Speculation Continued...

The debate over whether speculation is an important factor in oil markets continues. Here's a round up of today's debate (so far):

Jim Hamilton: How big a contribution could oil speculation be making?

I do believe that speculation has been another factor that contributed to recent high oil prices. However, a key element of the bubble story is that there needs to be a very limited response of quantity demanded to the price increases, which the most recent data persuade me is no longer the case. Some of the estimates I've been hearing of the size of the contribution speculation is currently making to the price are therefore difficult to defend. Here I explain why, essentially elaborating on Paul Krugman's theme.  ...

Arnold Kling: My Model of the Oil Market: Option Value

Near the end of a "tiny theoretical paper," Paul Krugman writes,

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.

...My model of the oil market treats inventories and oil in the ground as the same. I don't care whether it is sitting in a storage tank or sitting under the Saudi sand--it's all part of the stock of oil. To look for shifts between under-sand oil and in-tank oil as evidence one way or the other on speculation does not strike me as compelling...

Arnold Kling: My Question for James Hamilton

...My question is: what were speculators thinking a year ago, when oil prices, including prices for futures contracts expiring in 2008, were substantially lower than spot prices are today? ...

If you believe Hamilton's view of fundamentals, and you believe my view that it's the job of speculators to anticipate fundamentals, then what you should blame speculators for is keeping prices too low in 2006 and 2007 (in fact, in all previous years).

That is, in fact, the most plausible story. But it could be that today's speculators have it wrong, and that today's futures price for June of 2009 over-estimates the realized spot price that we will observe then. And if speculators do have it wrong, I do not know where to look for evidence of that.

Tyler Cowen: Exasperating Paul Krugman

Krugman writes here on why speculation is not driving higher oil prices and offers a simple model here.  I agree with Krugman's conclusion but not his reasoning.  Arnold Kling responds here and basically Arnold is right...

Paul Krugman: Confusions about speculation

OK, Tyler Cowen weighs in — but I think that he partly misunderstands my point. ...

Also, I see that Arnold Kling has a question for Jim Hamilton. Here’s my answer...

In the stories where speculation is playing a large role, and storage somewhere (in ground or in tanks) occurs, how do you explain the large run up in, say, agricultural commodities which cannot be left "in the ground" until later? There's no evidence of substantial inventory accumulations for commodities generally. Perhaps Arnold and Tyler can explain this, but it seems problematic to me. And what about Krugman's point about iron, how is that explained?

If prices suddenly come crashing down and stabilize at a lower level, I'll change my mind (and Krugman's distinction in the post linked above between bubbles and speculation is important to keep in mind here), but for now I don't find the speculative bubble story as the most likely cause of (most of) the oil price run up, or the increase in the price of commodities more generally.

Comments

[anne]

When Arnold Kling is annoyed, really annoyed, annoyed as only Kling can be annoyed, my heart goes pitter patter all the way to market. Tyler Cowen's ever manipulative whining just makes my pleasure all the more sure.

[anne]

The point about the annoyed and whining is that there is no concern at all with what the effects of the oil-food price increases have been for poorer peoples, and how the effects might have been and might be lessened even beyond the immediate supposed cause.

says...

Speculators are making money (a lot of money) on futures contracts. Speculators are not driving the price of oil. Oil prices are a set by demand, instability of supply due to social disruptions and cartel actions. Right now the cartels don't have much influence because they have little room to increase supply. They will be hit with a major backlash because cheap oil is no longer a barrier to investments in alternatives and after a short lag, demand will again drop.

Bush has done nothing to advance conservation, efficiency or otherwise control demand. But Bush is gone in 7 months and his replacement will chart a new course to reduce demand.

Bush foreign policy has fostered world social and political problems (or not doing much to stabilize them) that are causing disruptions. There are consequences to a unilateral foreign policy of "preemptive engagement", neo-colonialism, imperialism and disdain for international institutions and agreements.

No matter what is causing the high prices, the solution is to use oil more efficiently to reduce demand. Once demand drops, price will follow. It would be more productive to discuss how to reduce demand than to argue over who is at fault.

[bill]

And if you laid all of the economists end to end, they'd still not reach a conclusion.

[SGC]

I think there are two different issues here that are getting confused:

(i) is there a speculative bubble -- i.e. will prices crash sometime as opposed to readjusting moderately downward?

(ii) is commodity investment (i.e. for capital gains, not for physical use) causing commodity price inflation?

Most of the discussion seems to assume that high futures prices can only shift the supply of commodities today. But surely high futures prices will also shift the demand for commodities today (storage may be a little harder for purchasers, but very possible). If both supply and demand shift in response to changing price expectations, all we know is that the spot price goes up. The effect on quantities -- and inventories -- is indeterminate.

[anne]

http://www.nytimes.com/2008/06/23/us/politics/23ethanol.html?hp&pagewanted=print

June 23, 2008

Obama Camp Closely Linked With Ethanol
By LARRY ROHTER

When VeraSun Energy inaugurated a new ethanol processing plant last summer in Charles City, Iowa, some of that industry's most prominent boosters showed up. Leaders of the National Corn Growers Association and the Renewable Fuels Association, for instance, came to help cut the ribbon — and so did Senator Barack Obama.

Then running far behind Senator Hillary Rodham Clinton in name recognition and in the polls, Mr. Obama was in the midst of a campaign swing through the state where he would eventually register his first caucus victory. And as befits a senator from Illinois, the country's second largest corn-producing state, he delivered a ringing endorsement of ethanol as an alternative fuel.

Mr. Obama is running as a reformer who is seeking to reduce the influence of special interests. But like any other politician, he has powerful constituencies that help shape his views. And when it comes to domestic ethanol, almost all of which is made from corn, he also has advisers and prominent supporters with close ties to the industry at a time when energy policy is a point of sharp contrast between the parties and their presidential candidates.

In the heart of the Corn Belt that August day, Mr. Obama argued that embracing ethanol "ultimately helps our national security, because right now we're sending billions of dollars to some of the most hostile nations on earth." America's oil dependence, he added, "makes it more difficult for us to shape a foreign policy that is intelligent and is creating security for the long term."

Nowadays, when Mr. Obama travels in farm country, he is sometimes accompanied by his friend Tom Daschle, the former Senate majority leader from South Dakota. Mr. Daschle now serves on the boards of three ethanol companies and works at a Washington law firm where, according to his online job description, "he spends a substantial amount of time providing strategic and policy advice to clients in renewable energy."

Mr. Obama's lead advisor on energy and environmental issues, Jason Grumet, came to the campaign from the National Commission on Energy Policy, a bipartisan initiative associated with Mr. Daschle and Bob Dole, the Kansas Republican who is also a former Senate majority leader and a big ethanol backer who had close ties to the agribusiness giant Archer Daniels Midland.

Not long after arriving in the Senate, Mr. Obama himself briefly provoked a controversy by flying at subsidized rates on corporate airplanes, including twice on jets owned by Archer Daniels Midland, which is the nation's largest ethanol producer and is based in his home state.

Jason Furman, the Obama campaign's economic policy director, said Mr. Obama's stance on ethanol was based on its merits. "That is what has always motivated him on this issue, and will continue to determine his policy going forward," Mr. Furman said....

[Cynthia]

And what I find funny is that when speculation was clearly fueling the NASDAQ and housing bubbles, Congress (and the White House) did nothing to restrict speculative trading. But now that speculators are playing a not-so-clear role in jacking up the price of fuel, our elected officials are all gung-ho about putting the brakes on speculative trading. Go figure!

[Bruce Wilder]

anne discovers that the Democrats, after losing two close elections in the Midwest, with candidates from the South and the Northeast, turns to a Midwesterner, the Midwesterner likes corn. anne will play Bette Davis in the Movie.

[Bruce Wilder]

My feeling is that Krugman has been arguing with a strawman of his own construction, but he's still, more or less, on the side of the angels, here.

It would be helpful if economists were sufficiently familiar with the workings of actual institutional markets, that they were aware that the spot market is NOT "the" Market for oil. But, oh well.

[Bruce Wilder]

anne, lookee, Obama is from Illinois, a major coal state; Obama likes coal, too. Swoon. "We're in for a bumpy ride."

[anne]

What is important, always important is that no matter the policy positions of Barack Obama, no matter how problematic, the positions must be defended, so that as the candidate becomes ever more conservative in policy we will be assured an ever more conservative Presidency. No problem.

http://www.nytimes.com/2008/06/23/us/politics/23ethanol.html?hp

Mr. Obama does talk regularly about developing switchgrass, which flourishes in the Midwest and Great Plains, as a source for ethanol. While the energy ratio for switchgrass and other types of cellulosic ethanol is much greater than corn, economists say that time-consuming investments in infrastructure would be required to make it viable, and with corn nearing $8 a bushel, farmers have little incentive to shift....

[hari]

Goldman & Sachs are projecting a crude price of $200/b....
What's curious to me about speculation on Futures Market is that it is based on future price projections (as above). Why would hi fi leveraged banking institution promote such a price if it was not profitable? Do they know something which traditional commodity traders don't know? Is it once again a replication of a derivatives market based on insider info on geopolitics in the region? Or is it a cabal with talmodic logic of its own?

[hari]

Bruce is right...in this particular case academics with armchair knowledge are least competent to understand what tics the crude price. Theory and whatnots aside, for the foreseable future hydrocarbons are the best bet in town for energy consumption.

Renewables like ethanol will become competitive, at this unit price level, but also impact cost of basic food items.

My hunch is that recent IDF trial-runs (using 100 US jet fighters) to obliterate Iranian nuclear sites have strategic implications to crude supply thru Strait of Hormuz. The Gulf Crude is exclusively transported thru that narrow passage, and if Iran should blockade it (in anticipation and/or after an attack by IDF), we shall surely enter into a new geopolitical paradigm shift.

Maybe Godman & Sachs have inside info to allow them to project barrel price @ $200.

[spencer]

In contrast to the stock market, futures markets are a zero sum game. Every time one trader in the futures market makes money some other trader in the futures market loses a like amount.

Klings assumption that oil in the ground substitutes for oil inventories just does not make sense. First, the futures contract calls for the delivery of a specific grade of oil at a specific time and place. Oil in the ground can not meet that requirement so it is not a factor in the futures market.

Second, assuming away that problem, relative to the above ground supply that speculators and traders can call on, for all practical purposes the supply of oil in the ground is essentially infinite. Ok, now explain to me how an infinite potential supply impacts the futures market. Doesn't it drive the price to zero?

[anne]

There is by the way a problem with building coal-fired power plants, and that is the need for carbon-capture technology for the plants to be environmentally sound, but my understanding is that such technology is a decade or so away. Then, legislation to require that only plants with carbon capturing technology be licensed by the EPA would if passed end construction of coal-fired plants for quite a while. I would guess such legislation will not be successful, though already introduced, but building coal-fired plants may be becoming more difficult.

says...

"The point about the annoyed and whining is that there is no concern at all with what the effects of the oil-food price increases have been ... and how the effects might have been and might be lessened even beyond the immediate supposed cause"

precisely

all this isle of laputa talk
while below
the emergency heating oil ration system is not being prepared for next winter

[anne]

http://www.earthpolicy.org/Updates/2008/Update70.htm

February 14, 2008

In a report compiled in early 2007, the U.S. Department of Energy listed 151 coal-fired power plants in the planning stages and talked about a resurgence in coal-fired electricity. But during 2007, 59 proposed U.S. coal-fired power plants were either refused licenses by state governments or quietly abandoned. In addition to the 59 plants that were dropped, close to 50 more coal plants are being contested in the courts, and the remaining plants will likely be challenged as they reach the permitting stage....

-- Lester R. Brown

[I have no sense of what this means.]

[paine]

"My feeling is that Krugman has been arguing with a strawman of his own construction,"

i agree

the real problem
what makes crude prices happen as they do ??

we haven't a clue toward a decent model
let alone such a model

how the crude oil markets work is simulate able i'm sure
but where's the detailed model

this is not academic science
its price engineering
no one wants such a costly specific model
that could afford one

"but he (krug)'s still, more or less, on the side of the angels, here"

why conceed that

the cry speculators causes popular alarm
aND THAT IS PRECISELY WHAT WE NEED HERE

action ust be taken now
massive wind falls must be taxed away now
to pay for heating oil ration stamps
or at least to retire the debt incurred funding this rationing plan

says...

anne you need to folow your own guide line
forget about building more capacity for 2012
and face winter 2009

[paine]

lets stick to the real target wind fals

are they all accruing to oil state out fits ??

no

are the trans nat incs wind fallers too
are they taxable ..yes
for that matter are the commodity specs taxable ...yes

go after all of em ...now
sort out who got what
when you have the totals
as part of the emergency tax probe audit

as to how they got it

leave that to the scholars

[paine]

one point calvo made

if the spot/ future links
are working
the spot market will prevent storage for pure spec
by reducing the differential
to carry cost or less
in this light obviously
a falling or rising interest rate adds some additional
minor motion of course

[gc]

Prof. Thoma, Your remark on the irony of the participants' respective positions suggests to me that the argument deserves little attention. In words, this is an unimportant discussion on whether speculation is an important factor in the spot price of oil. If it is such a factor, then so what? If it is not such, then so what again. We do not appear to be organizing a posse to round up all the usual suspect speculators. Moreover, the Cheney administration acts to prove that, for them, the high price of oil is a feature of their policies, not a bug. If we were to organize our society to reduce the demand for oil, as the unidentified commentator above suggests, then we could have quite a few speculators who have lost money on oil to correspond with those that have made money. That wouldn't be so far different than the tech bubble. And we all know that the tech bubble wasn't speculation, it was innovation.

[paine]

if those settng well head prices and output
suddenly
"today"
expect a much higher future price path then
they collectively expected "yesterday"
no matter why
then prices will jump right ???

expectation changing causes

peak oil
the dollar plunging forex expectation

a far faster growing global demand

what else ???

[BottyGuy]

How does oil storage in the ground work? Oil Production and been relatively steady for the last two years.

If I buy an oil contract, I expect the oil to be delivered when it expires don't I? In which case I need to store it. Can I ask the originator of the contract to just hold it in the ground for later? (I don't think so)

So unless the speculators are oil producing countries not originating contracts I don't see how there is storage in the ground. Plus it doesn't look like there has been any capacity taken off line, ala Enron and California Electrical Market.

[Mark Thoma]

gc -

Decided to take that statement out - I'm not sure it was completely accurate. There do seem to be people talking past each other due to speculation and bubbles being used interchangeably, and more clarity here is needed.

says...

"Right now the cartels don't have much influence because they have little room to increase supply"
why in hellwould they ever increase supply if elasticity
is so low

many "poorer " per capita
oil exporters always operate at practical max

its the large high per capita exporters
who can and will cut out put

the irregular period
of the crude price policy cycle
often a decade plus in length
btw
requires the ever present threat of a price collapse
to scare off high fix cost alternatives

right now folks ae still using 40-60 crude
as the bench mark for alternative energy products

[ddt]

OPEC President: No need to raise supply
BRUSSELS, Belgium (AP) — OPEC President Chakib Khelil said Tuesday that oil producers saw no need to raise supply and blamed record oil prices on factors outside the cartel's control, such as U.S. pressure on Iran and the weak U.S. dollar.
Following talks with European Union nations, Khelil said oil states believe they are pumping enough oil to satisfy demand and there is also stock and capacity to spare...

"All you need to do is to look at the data to be convinced that the market is well supplied in oil and that we have enough surplus capacity and that we have enough stocks in the market," Khelil said.
Khelil blamed high prices on the U.S. mortgage crisis. Banks became fearful of lending to each other last summer when complex securities based on U.S. housing loans to people with poor credit emerged as far more risky than first believed.
He also blamed speculators that have sought higher returns in commodities markets.
Khelil said OPEC is concerned that record oil prices are "destroying demand."...

http://ap.google.com/article/ALeqM5j7QR2sqVEfjaAEcLTEFT2mQmiz2wD91GG8AG0

[paine]

"If I buy an oil contract, I expect the oil to be delivered when it expires don't I? "

no a futures contract
gets bought and sold multiple times by specs

the links between markets users and specs gets pretty complex

[ddt]

Iran says extra crude will not dent oil price

TEHRAN: Iranian Oil Minister Gholamhossein Nozari said on Tuesday the oil market had sufficient crude and any additional output would increase inventories rather than bring down the price.

"Currently the situation of the global market is ... that it has enough oil and any increase in oil production will have no impact on (the crude) price," Nozari was quoted as saying by the official IRNA news agency.

He pointed to a price rise that followed Saudi Arabia's decision to raise its output.

http://economictimes.indiatimes.com/News/Economy/Iran_says_extra_crude_will_not_dent_oil_price/articleshow/3160861.cms

[paine]

just reviewed st paul's model

all those marshall crosses won't scare away
the wind fall vamps

take home question:

what if we make supply and demand both vertical
and
super imposed on each other
then what ?? ..err can we do that ???

extra credit : if we can
how could that be
a realistic today type
short run market sructure ???

[paine]

"Currently the situation of the global market is ... that it has enough oil and any increase in oil production will have no impact on (the crude) price,"

these are of course independent claims
if the supply is already adequate
and more is produced
the additional output could only be sold if a lower price would both induce more demand AND ...a lower price would be administered

obviously
if the price is fixed
inventory will rise if supply exceeds demand

butthe question remains
why is the price able to be fixed ??

[James Killus]

bottyguy, the real question is why has production remained fixed for two years, in the face of rising demand.

Also, purchasing futures contracts in anticipation of price increases does not require that one be an oil producer, just that one has a reason to believe that the oil will, in fact, be left in the ground and not produced. So the answer to the first question becomes even more important.

[Richard H. Serlin]

In response to Arnold Klingman's June 24th post (at: http://econlog.econlib.org/archives/2008/06/oil_speculation.html):

Arnold, you're not wrong in saying that your misinterpretation of a Krugman quote is wrong. The problem is that Krugman never meant what you think he meant.

Here's the quote you refer to:

"Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price"

You're interpreting it as though Krugman said it has no effect on the spot price. He didn't say that. He said it has no direct effect on the spot price. And just two sentences later he goes on to say, "Any effect on the spot market has to be indirect...".

What did Krugman mean by all of this?

The Futures market and price is clearly related to the spot price, and can clearly affect it. You don't have to get all flowery and philosophical to see why, the main direct way is through arbitrage. The futures price cannot get too much higher than the spot price or else there will be arbitrage opportunities that are easy to see and will be jumped all over, bidding the futures price down and the spot price up.

For example, suppose the futures price of oil in one month were $140, and the spot (today) price were $130. An investor with good credit and access to funds could sign a futures contract to sell 100 million barrels in one month. Then, he could borrow $130 million and use it to buy 100 million barrels of oil. He would store the oil for one month, and then sell it at the price guaranteed in the futures contract, $140/barrel. With no risk, he would guarantee himself a profit of millions because interest costs on the $100 million he borrowed for one month, and the storage costs of the oil for one month, will be less than the $10 million difference between 100 million barrels bought at $130, and sold at $140.

Arbitrageurs will jump all over this and keep buying at spot and selling at futures until the futures and spot prices get close enough that the difference between them won't be big enough to pay the interest and storage costs. So, the futures price can never get too much higher than the spot price. And when the futures price is bided up – perhaps by speculators, this will pull up the spot price with it – but notice how, through arbitrage, through speculators buying on spot and holding in storage – hoarding! Just like Krugman said.

Speculation is only going to boost the spot price if there is some hoarding.

But an important issue, still, is how much hoarding is necessary. I discussed this in my June 17th post (at http://richardhserlin.blogspot.com/2008/06/would-it-take-that-much-hoarding-for.html), and Columbia economist Guillermo Calvo eluded to it as well in a June 20th post (at http://www.voxeu.org/index.php?q=node/1244); the amount of hoarding necessary to push up the price a lot depends on how inelastic the supply and demand curves are in the short run, or very short run.

If you look at Krugman's graph in his May 13th post (at: http://krugman.blogs.nytimes.com/2008/05/13/more-on-oil-and-speculation/), he has the supply and demand curves drawn pretty diagonally, indicating a lot of elasticity in both the supply and demand. The empirical reality in the very short run might, however, be that those lines are very inelastic, very close to straight vertical lines. In that case, when you boost the price, the gap between them that develops is very narrow, indicating that not that much has to be hoarded.

So, if supply and demand in the short run, or very short run, are inelastic enough, then perhaps a small enough amount would have to be hoarded that it could go undetected by the oil inventory records. Theoretically this is possible, but I'm just not expert in oil inventory recording and the empirics of oil elasticity, to say how likely this is in the real world.

In any case, Krugman is right that speculators can only hurt us if they're hoarding. That's the only way they can affect the price, and this is true for anything. Speculators helped bubble up housing because they bought homes and held them for like a year or more. They held them, hoping the price would keep going up. They didn't sell them the next day, and when they did start selling them that really helped deflate the bubble. Speculators helped bubble up tech stocks in the late 90s because they bought them and held them for like a year or more, hoping the price would keep shooting up. If they sold them the next day, they would not have contributed to the bubble.

[bakho]

"the real question is why has production remained fixed for two years, in the face of rising demand."

Look no further than inelasticity and uncertainty.

Inelasticity: It takes time and considerable investment to bring new oil to market.

Uncertainty: The US is terribly inefficient in energy usage. If the US finds the political will to improve efficiency, the market will shrink, not expand in the short term.

The cheapest oil is produced first. Cheapest oil will always be profitable based on demand. Hardest to get oil is only profitable if demand is high. When costs to produce the oil exceed the market price investments in expensive oil lose money.

Because of the considerable investment needed to bring new oil online, investors must bet that demand will remain high. At present prices, oil alternatives (ethanol, wind etc) become viable competitors. We are seeing a trend to more efficient vehicles. Gasoline use in the US is already starting to decline.

Would you bet billions and a couple of years on bringing new expensive oil to a market in an environment where that demand may not exist in 4 or 5 years? Some would take that bet but most will not. The refining industry is unwilling to build new refineries because they are only one coherent energy policy away from being well over capacity.

Business decisions are based on projected demand over the payback period of the investment, not the current demand. This should be obvious. The payback period for oil extraction investments can be relatively long.

BTW, the 11:26 am post was mine. Accidently anonymous, bakho

[JKH]

Richard H. Serlin:

This is the most coherent explanation I've seen so far. Whether its ordinary supply and demand in the spot market, or investment/speculation in spot and futures markets, the full answer seems to involve very tight spot supply/demand balance, very inelastic spot supply and demand, and ongoing arbitrage between spot and futures. Tightness and inelasticity results in extreme price level changes in this environment.

[paine]

it might help if our more pundit like commenters read prior comments too
not just posts
a thread is a thread

if not
then note otherwise
no ham no foul
as in
i haven't read comments
so if in the floowing i repeat others ...

blah blah blah

serlin
maybe te whole marshall paradigm
brakes down where elasticity
becomes "vertical"
or close to vertical

after all using the usual alfred the greart story line
what keeps price sets from going even higher
till the profit max point

example of thumb ruled production level for the few slack producers
if you asume slac
u start first with a poorly behaved supply schedule
as in
throw out increasing marginal cost
u end up with the slackers
replacing full tilt
with a production level
that keeps global inventory stabilizing
within some moving target range ..etc etc etc

maybe this dust up among remote controled egg heads
might force some better simulations

[paine]

"the real question is why has production remained fixed for two years, in the face of rising demand."

no maybe not
the question if our iranian friend
quoted above is to be taken seriously

at least today seems to be
why does the market system
for crude oil ...
act like its operating
with a noisily rising price floor ?

[anne]

http://angryarab.blogspot.com/2008/06/so-saudi-arabia-receives-criticisms-in.html

June 25, 2008

So Saudi Arabia receives criticisms in U.S. congress and media over oil prices, and Saudi Arabia immediately and conveniently responds by announcing the arrests of hundreds of Al-Qa`idah members in Saudi Arabia. One of them was found in the private quarters of the king.

-- Asad AbuKhalil

[anon]

e e cummings and posse:

It might be appreciated by some if you would not judge and proscribe on the value added from other categories of commenters. This is not your blog and this blog is not your thread.

[ddt]

Paul Krugman: "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?"

OPEC President Chakib Khelil (controls 40% of world oil output, who acknowledges that output could be increased, but refuses to increase it), speaking yesterday:
""All you need to do is to look at the data to be convinced that the market is well supplied in oil and that we have enough surplus capacity and that we have enough stocks in the market,"
"There is a balance between supply and demand and stocks are adequate -- currently at about 53 days of stocks, while last year they stood at 51 days. There is no problem with fundamentals...which in no way justify current high prices, which are due to speculation and the use of financial instruments and investments in oil commodities to generate profits that investors are unable to make in other sectors."

Either OPEC is lying or Krugman is wrong.

[paine]

"It might be appreciated by some
if you would not judge and proscribe
on the value added
from other categories of commenters...."

judge ...maybe sort of

but
proscribe ???

never !!!!!!!

let the good memes
roll where they may

" This is not your blog.."

indeed

"and this blog is not your thread"

fair enough ..anon

just hold the self promotion to a dull up roar

[paine]

"Either OPEC is lying or Krugman is wrong"

krugman is wrong

[ScentOfViolets]

An honest question here, regarding speculation vs commodity investment leading to commodity price inflation: how are we to tell which it was in the aftermath? What is the difference between a bursting bubble and a 'readjustment'? Is this going to be yet another case where both sides are going claim victory should prices subside to their 2007 levels?

This is one of those things that frustrates me about economics - and one of the reasons why I decided not to go into the field.

Btw, let me add my thanks to J.K.'s for Richard Serlin's explanation.

[reason]

OPEC is lying (why should they change now).

[reason]

By the way Krugman could be wrong AND OPEC could be lying.

[reason]

Thanks Richard H. Serlin wonderfully clear writing (I really are envious).

Now to responde to Paine - we have seen already (US demand has fallen) that the elasticities are not 0. I'm sure the environmental economics blog discusses what the elasticities are measured to be (short and long term).

However, I will say there IS a way that speculation could cause a bubble in price. If producers thought that prices were going to continue to rise rapidly (not merely that they might stabilise at a higher level) then it would be in their interest to hold back production. Similar expectations on the part of consumers would cause them to buy now rather than later, driving up the price. The consumers would EXPECT to increase their stocks, but falling production would mean that ex-post they wouldn't be able to increase their stocks. But I don't believe this situation can last for long. It requires oil price inflation consistently higher than general nominal interest rates (the return on alternative investments), and is always potentially offset by new supplies coming online. And it implies that suppliers know that supplies are tight.

[reason]

As regards an understanding of the peak oil doomsters, to clarify for those who don't understand their arguments
1. They are not saying oil is running out soon.
2. They are saying that the rate of production will reach a peak so that no more cheap oil supplies will be available
3. They point out that our society depends on oil burning technology that already exists, and whose stock is still increasing
4. What happens when those new machines can't get any fuel because it is not available?

[reason]

Point 5 (Seperate because it deals with the response) we need to use our old (oil burning) technology to move to new (sustainable?) technology. Some wonder whether this retooling is doable as well as continuing to run our current society.

The very eloquently written preface to World Changing suggest that we have a chance - ONE chance. Hence it is urgent that we do it right.

[hari]

There is no current/profitable alternative to hydrocarbons, and won't be for a generation or more.

Amazing level of literacy we've among academic economists on *spot* and *futures* price * their inter-relationship... don't forget Futures Market was introduced by CFTC to cater principally for (US) hi fi speculators....

This further amplifies magnitude of intellectual accumen between commodity traders and armchair pundits. I've a feeling this subject is now getting a bit trite/exhausted due principally to lack of practical trading knowledge and experience in commodity markets....

[reason]

Hari - we'll see.

[ndd]

I'm really disappointed that paine broke form. I would have expected something like

Krugman

is

Wrong.

There, much better, my world is in order again!

[Ken]

OK so Krugman says its not speculation. then explain something to me. Our Co. uses alot of steel. and steel prices are out of control. 70% yoy inflation and thats accelerating. Month on Month annualized is now over 130%.

USSteel is reporting that in pounds they are shipping 10% more than they did last year. 10%...how dou we account for 70% inflation on a 10% increase in demand? You can look at some of the other steel makers and you'll see much of the same. The dollar is down 13.5% during that time. i suppose that accounts for some of it also.

so if its not speculation driving commodity prices what is?

[reason]

Ken,
where are they shipping it to and what are paying for raw materials? It is a world market and if demand is growing faster then with relatively inelastic supply and demand then prices can rise very rapidly without speculators driving up the price. And IF speculators are driving up the price, they are doing it by buying and holding (i.e. increasing inventories).

[hari]

Rubbish!

Mittal has just gone on record against Futures Market in global steel. Why? Because, he argued, as world's largest producer now, steel would be high-jacked by speculators!

DO you need a more representative voice against futures market in steel?

[reason]

hari...
are you saying there isn't a futures market in steel now? If so what are you saying? You seem very definite, but I am yet to see you explain the mechanism for how speculators can drive up the price without increasing inventories.
But I think time will tell, so a shouting match now is irrelevant.

[ddt]

as paine was saying, I think the interesting question here is: "Can speculative buying of futures contracts increase the spot price?"

as ndd, hari and others have pointed out, virtually every participant in the commodities market is convinced that, while there are strong fundamentals, the recent run-up in prices is largely caused by speculative investment in futures. On the other hand are the academic economists who mostly seem to think that it is impossible to bid up prices solely by rolling futures contracts in the manner that long-only index fund positions do.

so... who are the experts on futures anyway? can anyone recommend to me some papers or foundational texts on the theory of futures? is there something equivalent to Graham's Security Analysis but for futures?

I've found one good article that seems to raise some interesting points, and I think is probably worth a look. I haven't had a chance to go through it, but it just came out and touches on a lot of the topics that have been discussed here:

Sanders, D. R., S. H. Irwin, and R. P. Merrin. “The Adequacy of Speculation
in Agricultural Futures Markets: Too Much of a Good Thing?” Marketing
and Outlook Research Report 2008-02, Department of Agricultural and
Consumer Economics, University of Illinois at Urbana-Champaign, June
2008.

http://www.farmdoc.uiuc.edu/marketing/morr/morr_08-02/morr_08-02.pdf

[hari]

@ Mark - ECB/FED on inflation.

Spiegel has an interview with the Chief Economist of ECB, Jurgen STARK (26th June 2008).

Spiegel - "Is cheap money in the US causing another bubble to develop this time on the commodities market?"

Stark - "All indicators suggest that there is plenty of available liquidity worldwide. This money is washing through various asset classes. What emerges from the real estate sector is now migrating to the commodities sector. I see rolling bubbles, that is, dangerous exaggerations moving from one sector to next."

Stark - "...international invoices are increasingly being issued in euros and no longer in dollars."

[hari]

In this age of globalization, forget about your textbooks on macroeconomics and whatnots. That knowledge is now getting surpassed (as I learnt recently) by what is happening not only in global credit markets but the impact of globalization per se.

[SGC]

ScentOfViolets

The facts are not political, but the vocabulary is.

"speculative bubble" used by (i) those who want to constrain the growth in commodity prices -- and may not even care whether there is a bubble in the sense of prices coming down hard in the future, and (ii) those who believe that commodity prices in certain markets are being manipulated. (Note that if Kling's argument is right then commodity markets will be relatively easy to manipulate, so this possibility needs to be disproven, not just discounted.)

"It's all fundamentals" is the argument used by those who don't want intervention in the markets, but don't want the Fed to reduce liquidity either.

"Commodity investors" is used by those who don't expect a hard price adjustment (and/or want to discount the manipulation argument), but think to the degree there is a solution to high commodity prices it's tighter monetary policy.

Large bubbles can be identified very clearly in retrospect and both sides don't get to declare victory. Both the stock market bubble and the housing bubble are not in question any more.

My interpretation of your rejection of economics is that you did so out of disgust for the political aspects of the economics debates.

[Cynthia]

So when the so-called oil bubble finally bursts dropping oil prices down to only, say, the $100-to-$110-a-barrel range, Krugman will prove to be more or less right. But if after the burst oil prices drop all the way down to, say, the $70-to-$80-a-barrel range, then it can safely be said that OPEC was lying all along.

BTW, "NDD", I'm still betting that Krugman is right (and paine is wrong, regardless of form) and OPEC is distorting the truth. Only time will tell, though...

[Cynthia]

oops -- I meant to write "OPEC was telling the truth all along", not "OPEC was lying all along."

[hari]

@ ddt - Thanks for link to Urbana campus ( I've visited that campus and maybe they did the report for CFTC).

I read the summary and a bit of the conclusion.

The data base is more or less current (no question). The analysis is ok, I find.

However they're raising the issue of *index funds* dealing with commodities - the tool required for non-traditional traders ( with no or little understanding of commodities).
They recommend further study on how commodity index funds are (mis)used by speculators.

Finally, they don't consider it a problem that speculators provide the hedging on future prices/contracts. Actually, I think they should try and define what they mean by speculators (traditional or non-traditional commodity traders?). Me thinks they are pointing their fingers at non-traditonal traders from the hedge funds and others.

[hari]

I also think the Urbana report was commissioned to counter the arguments to levy margin fees on futures contracts by Congress. Could be part of CFTCs bargain with Congress on regulatory controls or not.

However, from a professional perspective, I'd like to keep the non-traditional index speculators at arms-length- transaction.

We did that in international sugar under ISA - the market has proper oversight based on supply, inventories/stocks, etc.

[ddt]

yeah, as you can tell from the title, there is a definite bias there against limiting or regulating futures investment. Not the greatest article, but one of the more relevant ones i have found. They do at least entertain the possibility that the old models aren't working correctly:

"Unlike traditional speculators in Working’s day—who were regarded as scalpers, day
traders, or position traders and who were responsive to hedging needs in the market—long-only index funds appear to be more mechanical and less responsive to hedging demands. While this does not alter the calculation of the speculative index, it does bring into question Working’s maintained assumption about the nature of speculation in today’s markets. It is also possible that the commercial category still contains “contamination” both from hedgers who are really speculating and swap dealers who are hedging OTC swaps not used for commodity index investments. The degree of this contamination is unknown plus it is unclear whether it would lead to over- or underestimation
of long or short positions. So, the potential directional impact on Working’s T is
difficult to discern.
In sum, agricultural futures markets do not have a historically high level of speculative
activity based on Working’s speculative T index. Working and others strongly maintained that futures markets were hedging markets, where speculators enter the market in response to hedging pressures. For example, Peck (1979-80, p. 329) unequivocally states, “Taken together, the historical evidence is clear: futures markets reflect commercial needs.” The rise of long-only index funds in agricultural futures markets opens this basic tenant to debate and may bring into question the appropriateness of traditional measures of speculative market balance."

[wogie]

I posted a similar question on Econobrowser

Not very up on commodity trading, but I took a look at the June 17 Commitments of Traders Report for crude oil on the NYMEX -- futures and options combined. By far, commercial interests account for most of the positions. Speculative large traders (presumbaly those of interest on the speculation issue -- driving futures and spot prices up) accounted for just 28.4% of total positions.

And intersting, spread positions accounted for 69% of total large trader speculative positions, i.e., their long trading offset by short contracts. These traders presumably seek profit from the narrowing or expansion of the spread betwen selected futures contracts (it would be interesting to see which contracts they are trading -- and what has happened to the spread). For speculative large traders, other than sptreading, the net long position amounted to only 3.9% of total long positions, including commercials

Since the long and short contracts offset each other in spreading, its not clear to me how the trading drives the large increase in futures and spot prices

[hari]

It's the impact of volume trade by index speculators whose margins are not big but in dollar terms it can be good profit. So volume is what moves spot price contracts.
No trader wants be out done by *outsiders* dipping into their leveraged credit supply to strike a price....

[OhNoNotAgain]

Geez, a lot of talk and no answers. How about someone start applying some logic here. How on earth are we seeing huge increases in the prices of almost every commodity worth having *immediately following* the bursting of the real estate bubble ? There's coincidences, and then there's the evidence right in front of your face. I'm going with the latter.

The next question becomes, how do we stop these financial masters of disaster from continually wrecking our economy every 4 years for their own profit ? This needs to get reined in, or we're never going to get anything productive accomplished. We've seen some of most egregious mis-allocations of resources over the last 30 years, and all have been due to these financial sector distortions. It's like, "Gee, Mr. Scientist, I'd really like to loan you that million bucks for developing an exciting new form of renewable energy, but I can make a lot more money investing in Pez candy because it's hot, I mean hot, right now !!!!".