Tuesday, July 7, 2009

Ending Speculation?

As the price of oil continued to fall (both Brent and NYMEX Crude dipped below $63/bbl), the New York Times reported this afternoon that Glen Gensler, chairman of the Commodity Futures Trading Commission, would consider limits on the volume of energy futures that purely financial investors would be permitted to hold:

My firm belief is that we must aggressively use all existing authorities to ensure market integrity
The Times cited volatility in the oil market over the last year and concerns that such volatility was linked to speculators as Mr. Gensler's motivation. While I generally agree that over the last 18 months to 2 years, crude valuation has been significantly impacted, if not outright driven, by speculation, I am left wondering why not bar “purely financial investors” from investing in oil futures all together?

No really, why don’t we? I know market regulation is a favorite bogeyman of the Right, but purely financial investors, or speculators, have absolutely nothing to do with the market for oil -- that is, they do not actually seek to purchase or sell oil. Rather than reflecting the dynamics of supply and demand, these sorts of investors effectively place bets on crude's price and inject a wholly artificial pressure into the market. Never mind the folly of allowing the price of a commodity so vital to our economy and our national security be tortured by the whims of these sorts of investors, limiting the volumes of futures they might hold seems at best artifice and a half-measure.


Colin said...

Speculators have plenty to do with the market as they help the price discovery process. If I think that oil is priced too low then I am inclined to buy some of it. That will both push prices up. That in turn will do two things:

1. Promote additional production as people rush to take advantage of high prices.
2. Promote conservation to avoid high costs.

Speculators help determine prices. Accurate pricing is essential to a functioning market.

Surely you wouldn't begrudge someone for buying a condo that they think is undervalued and they hope will appreciate, why should a barrel of oil be any different?

More practically, how would regulation determine who is a speculator and who isn't?

Finally, if I want to buy oil, why shouldn't that be my right? Why do we need to infringe on someone's liberty to do this?

Colin said...

Worth reading:


Ben said...

To respond to Colin, I think the analogy you draw between buying oil and buying a condo is flatly misleading. Your condo has nothing (or very little) to do with the economy overall and, more importantly, national security. I don't have a problem with you engaging in speculation on the values of condos, though if I were intending to actually purchase a home in the neighborhood you're speculating in, I'd probably be annoyed that you've inflated my purchase price and, if speculation is rampant, that it'll probably result in undervaluation. As far as price discovery goes, I just flatly disagree but I think that is because you and I come to the question from different points - from my perspective, I think the market's price discovery function (which I agree is very valuable) is served by parties who actually own the commodity and parties who actually need the commodity. That the price of oil completely de-coupled from market fundamentals and even geopolitical trends over 2006-2008 I think proves this point.

Colin said...

Ah, but my condo is in fact part of the economy. Is not the housing sector a significant driver of economic activity? True, my individual condo may count for little, but then again neither does an individual barrel of oil.

Further, my speculation in condos should please you as a prospective home buyer. After all, if my purchase helps create demand and bids prices up this will encourage the construction of more housing units and increased supply (although this does not hold in practice in places like DC where zoning restrictions, height restrictions, affordable housing mandates and other regulations prevent this from occurring).

If I overpay for the condo then I am an idiot an the seller takes my money.

Lastly, while there may have been a speculative bubble in oil recently, I would like to make a few points:

* If you price oil in terms of gold, rather than dollars, there was no bubble:


Thus, this may have been a case of the dollar being weak rather than oil being strong.

* Bubbles have occurred throughout history -- the tulip bubble, the South Sea bubble, the dot-com bubble. Each time speculators have been hammered with steep losses. Losing your money strikes me as the best disincentive to preventing such speculative activity.

* Let us say that, reading the oil tea leaves, I decide that oil is undervalued. I speculate and buy some at $100 a barrel, betting that it will rise to $150 in six months.

Now, one of two things will occur. Either the price will go up or down. If it goes down then my idiot status is confirmed and I lose money on the deal. The only person harmed is myself. If it goes up, however, I have performed a service.

The first service is that I sent a signal to the market -- via the futures contracts -- that more oil was going to be needed in the future and to increase production. Others may see it as a signal to cut back on consumption. Either way more oil is made available.

The second is that by selling the oil I have released a valuable commodity in high demand on to the market that otherwise would have been consumed at $100/barrel.

Now, in fairness I will note that the oil market doesn't behave this way, largely owing to the fact that something like only 5-15% of reserves are privately owned, with the vast majority owned by government entities that are not beholden to market forces.

Colin said...



Ben said...

So, I think that your comment probably requires a longer response but I want to make a couple of points quickly.

Setting aside your valuation of oil in gold, the utility of which I do not see, the point I am making is:

1. The oil market behaved as a bubble in 2006-2008 and appears to be behaving that way again. More importantly, its valuation has decoupled from market fundamentals - supply and demand - for instance, compare the EIA's supply and demand figures with the rate of price increase and decrease over the last year: http://www.eia.doe.gov/emeu/ipsr/t21.xls

2. Speculation does not elucidate the value oil. The last 24 months provide empirical evidence of this fact. It is no answer to say that if I bet that the price of oil goes up and it goes up that I have provided a service, especially when there are legions of you all betting the same way and doing so with apparent disregard for market fundamentals. Instead of performing the other great market function of generating information, you've simply generated noise - contributing both volatility and irrationality. The market can, and frequently does, perform valuable functions and services - it is not, however, infallible nor is it always rational.

3. Your condo is not vital to national security. It does not have the wide-ranging importance to the economy that oil does. The negative impact of your and your friends irrational bets on price are not limited to you and your friends.

Colin said...

The use of pricing oil in terms of gold is because gold is a store of value. It has been used as money for centuries. When you price oil in terms of gold we saw no increase. This in turn leads to suspicions that the rise in oil reflected a weak dollar than overzealous speculation.

Regarding your points:

1. If oil prices decouple from fundamentals then those who speculate in oil and bet on higher prices will lose their money. Why should we feel sorry for them?

2. If people are simply generating noise and not contributing to the price discovery process then they will lose money. Again, no need to feel sorry for them.

Further, exactly what is a speculator? After all, companies that produce oil speculate about the price all the time, attempting to maximize production when prices are high and attempting to read the future.

Why should oil companies get to speculate but not investors?

3. I don't get the national security argument at all. I mean, I have heard this advanced -- perhaps most notably by John McCain -- in the context of not wanting to give money to people that don't like us. But if you want to make that argument then you should also favor high oil prices, since that will be the best deterrent to the use of oil and will help promote the development of alternatives.

If you are trying to make the argument that it is a strategic resource or some such the I fail to understand the logic. After all, no one country has a monopoly on oil. Should we really base policy on the possibility that one country will stop selling us oil through a unilateral embargo? And what are the odds that our top 2 sources -- Mexico and Canada -- will stop selling to us? Or even #3 Saudi Arabia?

Now, of course OPEC imposed an embargo in the 1970s and gave the US an oil shock -- but did that come to the detriment of US national security? Furthermore, there is a very good reason that OPEC has not done this since: high sustained oil prices will only encourage the development of non-petroleum based sources of energy.

More generally -- and I am not accusing you of this -- I will note that most national security arguments are pretty bogus and employed by people more interested in emotional appeals than logic. You hear similar stuff bandied about by those that advocate high tariffs on imported steel to preserve the US steel industry due to national security arguments.

Ben said...

Well, I'm no expert on Gold so I'm loathe to engage further on this thread but, as I understand it, Gold, like Oil, is often dollar-denominated. As such, you’re not actually providing any new information by substituting the valuation of oil in terms of dollars with that of gold. In fact, what you’ve done, is simply to map the value of the dollar and it should come as no shock that you don’t see a bubble – you really see nothing at all: O = f1($); G = f2($); $ = f2^-1(G); O = f1(f2^-1(G)); which is of course, roughly (there would be a normalization factor missing), $ = $.

The problem with your first two points is the same problem with your general thesis, I think. You’re ignoring the very real – indeed, we see it – prospect of noise having an actual effect on others in the market. Yes, maybe you erratically buy a future contract on a barrel of oil for $10 too much. The effect on the market is negligible, maybe it moves the way you like, maybe it doesn’t.

But take, say, all the money leaving hedge markets in late 2007 and dump that into crude futures. If all those futures purchases are spot+$10, that injects an inflationary pressure into the market. If the inflationary pressure is tied to actual demand then it provides useful information on the value of the commodity and the market ought to respond. If, instead, it’s based on a whim, or at least not on demand, then what is the utility of that bet? I say none.

As far as what a speculator is, I should begin by noting that the definition used in by Mr. Gerson was a “purely financial investor.” First, let me say that I don’t think that banning all “purely financial investors” is plausible; I’m not sure how you would even begin to identify them in practice, and the point I was making in my post was two-fold: 1) that speculation has had a great deal of influence on the market (something I think you conceded at one point and have since backed away from) and 2) why, if you can identify speculators, only institute limits instead of an outright ban – it was meant to be hyperbole. Second, if we accept Gerson’s definition of a speculator then I think it is clear that oil companies are not speculators being producers (or at least refiners and distributors) of petroleum.

Assuming, for the sake of argument, that producers do maximize production when prices are high, isn’t that not speculation, as you describe it, but simply the natural operation of the market?

But, fundamentally, shouldn’t price be high (and production likewise high) when demand is high? If you compare the world oil supply and demand figures I linked to via the EIA with price like I suggested you’ll see that even as supply was catching up with, and then outpacing, demand, the increase in price was accelerating.

I appreciate you giving me the benefit of the doubt with regard to national security. I was not trying to make an emotional appeal, and nor was it an attempt (I think clearly) at jingoistic Saudi-bating of the stripe Mr. McCain engages in. Rather I think the strategic and tactical value of petroleum to the United States is quite clear. At least for the time being, petroleum will play a key role in agriculture, freight transit, energy generation, and our ability to project hard power. I guess I don’t see where our disconnect is, there.

There are many reasons why OPEC has not engaged in another embargo. While a desire that the United States remain a petroleum-based economy is certainly one of them, I would argue that foremost among them have been a dearth of strategic goals to underlie an embargo (as compared to the 1970s) and incredibly poor production discipline on the part of OPEC – so much so that it yearly undermines the cartel canard.