Oil and Speculation

As best as I can determine, Paul Krugman is right.

Paul Krugman says that either the price of a storable commodity can be determined by supply-and-demand on the spot market, with no stored reserves held off the market for speculative purposes:

Or the price can be determined by speculators, with them holding enough of the commodity off the market in their speculative inventory in order to drive the current spot price up to a level where it no longer pays for speculators to take even more of the current supply off the market:

In which case the current and the futures price of the commodity should be in contango: the future price should be higher than the current price by the cost of storage plus the interest rate. Since we don't see either large inventories of tanker cars filled with oil on the sidings or futures prices for oil above spot prices to make storing marginally profitable, he concludes that speculation is not driving oil prices today:

http://www.princeton.edu/~pkrugman/Speculation%20and%20Signatures.pdf [H]ere’s the thing: the actual data we have on crude oil don’t show the signatures of a market driven by speculative demand. Inventory data don’t show a big accumulation; and the market has mostly been in backwardation, not contango. It made news when, late last month, a slight contango developed – because until then there had been backwardation. Maybe I’m misinterpreting what the advocates of a speculative story are thinking. But in that case, what are they thinking? I’m curious.

And:

Various notes on speculation: Right now I see well-trained economists getting caught up in an equivalent fallacy — the doctrine of immaculate hoarding? — because they’re getting hung up on the financial relationships between spot and futures. Whatever you say about the futures market, it can only drive up the spot price by causing physical hoarding of physical goods.... [S]ome readers have asked me why my inventory argument didn’t apply to the housing bubble. The answer is that a house is a durable good, which unlike oil, which you have to burn, isn’t used up by the consumer; what we consume are housing services — in effect, consumers rent houses, from themselves if they happen to be homeowners. To see the equivalent in housing of what the oil bubble types think they’re seeing in oil, we’d have to have seen a sharp rise in rental rates. It didn’t happen....

Third, some people have asked what I said about the California energy crisis of 2000-2001, perhaps history’s greatest example of market manipulation.... During that whole period, I was pretty much the only voice in a major news outlet even suggesting that market manipulation might be a central factor. And here’s the thing: I applied pretty much the same reasoning to that crisis that I’m applying now. The only way market manipulators could have been driving up prices was by keeping physical supply off the market. And they were in fact doing just that: there was huge unused generating capacity, consistent with the idea of deliberate withholding. Some years later we would actually get hold of control room tapes in which Enron traders called plants and told them to shut down, and boasted about cutting off Grandma Millie’s power.

I’m still waiting for evidence that physical withholding is going on in the oil market.

Dangerous populists?: Dangerous populists? Martin Wolf calls for

abandonment of the silly idea that price jumps in oil or food are the result of wicked “speculation” – a fantasy promoted by dangerous populists across the globe.

Hmm. Who are these “dangerous populists”? Well, elsewhere in the FT there’s an article titled “U.S. senator seeks clampdown on speculation in oil markets”, which quotes Joe Lieberman saying that speculators are a:

significant contributing factor to the economic distress now being felt by American consumers every time they stand in the grocery store checkout line or pay for a fill-up at the gas pump

Joe Lieberman, the Huey Long of Greenwich! And let’s not forget those wild-eyed, shaggy-haired leftists at National Review, who have been telling us that high oil prices are a bubble that’s about to burst for more than 5 years. By the way, the FT article on Lieberman mentions that

Some observers say lawmakers have not explained how speculators or pension funds are boosting prices or why the prices of raw materials such as iron ore, rice or coal - in which speculators have limited access - are also booming.

I’m delighted at the promotion. I used to be one of Those Who; now I’m Some Observer...

And:

Confusions about speculation: I’m asking whether expectations of a higher future price and/or investment in the futures market by institutional investors are pushing up the current price. If the answer is yes, then we can ask whether there’s a bubble — that is, whether the expected future price is unreasonable. It’s quite possible to have speculation that isn’t a bubble.... [B]ut is speculation, rational or not, driving the price of crude?

Basically, it’s hard to reconcile the view that it is with two facts: for most of the recent runup, inventories were static or declining and the futures market was in backwardation, not contango. (Can the futures market pull up the spot price when the futures price is less than the spot price?)

OK, you can offer excuses. Maybe the oil inventories are being held in the ground; but do we have any evidence that oil producing countries are withholding output? (And for those who blame speculators, are Kuwait and Saudi on the other side of those futures contracts?) Maybe there’s a shifting liquidity premium that mucks up the relationship between spot and future. But this really is starting to sound like epicycles — an attempt to rescue the speculation hypothesis, which originally was supposed to be based on compelling evidence, by saying that there’s actually no evidence that could refute it...

Comments

[dis]

steve waldman over at interfluidity makes the point that if to storage and interests costs you convenience yield, the market might indeed be in contango.

he offers evidence that while convenience yield can be sizable. take a look at his post and charts

http://www.interfluidity.com/posts/1214354098.shtml

in the comments the discussion about thinking of convenience yield not as a fudge factor, but as embedded optionality seemed interesting to me.

would love to hear your thoughts on all this

[khr]

One question that has little to do with the actual topic of the post:

I am always puzzled by these supply and demand graphs in economic articles.

And it's nothing about the logic behind them. It's simply the way they are presented:

Why is the price on the vertical axis and the quantity on
the horizontal axis ?

In all other graphs in all other disciplines I know, the independent variable is plotted on the horizontal and the dependent funtion on the vertical. This is even true in economocs, e.g.in time series where the time (independent variable) is on the horizontal and the dependent (e.g.GDP) is on the vertical.

As far as I understand the supply/demand issue, I understand the price to be the independent variable and supply and demand are a function of the price. So why the convention of drawing the graphs with price on the vertical ?

Greetings
KHR

[bigTom]

Krugman is performing a valuable service here, refuting one of the distraction myths. All of these popular conspiracy myths are serving to distract us from the real job that needs to be done, making the changes needed to deal with the new era of declining percapita commodities supply. The task of refuting the oil depletion distraction myth of the day resembles the problem of refuting the Anthropic Climate Change refutation psuedo-theory of the day. New myths pop up as fast as you can shoot down the old ones, and precious time slips away. IMO, the fundamental problem is that some foundational myths of economics have been unquestioningly adopted by the economics/political class. One of these is that Malthus was wrong, rather than simply being well ahead of his time. The other destructive religiously held dictum, is that price is the only legitimate means of rationing for scarce commodities. How will our explanations, and proposed solutions differ is we suspend our belief in these two principals? First, the data which says that resource depletion can happen faster than innovation to deal with it won't remain hidden from out gaze. Modified Malthusian economics (it's not just the overall population increase that matters, but population weighted by the ability to consume resource X that matters). In the case of oil, the rapidly expanding global middle class is increasing the base demand of a crucial commodity at a much faster rate than world population. On the rationing of scarce goods issue. I think most of us would be much more comfortable being told that five years from now we will only be allowed to consume say 80% as much gasoline as we do today, but that the price wouldn't change, than that the price will rise dramatically, until demand is squashed by the same factor. In the second instance, not only do I (as a hypothetical average global consumer) have to consume less, but I will also have to pay a huge sum to do so. The social superiority of rationing should not be dismissed immediately. The real issue regarding rationing is how can we make it work.

[NeilS]

Perhaps I misunderstand this problem, but I don't see why the oil producers cannot perform the function of providing oil and speculating on futures by controlling the rate at which they deplete reserves in the ground.

I thought that most of the oil production was controlled by quasi government bodies that openly collude in fixing production quotas. So why is it unreasonable to think that they are colluding to maximize the value of their asset: oil.

Is this all naive?

[RedCharlie]

Interesting interview with Albert Edwards and James Montier, pdf available from the big picture:
http://bigpicture.typepad.com/comments/2008/06/appalling-marke.html

For Edwards and Montier, food and energy (up) are just anomalies compared to the rest of the commodity picture (flat), and they are more focused on the demand side than supply. That said, they do make a convincing argument that the current spike in oil and food is unsustainable. They also mention a WSJ article reporting oil accumulation in tankers in the Gulf, but I haven't found that myself.

I'll even recruit Krugman against himself. As he's pointed out, high energy prices will suppress global trade due to increased transport costs. And demand for oil is already falling in the U.S. Long term, $140 oil is unsustainable as it will both slow the world economy (destroying demand) and spur the development of alternatives to oil (also destroying demand).

Also, couldn't the market be in backwardation if those doing the hoarding believe the future price will go up but those selling the futures believe it will go down?

[bigTom]

Neil: You are correct that for a producer a rational computation of current value of a marginal change in production rate today versus tomorrow would evaluate differently from that of the spectulator cum storage. Clearly he wouldn't be dealing with the cost of storage. He does have to deal with degradation of capital equipment; pipelines, wells, processing facilities however. Many of these are subject to corrosion, even if idle, so it is not necessarily more favorable for him to defer production than for a spectulator to buy and store. Many oilfields could be pumped harder, at the risk of excessive equipment wear, and/or of leaving a greater fraction of the oil in the ground. Easiest for the producer would be to defer capital expenditures on new capacity. I think it is highly credible that the mentality of key OPEC producers has undergone a change, from "our supply is infinite, maximize current profits", to "our supply is finite, and we need to consider the needs of our future population". This could well have had an impact on the aggressiveness with which they invest in new capacity.

[Dave H.]

I think you and Paul have both fallen into the trap of assuming perfect knowledge. In the real world, this assumption is clearly incorrect.

If I own a refinery, I have a massive financial incentive to conceal my daily inventory... and I have a financial responsibility to sell to the highest bidder, whether that bidder is an end user with imperfect information or a speculator meeting a margin call caused by imperfect information.

If the first customer of the day offers me $140 per barrel, the second customer of the day will have a hard time convincing my closest competitor that the market price is only $132.

This magic only works if my competitors are smart. If my competitors are dumb as rocks, they will continue to sell oil at $132 in spite of the customers who are now offering a higher price.

Even if my competitors are dim-witted, slow-thinking, mouth-breathers, as long as quantity demanded is increasing, I will pull the same scam (called "selling to the highest bidder") again tomorrow.

...Or perhaps ten minutes from now.

[mark blyth]

So according to this logic the housing bubble was caused by a shortage of houses and the equities bubble was caused by a shortage of shares? Its interesting to me that the people who trade this stuff, e.g. Soros, are quite convinced that its a speculative bubble while those who don't are convinced that its not. We have seen two such bubbles in the past decade. Why are we so resistant to seeing one here?

[Neil B.]

"either"..."or" - why not both?

BTW Brad, you comment tags can show "zero" even when comments are present.
But I do appreciate that you reduced the bulk of the front page, my God that was choking my computer.

[Tuco]

"Paul Krugman says that either the price of a storable commodity can be determined by supply-and-demand on the spot market, with no stored reserves held off the market for speculative purposes ... Or the price can be determined by speculators, with them holding enough of the commodity off the market in their speculative inventory in order to drive the current spot price up"

Someone help me out here, if there isn't any hoarding (or manipulative drop in production) then oil consumption should be matching the increase in price. This means a rather dramatic increase in consumption. Oil at $100/barrel in January and the world has increased consumption by nearly 40% in just six months?!? Somehow I don't think so.

[Ken Houghton]

Actually, Tuco, the gap between worldwide production and consumption HAS closed over the past few years, and especially in the past six to nine months. Check the EIA data.

Dave H - The assumption that you can conceal your inventory is dubious. (It was sold on the open market, or shipped in containers of known maximum volume. You might be able to conceal that you have LESS than others believe, but you couldn't hoard without people being able to do subtraction. Not to mention that storage costs != 0.)

Also, you have to figure out why you would do this now, but (by your reasoning) were NOT doing it a year or two ago.

[bigTom]

To complicate matters there are in an incomplete sense, two oil markets, light sweet crude -which is usually what is quoted, and heavy crude. The latter is hard to refine, currently Iran is storing increasing amounts of heavy crude in rented supertankers (15 at last count). But this is not hoarding, their heavy crude customers refineries are undergoing a major maintainence cycle. So the claim about lack of refining capacity is somewhat true, the world doesn't have enough heavy oil refining capacity to consume all the heavy crude that could be produced today. The Saudis, and some their customers are building some new heavy crude refining capacity, so in the next couple of years a couple of million barrels/day of heavy crude which can't be sold today will be usable. But of course depletion of existing production is estimated to be roughly four to six percent year year (3-5 million barrels per year), so even to break even a lot of new oil production must be brought on line. A lot of people are trying to talk down the price, by publicizing the planned (and oftentimes simply hoped for) increases, but even these are not enough to negate depletion, let along depletion plus (nominal) demand growth. So the expectation that the supply demand situation will grow worse with time seems inescapable. That is what is driving up futures prices.

[vtcodger]

Krugman's argument is persuasive. But the lack of build up or draw down of crude inventories seems to me to indicate that the oil companies not only are not responsible for the price increases, they also have no idea where future pricing will go. If they thought prices were going up, they'd be stockpiling crude. If they thought prices were going down, they'd be dumping inventory. If the oil companies can't predict future prices, doesn't that imply that the entire petroleum market has left the tracks and is wandering off into unknown territory? Why would that be?

[rnk]

To KHR:
Marshal got the axis backward in 1900. It has been convention to do the same every since. So the moral here is if you are an economist, and a mistake was made 100 years in the past, be sure to make the same mistake in the present. Another reason, is that both price and cost can be expressed in terms of output, where cost really is the dependent varible where output should be placed on the horizontal axis.