Even More Speculation

Paul Krugman with even more on speculation:

Speculation and Signatures, by Paul Krugman: I’m trying to get my own thoughts on the oil stuff clear; so for the econowonks, a tiny theoretical paper for your enjoyment and/or detestation.

After reading the paper, which explains when you would and would not expect to see inventories, what contango and backwardization mean, and importantly the signatures of speculation, some of you may wonder how monetary policy fits into the model. Here's a quick first pass at showing how this works (the two graphs in the top row mimic the graphs in Krugman's model in the paper, I'm adding the money-demand money supply diagram much as Krugman and Obstfeld do in their analysis of exchange rates in their book on international economics):

In this graph, starting in the upper left-hand diagram. E is the expected appreciation in oil prices, i.e. E=E(p, pf)=(pf-p)/p, where p is the spot price and pf is the future price. E is decreasing in p and increasing in pf. The line s+i represents the sum of interest foregone on stored inventory, i, and the actual storage cost, s. The storage cost is exogenous to the model, and the interest rate is assumed to be set by monetary policy. (Think of E as the expected benefit and s+i as the cost, the equilibrium (pf-p)/p = s+i sets the marginal cost of holding one more unit in inventory equal to the marginal benefit).

The diagram on the upper right is the flow supply and demand diagram for oil. The distance ab, the excess of flow supply over flow demand at the initial spot price of p₁, is the initial level of inventories. [The supply and demand curves are drawn relatively flat for ease of illustration.]

The diagram in the bottom row is the supply and demand diagram for money. Real money demand is L(y,i), nominal money demand in PL(y,i), and as usual L is increasing in y and decreasing in i. The money supply is M, and it is controlled by the monetary authority. It is assumed the i is the policy variable, so that M takes whatever value is needed to hit the target value of i for a given level of money demand.

The initial target for the interest rate is i₁. At i₁, the spot price of oil is p₁ and inventories are ab. Now let the monetary authority ease up and lower the interest rate to i₂. This will cause the i+s line to shift to the left, and this in turn will increase the spot price of oil to p₂. At the higher price of p₂ inventories increase from ab to cd, so the net result of easing is to increase the price of oil in spot markets, and to increase inventories. Thus, an increase in liquidity from an easing of monetary policy would have an increase in the spot price and increases inventories as a signature.

Intuitively, the model starts in equilibrium with (pf-p)/p=s+i. Then, i falls due to the increase in liquidity causing (pf-p)/p>s+i. Since the benefits of speculation now exceed the cost at the margin, there is more demand for oil to be put into inventory, and this drives up the spot price until (pf-p)/p=s+i once again.

[I should add that if the market is in backwardization, which Krugman argues has been the case recently  - see figure 3 in Krugman's paper and the associated discussion - then variations in the i+s line will not change the equilibrium. Thus, in this case changes in the target interest rate will not change the spot price or change inventories (which are zero, again, see figure 3 and picture the i+s line shifting left or right).]

There are lots of thought experiments one can conduct with this model, e.g. ask what might happen if pf goes up, y goes down, etc., and I should stress that this is partial or short-run equilibrium, for example there are no feedback effects through the aggregate price level P or output y, both of which are held constant in the analysis, and if p is permanently higher, pf might increase as well (and these sorts of "chase your tail" mechanisms can lead to bubbles, e.g. pf goes up for some mysterious reason shifting E to the right, this causes an increase in p, which could increase pf if it's thought to be permanent, which increases p, then pf again, etc., until it eventually peaks and then comes crashing back to fundamentals), but this should give some idea of how it all fits together.

Comments

[Winslow R.]

So this is the monetary transmission mechanism that fails so miserably :)

[Simple Answers]

I gather there are similar papers and complex calculations for housing, when speculators were being blamed for the housing bubble.

The simple answer is that we're being abused by the monetary authority, the Fed, once again. In a way that not one man in a million can diagnose. And these calculations serve to hide the truth. India today raised rates, and their central bank dares to speak the truth - that demand must be reduced. Here the gutless Fed will jawbone and bailout, and continue to destroy the productive economy with the destruction of the currency.

[hari]

Intuitively, lack of equilibrium between spot/futures markets is directly playing into speculation by non-traditional commodity traders. By autumn, Fed/ECB actions will most likely topple this market resting on a precipice right now, me thinks.

Recall old-adage, 10% of market is factually based and 90% speculative. And when global liquidity has no other place to go to earn profit, this is what transpires....

says...

http://www.nakedcapitalism.com/2008/06/thomas-palley-beating-oil-barons-and.html

In Congressional testimony last fall, oil industry expert Phillip Verlegger (http://www.petersoninstitute.org/publications/papers/verleger1207.pdf)
explained that the role of inventories in the oil industry is misconstrued, particularly in a world with stores of value other than oil stocks:

that returns to storage for crude oil were positive through the second half of 2006 and the first half of 2007. Since the end of May 2007, though, returns have been negative. Logically, one would expect stocks to have accumulated during the second half of 2006 and the first half of 2007 and then be liquidated from June 2007 forward.

The data on inventory accumulation and liquidation confirm this hypothesis.

[baileyman]

Shouldn't the oil supply curve kink upwards? It seems higher prices bring no more supply.

[ddt]

The main problem with Krugman's argument is the unreasonable burden of proof it shifts from himself to the opponents - a burden of proof that his own argument doesn't even meet.

Krugman says: "Show me the inventories"

I say: "Well, why don't you show that there are NO inventories? you can't, for the same reason that I can't show that there are inventories."

Nevermind the issue of what counts as inventory.. We are dealing with one of the most opaque markets in the world, yet Krugman expects his opponents to unearth the most closely guarded secrets on the face of the earth (saudi reserves etc.) in order to meet an arbitrary standard of proof that he demands..

Just because there is not evidence of rising inventories, doesn't mean that hoarding isn't happening. In fact, if there is hoarding going on, official inventory numbers are the last places I would expect it to show up.

Think about it: anyone who is hoarding has a massive incentive to keep their hoard secret, otherwise it will not have the desired effect of causing the appearance of a shortage and rising prices. THE WHOLE POINT OF HOARDING WOULD BE TO KEEP IT OUT OF THE OFFICIAL INVENTORY NUMBERS!

Does Krugman know for a fact that there aren't any inventories built up in Saudi Arabia or elsewhere? Why does he assume that all the answers to huge unknowns are in his favor and must be disproved by his opponents?

[ddt]

Iran tankers can hold 5 months of Saudi oil hike
Published: Tuesday, 24 June, 2008, 01:43 AM Doha Time
JEDDAH/TEHRAN: Iranian supertankers now in the Arabian Gulf could store the equivalent of five months worth of the additional crude oil Saudi Arabia pledged to pump to curb prices, according to ship-tracking data compiled by Bloomberg.
Saudi Arabia said it would increase production by 200,000 bpd in July, after a summit of leading oil producers and consumers in Jeddah on Friday. Saudi Arabia and Iran are the Opec’s two largest oil producers.
Iran has 13 to 15 supertankers idling in the Gulf with capacity to hold as much as 30mn barrels, the ship-tracking data shows.
Iran has not said how much oil is in the tankers...
http://www.gulf-times.com/site/topics/article.asp?cu_no=2&item_no=226131&version=1&template_id=48&parent_id=28

[James]

ddt has it nailed. Krugman is trying to sneak out of a gaffe.

[kthomas]

I have to agree with ddt and James, though I still admire Prof. Krugman a great deal.

[2slugbaits]

Mark,

What about baileyman's point about the shape of the demand and supply curves? If the two curves were steeply vertical, wouldn't that be consistent with the speculation argument?

[Walt French]

"Show me the inventories!"

How are futures contracts that I have bought not the exact financial equivalent of inventory that I control, absent the fact that I've contracted out storage costs?

Yes, there's also the seller of that contract, who is now short what I'm long, so no net inventories are created in the deal. Presumably, however, in addition to speculative (!) motives in the sale, that seller soon hedges the risk of a price rise by buying the oil forward. (Otherwise, absent a clear crystal ball showing that the market will collapse in the near future, the seller soon will not exist.)

It may take a minute or a week before the seller eliminates his risk position by buying forward, during which any price change may have gnawed away at the original bid/ask profit. But the futures sellers are still there, so we presume they're net long or worst case, pretty well hedged at every instant.

So how is this not the inventories that speculators hold? As open interest keeps rising, paper inventory keeps rising, and more of the future production is spoken for.

I personally imagine that there are so many speculators in this market that there's little risk of collusion; Joe Lieberman will look in vain for somebody who's trying to corner the market in WTI. But that doesn't mean there aren't speculators raising the price of oil by increasing short-run demand. And like all speculative markets, we can expect that at some time -- maybe tomorrow and maybe in three decades -- the price will break and speculators will have significant losses.

Until then, I think that if we want to preclude speculation in oil, then we should also outlaw all use of hedge funds, stock markets and any purchase of a bond that is not intended to be held to maturity.

[Carlo DB]

Seems a little too easy. What if both supply and demand in the physical oil market are highly anelastic in the short run (as this model is meant to be)? Of course inventories would be much smaller and so it would be arbitrary to say whether they are "high" or "low" according to the average level. If you look at the data, well, they are over the 10 year average.