Sunday, April 22, 2012

Speculation and gas prices

I was getting myself frothed up about the recent idea that  "speculators" are behind the recent gas price increase.  Have we learned nothing in the centuries of witch hunts for "speculators" "middlemen" and "money changers"? And how horribly things go wrong when societies take these witch hunts seriously? Haven't the Europeans just woken up from a severe attack of denial that "speculators" were to blame for their sovereign debt crisis?

Then I found that Jim Hamilton already did a better job than I could hope to do, while skewering Rep. Joseph Kennedy's editorial in the New York Times calling for a ban on speculation. 

Jim reminds us that volume numbers are meaningless because most of the trading lasts hours: 
Many of the traders who bought a contract on Friday turned around and sold that same contract later in the day. If the purchase in the morning is argued to have driven the price up, one would think that the sale in the afternoon would bring the price back down. It is unclear by what mechanism Representative Kennedy maintains that the combined effect of a purchase and subsequent sale produces any net effect on the price.
And what's good for the goose is also good for the gander: 
It's also worth noting that on that same day, there were 146,000 May natural gas contracts traded... By what mysterious process can all this within-day buying and selling of "paper" energy be the factor that is responsible for both a price of oil in excess of $100/barrel and a price of natural gas at record lows below $2 per thousand cubic feet?  
Jim reminds us how futures markets work
But remember that for every buyer of a futures contract, there is a seller. The person who sold the initial contract to me also likely wants to buy out of the contract at some later date. I buy and he sells at the initial contract date, he buys and I sell at a later date. One of us leaves the market with a cash profit, the other with a cash loss, and neither of us ever obtains any physical oil. 
However, if you read too quickly, you will think that "speculators" in a zero sum game cannot affect prices. This is not true. If speculators collectively think that prices will be higher in the future, more of them want to buy than want to sell, so futures prices rise until there are equal buyers and sellers.

In turn, when futures prices rise, people who actually have some oil hold it off the market (or sell it forward).  This is precisely the correct economic function of speculation. As William Tucker, quoted in the  Wall Street Journal explains,
What speculators do, however, if they guess right, is smooth out the availability of supplies between the present and the future. By paying a higher price now, they assure that prices will be lower in the future. In effect, they hold supplies off the market today so that they will be available next week or next year when things become even more scarce.
If they guess wrong, they lose horrendous amounts of money. There is a lot stronger self-correction mechanism at work here than among politicians.
Adam Smith described this as preventing a "dearth" from becoming a "famine": 
When the government, in order to remedy the inconveniences of a dearth, orders all the dealers to sell their corn at what it supposes a reasonable price, it either hinders them from bringing it to market, which may sometimes produce a famine even in the beginning of the season; or if they bring it thither, it enables the people, and thereby encourages them to consume it so fast as must necessarily produce a famine before the end of the season.… No trade deserves more the full protection of the law, and no trade requires it so much, because no trade is so much exposed to popular odium.
 Adam Smith had seen a few witch hunts. Maybe I should have just started and ended with that one. 

Jim Hamilton again. The problem for all attempts to ban "speculators" whose assessments of price we don't like, is that your "speculator" is my "liquidity provider:"
 How exactly do we define the "speculators" whose participation in the markets is to be banned? Suppose for example, we stipulate that the only people who are allowed to trade oil futures are those who are actually physically producing or consuming the product. If we do that, what happens if a particular producer wants to hedge his risk by selling a 5-year futures contract, and a particular refiner wants to hedge his risk by buying a 3-month futures contract? Who is supposed to take the other side of those contracts, if all "speculators" are banned?
Meanwhile, the New York Times  joined the witch-hunt:
Research presented in Congressional testimony, academic papers, government and private studies indicate that excessive speculation, mainly by Wall Street index-fund traders, is needlessly driving up prices,...
Speculation by index-fund traders??? I don't have to explain just how silly that is, do I? Next thing you know, Vanguard's S&P500 index fund will be behind bubbles in the stock market.

The Times' links are a  fun too, or a bit depressing if you value the ability of  "research" to credibly inform public policy, or the Times as an impartial aggregator of consensus among serious academic researchers. The first one, by L. Randall Wray of the Levy Economics Institute of Bard College, starts out stating a fact so obvious it needs no documentation:
"Money manager capitalism has resulted in a series of boom-and-bust cycles in equities, real estate, and commodities."
"Money manager capitalism?" You get the idea where it's going from there. 


  1. Anyone who thinks the speculators are artificially pumping up the price is of course free to speculate against the speculators.

    1. exactly, put your money where your mouth is and sell short.

    2. Top comment, in my opinion!

      I feel the same way when people claim "oil prices are too damn high!" Well, if you think they ought to be lower, why don't you devise your own oil-extraction scheme and make a tidy profit?

    3. Thou shalt not steal
      A moral scientist does not short.

  2. While I don't necessarily agree with Congress's position on oil speculation, the price evolution of petroleum commodities is curious. Surely one cannot argue that consumption demand for oil doubled between summer 2007 and summer 2008 when the price per barrel doubled from $70 to $140. If we agree that there was a housing bubble, is it such a great leap to admit there was/is an oil bubble?

    1. There can be an oil bubble without it being driven by any inappropriate speculation. "Inappropriate speculation" being a Hunt brothers style attempt to create and exploit an artificial shortage.

      Investors, for example, might have been legitimately concerned that there would be some major disruption in supply. I am not sure what the elasticity of the demand for oil is but in a serious supply crunch (revolution in Saudi Arabia, for example) it would not surprise me to see prices go over $200 per barrel. If there are concerns about political instability then speculation would operate to increase privately held reserves of oil ready to be brought to market.

    2. If you look at the prices of all commodities in the time frame you reference, they went up in value. It was funds entering the market, and the Chinese buying like crazy ahead of the Olympics.

    3. If you are looking at the situation from a static supply-demand perspective, you are right this would require a huge demand bump.

      Yet, in the real world, we also simultaneously have supply-side disruptions pertaining to oil. The "low-hanging fruit" is gone and production is becoming more and more arduous, not to mention pricey. I won't even go into the potential supply disruptions from Iran, et al. Additionally, at the same time as this, developing nations are starting to bring their own oil demand to international markets.

      I need to ask, with the supply and demand issues dawn out in the sand here, why does there *need* to be a role for speculators to bring prices any higher than we would expect from this basic thought experiment? Aren't prices high enough from the fundamental factors, that we need to sully ourselves by dragging speculators into the picture?


    The above study is sober and conservative, and suggests speculation boosted oil prices by 17 percent or so. So I don't think it is wild to think speculators can raise prices, if the St Louis Fed says so, and they are probably a bit naive.

    The oil market is characterized by a few huge sellers. Natural gas is not. Ergo, cooperation among sellers, both in physical product and in financial leverage, is a lot easier.

    The supply and demand for oil is short-term price inelastic, making it a perfect market to game.

    Additionally, there are deep-pocketed payers with a vital stake in higher prices; think Russia.

    Really, Putin would not be patriotic if he failed to game the NYMEX.

    Okay, let's put it this way: Chavez and Venezuela and Iran are gaming the NYMEX. Now do you think it is possible?

    1. Benjamin, OPEC members are not speculators, they are members of a cartel. No one is arguing that cartels can't increase prices. Indeed, that's why cartels exist.

    2. Amen to that. Just look at the 90% broken window A grade policy of every university. You will get fired if you refuse to destroy students private PAID FOR property.

    3. I have read the little summarized release which does not discuss methodology significantly, but if speculators are such a huge part of the market as uninformed voices at the NYT and within regulatory government seem to think they are, 17% is a pretty modest and unimpressive number for an organization with some of the best theoretical and econometric resources and researchers.

      As another commenter here mentioned, you seem to be attempting to make strong implications that the oil game is being rigged from the production side. In fact, OPEC cannot be classified as speculators because as cartel monopolists they are the ones who do the price making/seeking.

    4. Benjamin,

      Phil Verleger understands the energy markets far better than do the authors of that simplistic St Louis Fed analysis. Verleger shows here some of the errors those Fed analysts made.

      Remember, of course, that the weak dollar is the main cause for the rise in dollar-dominated energy prices. The Fed, not speculators, are the culprit.

  4. Some of these arguments sound awfully familiar, as in, arguments why there couldn't possibly be a housing bubble. Because, you know, for every buyer there's a seller...

    Really, Professor Cochrane, you should be making the case that oil futures trading is fundamentally different from financial asset trading and here are the reasons one, two, three...

    1. You haven't explained why the arguments at issue are problematic when applied to the housing market. It's not that there can never be bubbles (which I would define as a situation where the market price misapprehends the "true" value of the asset). Rather, it's that we can't *know* whether the market signal of the future value of something, whether it's houses or oil, is correct.

      Yes, there were lots of speculative investors in residential housing at the height of the market. But they believed that the price they paid was fair given their estimate of the future value of the home. We know now that they were wrong, but at the time, it was impossible to know for certain whether home prices were driven by a sustained increase in the demand for housing, or by overly optimistic investors.

      However, given the transparent, highly liquid nature of the oil market, I'm highly skeptical that the price of oil reflects anything other than a natural equilibrium of supply and demand.

    2. Well PJ, you have made a cute little quip, but it is time to face the facts which you do not seem to have in your little lexicon.

      Real Estate was a particularly unique market because people perhaps irrationally believed that it was a market which would continue "going up forever." Not only that, but the US government was bending over backwards to make it simple for subprime borrowers to gain access to financing.

      This is a case where the very best of research, data, and econometric analysis either cannot find a credible link between speculation and oil prices, or can find only but a fragmentary inkling tying "speculation" to some oil market jitters.

      Rightly so, oil is not like Real Estate. Oil supply has been for a number of years running below oil demand, which has been rising from a number of developing sources.

    3. Is lexicon a word. I've never heard it before.

  5. I am a speculator. Speculated for over 20 yrs with my own money. I can tell you that moment to moment, you can drive the price up or down for an instant, but markets self correct. It's merely a big order getting in or out. There isn't a coordinated effort to drive up the price.

    We aren't a conspiracy. All we want to do is make money.

  6. Prof. Cochrane-
    I am wondering why the econoblogosphere is not abuzz over Saez and Diamond's nutty (yes, nutty) contention, in the WSJ yesterday, that 50-70% marginal tax rates won't hurt the economy.

    1. The only reason to think it is "nutty" is when the ignorant fail to read it and understand that the Saez-Diamond paper includes all forms of income tax (Fed./St./local) in its headline figure. It is also robust to both behavioral elasticities and a (quite) moderately-assuming social welfare function.

      But hey, you probably know equally as much of economics as you read of the Diamond-Saez paper-- which is to say, you seem to have a very limited economic repertoire!

    2. Chris: read the Additional Considerations section of their paper. Basically, once I read it I knew they were full of baloney with their 70% marginal tax rates idea.

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  8. The Streetwise Professor (Craig Pirrong) posted numerous times from 2007 onward on the problems of connecting futures speculation with rising spot prices over anything other than a few days. His point is that the only way this can work is for a substantial number of these futures buyers to take physical delivery of (huge) inventories of oil -- something that was not and has not been observed. Otherwise, the sales that net-out the positions will have the price-decreasing impacts that JC and JH discuss. Hamilton (along with Li) develop an affine model where futures speculations increases spot prices (in part by assuming segmented markets). The SWP has commented on this also.

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