures markets operate cannot be indicative of the complex strategies that can be used by speculators in that market.

The solution is one: limit immediately speculation in futures exchanges and monitor the results. My recommendation is to demand speculators to take delivery or deliver oil if positions are kept more than 5 days. This compromise will not deprive futures markets from intraday liquidity but it will increase transaction and other costs for speculators.

5:33 PM  
Blogger stefankarlsson said...

Sophist, if you want to be taken seriously you must be more specific and detailed in your assertion that I am wrong about this and describe exactly how these strategies could affect the spot price without accumulating physical inventories.

You can't simply assert that I am wrong and simplistic without explaining why.

8:08 PM  
Blogger Sophist said...

Thank you for demonstrating your Libertarian spirit by showing my post although I attacked it, of course not you personally.

I cannot possibly offer detailed answers and anyone interested can Google the subjects and get references.

You said: "What should further be realized is that first of all most commodity speculators invest in futures while what matters for the price of petroleum actually used in the economy is primarily the spot price"

This is wrong. Numerous studies have shown that futures markets serve as price discovery mechanics. In essence, futures price affect spot prices over the medium to longer term timeframes.

You said:

"Note further that commodity speculators can take both long position and short positions."

This is IMO a straw man. We are investigating the possibility of concerted speculation to srive prices up. Thus, we are only interested in the possibility that there exists a class of speculators that have a strategy to drive prices up. We do not care who takes the opposite side of the trade, speculator or not.

However, I will describe a model later on how this works and involves both buying and selling.

You said:

" If speculators as a group have equally large long and short positions then they will have no effect on futures prices"

No, that is a very static view of Th situation. It is the dynamic aspect of the market that contributes to the price rise, as I will explain later when I present the model.

You said:

"...and if they as a group have larger short positions than long positions then their speculations will in fact lower futures prices. "

No, no. This is not representative of how markets work. This is an entirely static view of markets. I will clarify later.

You said:

"If the speculators choose the first alternative, then this will push down the price back to the level where it would have been in the absence of the original purchase. In this case, speculation will thus have no effect on the spot price."

Nothing can be further from the truth. This is again a very static view and not how concerted speculation works. You also forget many dynamic effects like market psychology, price momentum, technical trading,etc. that contribute to further price rise under such environments.

You said:

"The fact is that there is no evidence of increased inventories."

You are only looking into the US inventories while forgetting that many countries, like China and Japan, store oil in old single hull tankers because of fear of future supply problems.

Lack of evidence does not constitute proof.

You said:

"As I indicated in the aforementioned review, the boom is primarily driven by structural long- or medium-term factors."

I partially agree with this statement. The important issue is how much speculative premium has been built into the price of oil. Is it $10, $30, $60?

I don't know. But I will describe below a model that goes beyond your static --- and basically wrong --- assessment of how futures markets can work in favor of speculators.

Concerted speculation works in a pump & dump fashion. Some speculators are the buyers and some are the sellers. The Buyers concede constantly to higher sell offers from the sellers. This is the fundamental force that drives the markets up. (the opposite force is when sellers concede to lower buy offers).

Thus, some speculators of the particular class build long positions and some others take the opposite side by constantly increasing their offer while the buyers concede purposely. Before first notice day, they square positions. Due to the zero-sum nature of the markets, the profit of the longs equals the loss of the shorts, minus commissions and other costs. Then, they rollover to the next contract month and repeat the same pattern.

This pattern can create a speculative bubble if there are enough speculators that can cooperate to share the expenses and the profits. Question: how do they profit is there is a zero-sum game involved?

This is the real essence of this story. They create a bubble in one market and trade other markets, like shorting the dollar, equities, or even going long the relevant ETFs, like USO.

Now, I do not have evidence this is happening but based on my experience trading commodities I think it is, like others suggested in hearing in the US. Also, it may not be intentional. Concerted speculation maybe the unintentional effect of too may hedge funds trying to profit from an oil bubble.

But I brought up this example to show you that you have a very static view of futures markets and there are strategies that powerful -- money wise -- speculators can play with other cross-asset strategies to benefit at the expense of the consumer.

Example: Back in 1994 if I recall correctly, there was a mini speculative bubble in Lumber prices in the futures markets that lasted for a few months. Many companies built up secretly inventories believing this is the end of the world and lumber prices will keep going up forever. It was not the speculators who accumulated physical lumber. For many years those companies showed losses after the price plummeted. At that time, no company would admit they were building inventories. Speculators made fortunes.

8:49 PM  
Blogger Allen said...

I don't get the point of calling anyone who buys or sells futures a "speculator". That market by it's very nature is guessing, that is speculating, on what the value of something will be in the future.

That said, the real question is not is there "speculation" occurring but exactly how much it could be affecting prices. I haven't seen in the press anyone claiming or at least implying that lion share of prices increases are due to speculation. That seems unlikely. Combined their lack of exact numbers let alone explaining how speculation is causing this leads me to suspect that it's a very small piece of the puzzle.

Think of it this way, if speculation alone was able to drive up prices, why are speculators doing that with oil now? Why didn't they do it 5, 10, 20 years?
More so why at the same time are these speculators driving up prices for Cocoa? Wheat? Copper? What causes them to do this with multiple commodities at the same time? Why aren't they driving up prices on Asset Backed Bonds? Why not stocks? That is, why if it's purely a matter of speculation is this happening with oil an not other things?

9:29 PM  
Blogger happyjuggler0 said...

sophist,

For an example of what a commodities market looks like without futures, look at the onion market. Here is an article that gives some details.

Here is a quote from that article: Since 2006, oil prices have risen 100%, and corn is up 300%. But onion prices soared 400% between October 2006 and April 2007, when weather reduced crops, according to the U.S. Department of Agriculture, only to crash 96% by March 2008 on overproduction and then rebound 300% by this past April

I wrote an explanation here of exactly why a lack of an onion futures market caused the volatility outlined in the above article.

It is impossible to outlaw speculators. If you eliminate outside speculators, you by force turn producers and consumers into speculators. This causes prices to be more volatile, and it can ruin either producers or consumers.

As many have noted, this is an election year in the US and everyone is scrambling to lay the blame for rising oil prices on a bogeyman (speculators in this instance) in order to score political points, or in order to stop from becoming a scapegoat themselves (oil producers), or in order to disguise the fact that they (i.e. the government) are the ones to blame.

However, just because there ia a lot of noise claiming that speculators are bad doesn't mean that the "noise" is true. Not only isn't it true, but speculators perform an incredibly helpful service by helping to more efficiently allocate scarce resources. We can only pray that nobody does something shortsighted like ban "speculators" (I prefer the term "conservationists") like you (i.e. sophist) suggest or car owners will soon learn what volatility really means.

11:58 PM  
Anonymous newson said...

"sophist", the name says it all.
from my time in commodity futures, it is indisputable that ultimately it is the underlying commodity demand/supply that determines price, not the various derivative products (though obviously there is a complex interplay until expiration).

the idea of separating bona fide dealers from speculators made me chuckle. before the forex market in australia was liberalized, only hedgers could participate in futures trades, under reserve banking regulations. the broking companies i worked for only had "hedgers" as clients (ie retail clients, masquerading as legit commercials). farical then, and would be no less so today.

without the liquidity of mug punters (scared away by the five-day rule), the commercials would suffer, and the risk premia would be passed on to the general public as higher prices.

4:46 PM  
Blogger stefankarlsson said...

"Thank you for demonstrating your Libertarian spirit by showing my post although I attacked it, of course not you personally."

That I published the comment hadn't anything to do with libertarianism. Libertarianism recognice property rights, and you have no more of a right to have your comment published here than I have a right to enter your home. I publish comments if I think they add value to the blog, not because of some non-existent right to be published.

"This is wrong. Numerous studies have shown that futures markets serve as price discovery mechanics. In essence, futures price affect spot prices over the medium to longer term timeframes."

Which studies? Carried out in what way? Testing what mechanism?

"This is IMO a straw man. We are investigating the possibility of concerted speculation to srive prices up. Thus, we are only interested in the possibility that there exists a class of speculators that have a strategy to drive prices up. We do not care who takes the opposite side of the trade, speculator or not.

However, I will describe a model later on how this works and involves both buying and selling.

No, that is a very static view of Th situation. It is the dynamic aspect of the market that contributes to the price rise, as I will explain later when I present the model."

Sounds like a very revolutionary model if it can show that an equal increase in demand and supply will push up the price. I'm surprised that you'd choose such a relatively unknown publication platform as this comment field for this.

"Lack of evidence does not constitute proof."

The burden of proof always lies on those making positive claims. Or do you think the rule of the world by the flying spaghetti-monster is a theory worth considering?

"Thus, some speculators of the particular class build long positions and some others take the opposite side by constantly increasing their offer while the buyers concede purposely. Before first notice day, they square positions. Due to the zero-sum nature of the markets, the profit of the longs equals the loss of the shorts, minus commissions and other costs. Then, they rollover to the next contract month and repeat the same pattern."

You don't get it, do you? Sure futures traders can agree to say $1 million per barrel oil prices. But those holding the long position in such a contract will lose and lose big once the contract expires, because there is no way that anyone would agree to pay such a price for final use. The only way to hold that up would be physically store all oil. But that would ultimately not hold, and since everyone knows that, no one tries. The same logic applies to any other futures price which exceed goods market equlibrium. It can't be uphold unless inventories are acumulated.

"Example: Back in 1994 if I recall correctly, there was a mini speculative bubble in Lumber prices in the futures markets that lasted for a few months. Many companies built up secretly inventories believing this is the end of the world and lumber prices will keep going up forever. It was not the speculators who accumulated physical lumber. For many years those companies showed losses after the price plummeted. At that time, no company would admit they were building inventories. Speculators made fortunes."

Look, asserting the existence of secret inventories is not meaningful unless evidence is provided for it. See previous point about the flying spaghetti-monster.

10:28 PM  
Anonymous Per Hedetun said...

Stefan, while I fully agree that speculators are not to be blamed for the rise in oil prices, you forgot to mention a very important factor that's also driving up the price: The war in Iraq, and the threat of war with Iran.

Iraq, for example, has vast oil resources, but how much of it is being refined and sold on the international market? Very little, since the instability in the region scares away investors.

And the instability in the Middle East can only be blamed on governments, of course.

Both Bush and Obama have expressed desire for a "magic wand" that can lower fuel prices. Bringing the troops home would be the closest thing to it...

10:11 AM  

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