The Speculation Continues...

As I continue to gather thoughts on the speculation question... [i.e. the question of whether speculation is driving up oil and other commodity prices, previous entries: Speculative Nonsense, Once Again, More Speculation, Even More Speculation, Speculation Continued..., An Answer?] [Update: New version of model here]:

Steve Waldman added another piece to the speculation model, so let me show how it fits into the graphical model that is being used to illustrate ideas.

First, let's review the model of speculation and inventory storage. I'll use Brad DeLong's pictures to illustrate. In the left-hand panel of the first picture shown below, the interest plus storage line (which I'll denote as i+s) represents the marginal cost of holding inventory, and this is always positive since interest rates and storage costs cannot be negative (I show how to add interest rate determination to the model here). The expected appreciation line, E=(expected future price - spot price)/(spot price), represents the expected marginal benefit from holding speculative inventory. If benefits exceed costs (E>s+i), inventories will increase, if costs are greater than benefits (E<s+i), inventories will decrease, and when they are equal (E=s+i), inventories will stabilize. Note, however, that inventories cannot be negative.

The spot price, in this case, is determined in the right-hand panel by the flow supply and demand curves for the good (say oil). However, at this spot price, and given the expected future price, expected appreciation (E) is negative. Since the benefit is expected to be negastive, and the costs (i+s) are positive, no inventory is held. [Note for now that, since i+s (interest plus storage) is always positive, if E is negative no inventory will ever be stored in this version of the model. Even if E is positive it has to be large enough to cover the interest plus storage costs before any inventory will be held for speculative purposes.

Okay, now let's generate inventory storage. We need to do (at least) one of three things. First, we could let the expected future price go up shifting E to the right. Second, demand could shift in. Third, supply could shift out.

Taking the first case, an increase in the expected future price, this shifts the E curve to the right. Looking at the diagram above, as E shifts out the intersection of the blue lines in the left-panel moves up and, when it crosses the dotted line showing the spot price, speculators are at the indifference point on storing inventory. This is shown in the next diagram (the orange line is the new E curve after the increase if the expected future price):

Now, if expectations rise even further, then the E curve will shift out even more. As it does, and speculators begin demanding some of the good for storage, the spot price is driven upward (and is hence determined by speculators as the label in the graph indicates). The result, after E is done shifting (and it turns from orange to blue), is the equilibrium below:

Thus, this shows how an increase in the expected future price can cause the equilibrium to move from one where there is no storage to one where there is. So, when higher future prices are expected, we should see both inventories and the spot price rising.

How else could we go from the first to the third diagrams, i.e. from no storage to storage? Go back to the first diagram above. Now, imagine either the demand curve shifting in (demand falling) or the supply curve shifting out (supply increasing). All we need is for the spot price to fall (holding the expected future price constant), and either change will accomplish that. As the spot price falls, the horizontal dotted line in the first diagram showing the spot price will also fall, obviously, and you can see that it will eventually hit the intersection of the two blue lines in the left-hand panel. i.e. it will hit the point of indifference over speculative inventories. Here's how the graph would look for an increase in supply:

If supply goes up even further so that the price keeps falling (increasing the spread between the future and spot price and increasing the benefit), we will again be at the situation depicted in the third diagram where it will pay to hold inventories.

It's easy to see that a decrease in demand works roughly the same.

Okay, now let's add in Steve Waldman's twist. Notice that in every case above where there was inventory storage, E= (future-spot)/spot, was positive. It has to be since the expected gain has to cover both the interest expense (the opportunity cost of the value of the inventory, it could be earning interest if converted to a financial asset) and the actual costs of physical storage. When the future price is greater than the spot price, and E is positive, it is called Contango. When the spot price is above the future price, and E is negative, it is called backwardization. In the diagram above, there can never be storage when there is backwardization since  E is negative and will always be less that i+s. It won't pay (in expected terms) to store anything.

Some have then taken an additional step and said that because prices have been in backwardization lately (see the graphs in Steve Waldman's post linked below), for the most part, how can there be any inventory speculation? Steve Waldman shows how this can happen be adding in a "convenience yield," which is basically the option value of having inventory on hand. For example, if you are storing a product and there is a temporary shortage driving the price way, way higher than anyone expected, you might want to sell some inventory now and realize a large profit, and replace it later when the price comes back down. Having inventory on hand allows these kinds of options, and that is called the convenience factor. Let me turn it over to Steve:

The convenience yield, by Steve Waldman: If a commodity is in "backwardization", that is, if futures prices are lower than current prices, does that imply that futures markets are discouraging storage (encouraging disgorgement)? Paul Krugman makes the case, here and here.

I'm going to challenge him with a low-down, dastardly kind of argument. ...I'm going to offer an unfalsifiable hypothesis. Krugman says that futures prices are too low to cause people to withhold physical oil and sell forward, as required to affect spot prices. But whatever forward price curve he shows me, I can posit an invisible "convenience yield" large enough to make hoarding oil worthwhile. I don't even have to be unreasonable about it. Extrapolating from historical data, we see that gently "backwardized" futures prices might be quite sufficient to encourage storage when convenience yields are taken into account.

Despite all of this, I agree with Krugman that futures markets can't explain the recent skyrocketing oil prices. Not unusually, he's been a voice of sanity and reason. ...

What is this "convenience yield"? Is it real? ...

Oil is a "spiky" commodity. Every once in a while, someone really needs it, now, and will pay a premium for immediacy. The market for oil in Cushing, Oklahoma might be reasonably efficient, but what happens when someone in Peoria needs oil today? Opportunity! ...

[S]ometimes oil spikes even on the wider market, so that anybody with physical oil can sell at a high price and while locking in low-priced near future purchases to replenish their stock quickly enough to meet any other contractual obligation to sell. If you estimate the profit you'd to earn from these occasional opportunities, and subtract a bit to come up with a "certainty-equivalent" value for this uncertain income stream, you'll have determined a convenience yield. It shouldn't be surprising that convenience yields are especially high for volatile commodities subject to frequent shortages and price spikes.

When futures markets are well-arbitraged (which might not always be the case!), the future price of a storable commodity is determined by the spot price plus the total cost of storage, defined as foregone interest, plus storage costs, minus any benefit of temporary ownership — the convenience yield! When a storable commodity like oil is in backwardation, that doesn't mean that the markets are predicting that its price will fall. It means there is a convenience yield. And in order to decide whether futures markets are creating incentives to store or to sell physical stuff, you have to estimate the convenience yield.

What Steve is saying, if I interpret correctly, is that the cost of storage is no longer just i+s, i.e. interest plus physical storage costs, it is now i+s-c, where c is the convenience yield. Thus, it's easy to see that if c is large enough, i+s-c can be negative, so that it's now possible for it to be profitable (in expected value terms) to store the good even though the expected appreciation is negative. If i+s-c < E, then there will be an incentive to store the commodity even if the values on both sides of the inequality are negative.

Here's how that would look graphically (the axis labeled "price" is at zero, and i+s-c is to the left of this):

However, as Steve notes, just because backwardization is consistent with inventory storage does not mean that explains what we are currently seeing in commodity markets. As has been noted again and again, there's' no sign of inventories piling up.

On that note, let me end with a question for Paul Krugman from Arnold Kling, and an answer from Jim Hamilton:

A Question for Paul Krugman, by Arnold Kling: Early in 2007, the price of oil was $60 a barrel. Recently, it has been above $130 a barrel. Which of the following does Paul Krugman believe:

(a) market fundamentals justified $60 a barrel then, and they justify $130 a barrel now; or

(b) market fundamentals justified a much higher price in 2007?

...We know that Krugman does not believe that today's oil price is out of line with fundamentals. Krugman's view, in effect, is that if speculators artificially boost the price of oil, then supply will exceed demand, and the excess has to go somewhere. Where are the inventories?

This view ought to hold in reverse. If speculators artificially kept the price of oil too low early in 2007, then demand should have exceeded supply and inventories should have vanished. Yet they did not. So is Krugman forced by his model to conclude that the price of oil of $60 also reflected fundamentals?

My view is that inventories are not a reliable indicator of supply-demand balance vs. speculation. Inventories, and the futures-spot differential, also reflect interest rates and "convenience yield" (or option value).

Steve Randy Waldman writes,

Krugman says that futures prices are too low to cause people to withhold physical oil and sell forward, as required to affect spot prices. But whatever forward price curve he shows me, I can posit an invisible "convenience yield" large enough to make hoarding oil worthwhile.

I may have understated it when I wrote that "convenience yield" is "something of a fudge factor." Thanks to Mark Thoma for the pointer.

In a different post, Mark writes,

while it may be possible to store grains and other commodities in non-traditional forms, if the claim is that's what's gong on now, why store grains in (what I presume are) more costly non-traditional methods when, with stocks this low, there is plenty of storage space available?

That is another good question. I think that I have to argue that non-traditional storage methods (keeping oil under sand, storing wheat as crackers) are in fact less costly (at least for large adjustments) than are changes in the quantities held in storage tanks and silos.

On oil, I'll basically repeat myself....

There has been a dramatic decline in interest rates over the past two years, so that we do not necessarily need to observe an increase in the futures-spot premium to say that the incentive to hoard has increased. Moreover, as Waldman points out, we can always appeal to the unobservable "convenience yield" (or perhaps tell my option-value story).

The other folks (Krugman, most notably) seem to want to say about the commodities markets, "Silos and storage tanks are not filling up. The futures prices are not high relative the spot prices. So you can't blame the rise in prices on speculation about future demand and supply."

My reply would be that there are other ways to store commodities. Oil can be stored under sand. Wheat can be stored as crackers. Also, the futures-spot price differential is affected by interest rates and changes in the fudge factor known as "convenience yield."

What I say is that you cannot possibly have prices in these markets that fail to reflect speculation about future demand and supply. I do not think it is reasonable to claim that the oil market was in long-term balance eighteen months ago and is in long-term balance today. Either speculators vastly under-priced oil back then or they are over-pricing it now, or both.

Here's Jim Hamilton's reply:

Kling's question on oil speculation, by Jim Hamilton: Arnold Kling poses a question for Paul Krugman. Here's how I would answer. ...

The "fundamentals" price of oil depends on a number of factors that cannot be perfectly foreseen. Among these are (1) will the world enter a deep and prolonged recession in 2007, and (2) will global oil production in 2007 be higher than it was in 2006? Today, we know that the answer to both questions is no, and conditional on knowing that answer, we can see that $60/barrel was too low a price. But a year ago, no one knew those answers.

Likewise, the price of oil today is very much dependent on the answer to questions such as (1) will the world enter a deep and prolonged recession in 2008, and (2) will global oil production in 2008 be higher than it was in 2007? Today, we do not know the answer to these questions. If the answer is yes, the price of oil today is much too high. If the answer is no, the price could still be too low.

As for the specific question of "where are the inventories", let's be a little more precise about the question being asked. The correct question is, Did the movement along the demand curve that resulted from the increased price show up as an increase in inventories? The correct answer is, no, it was offset by a shift in the demand curve for newly industrialized countries and the oil producing countries. For example, China may have consumed a half million more barrels of oil per day in 2007 compared with 2006.

Where are the inventories? China already burned them.

Update: Arnold Kling responds.

Comments

[ndd]

Question for Prof. Krugman et al: For purposes of my question, assume that in fact there is hoarding of oil. Given ddt's terrific comment that a hoarder of oil, to be successful, must keep it hidden from the likes of you, where would you expect them to hide it? How would you outwit them to find it?

[ndd]

P.S.: Re, it's been consumed by China:

Please set forth, in as much detail as possible, the privileged access you have been given to China's inventory statistics and the manner in which you verified the veracity of same.

Please take all the time and space you need to explain.

[Michael McKinlay]

Doesn't the Peak Oil Theory explain everything ?

Increasing demand and stagnant supply.

We see the same thing in grains where inventories are at all time lows.

[MG]

Kling stated: "This view ought to hold in reverse. If speculators artificially kept the price of oil too low early in 2007, then demand should have exceeded supply and inventories should have vanished. Yet they did not."

Actually, there is evidence to the contrary. In mid Jan 2007 the current prompt month WTI contract (Aug 08) traded for $57.50/B. The prompt month at the time (Feb 07) traded for $50. So you could have earned 15% by buying the spread and storing. This is good evidence of high inventories which were subsequently worked off by demand > supply.

[don]

So, I hope it is becoming clearer - the real issue is not whether speculation is raising the price of oil, but whether, in future, the price today will prove to have been too high or too low. If speculators are causing an increase in the price today, this will prove beneficial if the price proves to be in line with the price in future. If not, they will have done us a disservice, but they will pay for their transgression. If they are not affecting the price, then no need to worry at all about their activities.
In any event, those who know that speculators should be stopped strike me as being akin to the majority of those who know that stem cell research is morally bad, it having been revealed to them without the bother of reading any very rigorous moral philosophy.
I would prefer it if those who advocate controls on speculation could somehow be drawn to account if the current price proves, in future, to have been appropriate, just as speculators who bet wrong will be drawn to account.

[homer]

Krugman notes in one of his blog entries that the california electricity price rise was due to hoarding that was not evident until several years later. Why should we presume that oil speculators could not hide their efforts to "corner" the oil market (or at least a sufficient share of the oil market) to induce price increases? I'm not saying its happening, but can it be ruled out?

[homer]

http://krugman.blogs.nytimes.com/2008/06/24/various-notes-on-speculation/

[dd]

Does the natural gas manipulation from 1999-2002 have any relevance? Most focus on the electricity issue but there was a significant manipulation component in natural gas (false inventory reporting) that impacted pricing. see: http://www.ftc.gov/bcp/workshops/energymarkets/presentations/0411_mansfield_savvyconsumer.pdf (page 7) and the 4.4 billion paid in fines for natural gas manipulation: http://www.publiccitizen.org/documents/NatGasManipulation.pdf

Then there is the Amaranth case where NYMEX futures were allegedly manipulated to benefit OTC positions. See
http://www.cftc.gov/stellent/groups/public/@lrenforcementactions/documents/legalpleading/enfamaranthopinion052108.pdf

The natural gas manipulation lesson was hoarding is not necessary when the players control reporting and manipulation is possible from a non-producer entity. No doubt there are many differences and this may not apply to crude.

[anne]

http://krugman.blogs.nytimes.com/2008/06/26/speculate-speculate/

June 26, 2008

Speculate Speculate
By Paul Krugman

Some links for those who want more wonkishness related to the 6/27 column.

The Masters testimony is here. * My reaction is here. ** Jim Hamilton and Seeking Alpha had similar reactions.

I tried to think through the issue here. *** Mark Thoma has much much more.

All in all, a lot of food for thought — even if some of that food consists of stale crackers held for speculative purposes (sorry, Arnold.)

After the column was put to bed, I saw this from Tim Egan. **** I remember the California electricity crisis very well; I was one of only a handful of people in major media outlets to call market manipulation in real time. ***** But this doesn’t look at all similar.

[anne]

http://egan.blogs.nytimes.com/2008/06/25/the-petro-manipulators/index.html

June 25, 2008

The Petro-Manipulators
By Timothy Egan

Anyone who lived on the West Coast during the phony energy crisis of 2000 and 2001 cannot help thinking of Texas and two of its worst products — Enron and a politician not named George Bush — as gas creeps up toward $5 a gallon this summer.

What happened during the great energy heist at the start of the new century was like an extended bad dream, part "Twilight Zone" and part "Chinatown," the extraordinary 1974 film about water manipulation and long-buried secrets.

The price of energy spiked — tenfold, a hundredfold — despite low demand. Californians became the most efficient users of power in the nation, and still suffered through dozens of rolling blackouts. None of it added up.

And into the worst energy crisis since the Arab oil embargo of 1973 came Vice President Dick Cheney, blasting conservation as a sissy virtue and saying the nation needed to build a new power plant every week for the next 20 years.

The administration's neglect was breathtaking, a harbinger of what was to come when a natural disaster, Hurricane Katrina, would do to Louisiana what a man-made disaster had done to California. We now know, of course, that the problem eight years ago was caused by manipulation by Enron and other speculators who gamed a faulty system, sticking it to Grandma Millie while laughing at how easy it was to rob 40 million people.

Now consider the present dilemma: oil doubling over the last year, gas at $4.50 a gallon in places and the oversized influence of speculators in a market where few used to tread. Big investors are free to run up oil futures contracts thanks in part to former Senator Phil Gramm. He is the Texas Republican who co-sponsored the so-called Enron loophole in 2000 at the behest of what was later found to be one of the nation's biggest criminal enterprises.

Enron may be gone, but its legacy lingers in the work done by politicians who did its bidding. And Gramm, who once told corporate contributors, "I have the most reliable friend you can have in American politics, and that's ready money," is now the chief economic adviser to Senator John McCain.

Gramm's role in helping to unleash energy speculators has been well-documented in recent months, and Senator Barack Obama has made an issue of it. Both Obama and McCain have called for closing the loophole. But just how big a role that kind of global gambling plays in the overheated commodities market is only now coming to light.

Testifying before the Senate on Wednesday, the ever-knowledgeable Daniel Yergin blamed speculation for part of the run-up. Yergin, an author and the chairman of Cambridge Energy Research Associates, and pointed to numerous other causes, as have other experts.

But he also noted that 2007 may have been the peak year for oil demand in the United States....

[anne]

http://krugman.blogs.nytimes.com/2008/06/26/speculate-speculate/

June 26, 2008

Speculate Speculate
By Paul Krugman

I remember the California electricity crisis very well; I was one of only a handful of people in major media outlets to call market manipulation in real time. *

* http://krugman.blogs.nytimes.com/2008/06/24/various-notes-on-speculation/

[Right.]

[anne]

"All in all, a lot of food for thought — even if some of that food consists of stale crackers held for speculative purposes * (sorry, Arnold.)"

* http://econlog.econlib.org/archives/2008/06/mark_thomas_que.html

[Ramp up the corn flake production, Merv.]

says...

Flood damage to the corn crop in the Midwest is driving prices to the point where margins on livestock and ethanol production are both negative. The picture was already bleak before the floods.

http://www.purdue.edu/uns/x/2008a/080102HurtEthanol.html

January 2, 2008

Expert predicts 2008 corn crop won't be enough; need to ration

"Not only will ethanol be competing for corn in 2008, but other crops will too.

"All major crops are in short supply in the world, and some will outbid corn for acreage," Hurt explained. "The shortest of the major crops are wheat and soybeans, and the prices are expected to drive acres away from corn in 2008.

"Assuming a 6 percent decline in 2008 acres, U.S. production would drop to 12.4 billion bushels with a usage base at about 13.3 billion. This means there will be a need to ration the small crop with high prices."

Hurt said as a result it's likely the ethanol industry will have to cut usage below the 4.5 billion bushels (the level of full capacity) to a rate closer to 4 to 4.1 billion bushes.

"If so this means the nation's ethanol plants might run at levels that are about 10 percent to 12 percent below full production, or 88 percent to 90 percent of total production capacity," he said. "This also implies that cash corn prices will need to be high enough to convince some ethanol producers to run at less than full capacity.

"Given the outlook for $2-plus per gallon ethanol prices and $160 per ton distiller's grains into the fall of 2008, this implies we will be seeing cash corn prices in the $4.25 to $4.75 range. It will not be until 2009 when corn production may be able to meet the demand."

Today:
6/26/2008, 1:30 PM CDT

CHICAGO, Illinois (Agriculture Online)--CBOT corn hits an all-time high in the July '09 contract at $8.22.

After reaching a new record price of $8.22 earlier, the July '09 corn futures contract closed at $8.15 3/4. Today, marked the first time ever corn traded on the floor of the CBOT reached the $8.00 level. Last week, CBOT corn hit the $8.00 mark in overnight electronic trading.

July '08 corn closed 23 3/4 cents higher at $7.53 3/4 per bushel, and the December '08 corn contract closed 23 cents higher at $7.88.

[Richard H. Serlin]

With regard to Steve Waldman's writing above, "Also, the futures-spot price differential is affected by interest rates and changes in the fudge factor known as "convenience yield.", and with regard to just the general treating of the convenience yield as some "fudge factor" that you can take wide liberties in assigning values to. This is a bad way to think of it. It's a specific benefit, not some error tolerance that we can make as wide as we like.

And, it's not that hard to estimate with reasonable precision. I would think there's a lot of literature on what it is empirically, and that it would show that it's usually not that large.

In the case of arbitrage when the futures price gets significantly higher than the spot (as discussed in detail in my June 25th post at: http://richardhserlin.blogspot.com/2008/06/dont-mess-with-krughan.html), an arbitrageur has zero convenience yield if he wants to keep it at true arbitrage, which means payoff with no risk, because he can't do anything with the oil while he waits. He has no options if he's engaging in true arbitrage (no risk at all). He just has to keep the oil in the tanks so he has it to fulfill his futures contract.

[Paul G. Brown]

Probably been brought up before, but it concerns me that this term 'speculators' is being flung about without careful definition. (I'm writing this after listening to two oil-and-financial types try to explain to an NPR journalist what is going on).

Speculators "speculate" in asset value. It seems to me that there are at least 2 assets at play here. One is "Oil" - a physical commodity requiring physical storage. Another is "Oil Price Future Contracts" - a non-physical commodity that needs a few inches of well maintained disk.

If I believed that the value of "Oil" was going to increase then I would buy the stuff and pump it into a tank. If enough people shared my conviction then that tank's gauge would show closer to "full". Krugman et al. points out that this gauge is NOT showing anywhere near full, and isn't even increasing.

If, on the other hand, I believed that the values of "Oil Price Future Contracts" was going to increase (because, for example, the underlying asset value was increasing) I would buy "Oil Price Future Contracts" and hold them. But that kind of speculation wouldn't show up on the gauge on the tank at all. I am still a "speculator" in the popular sense of the word. But I'm not doing anything to change the value of the price of the oil in the sand/tank/pump.

So - we might well be looking at "speculation" in the market for "Oil Price Future Contracts". But given the reality of the underlying market this is "speculation" of an entirely reasonable kind. As a hypothetical "Oil" producer I want to lock in prices, so I will engage in the "Oil Price Future Contracts" market. What the "speculator" in the "Oil Price Future Contracts" market does is to reduce the risk faced by an "Oil" producer.

Yet at the same time, the value of the oil in the fundamental market -- what it costs to produce, how much utility consumers extract from it given the other things they might choose -- isn't affected.

When one "speculator" makes money, another "speculator" loses money.

[ddt]

"When the future price is greater than the spot price, and E is positive, it is called Contango. When the spot price is below the future price, and E is negative, it is called backwardization."

Mark, I think that's a typo. the second sentence should be "when the spot price is above the future price, and E is negative, it is called backwardation"

[Mark Thoma]

yep - thanks, will fix.

[ddt]

Waldman brings up a great point.

Waldman's "convenience yield" is basically the same principle that applies to buying call options where it is called the "time premium" or "time value". If you buy a call option (right to buy asset at strike price any time before expiry) that expires in a month at a strike price equal to the market price, you will pay a premium on top of the market price that is roughly determined by the time until expiry and the expected volatility of the underlying price. These two factors determine how many chances you will have to cash in on a price spike by exercising the option to buy at the low fixed strike price and then sell at the high market price. the higher the volatility, the higher the premium for the option.

If this carries over to futures markets, it would make sense that spot prices would carry a premium over futures prices depending on volatility, since it gives you the option to sell your oil inventory when the spot prices spike above futures, and you are therefore able to lock in your profit at your convenience. The main difference with commodities is that there is a fixed storage cost subtracted from that premium.

So there seem to be 3 factors determining the difference between spot and futures prices:

a) storage + interest cost - always pushes equilibrium towards contango
b) expected price - can push either way
c) volatility - always pushes equilibrium towards backwardation

It seems that since storage costs are generally fixed, whether the futures price is in contango or backwardation is a function of variations in both expected price and expected volatility.

I guess this raises a question: If the convenience yield on the spot price for oil behaves similar to a call option, what are the implications? Could the run up in spot prices be driven largely by increases in expected price volatility, independent of the expected future price level? What do you guys think?

[ddt]

a cursory googling reveals a few articles. anyone got access and feel like sharing the wealth?

The Information Content of the Implied Convenience Yield: Using American Call Option Based Structural Model

Abstract:
This study examines the relationship between volatility and the spread of two commodity futures with different maturities in the NYMEX crude oil market. We find that convenience yield behaves like an American call option, which suggests that the information content of convenience yield is volatility behavior. Our model successfully quantifies the sensitivity of the spread with respect to volatility and provides satisfactory predicting power. For practical applications, we show how to calibrate our model in a trading strategy that can generate significant profit. Our structural framework lays the groundwork for studies on how volatility dynamics are related to commodity fundamentals.

Chen, Te-Feng, Lin, Ming-In and Wang, Kehluh, "The Information Content of the Implied Convenience Yield: Using American Call Option Based Structural Model" (January 2007). Available at SSRN: http://ssrn.com/abstract=957621

Uncertainty and the convenience yield in crude oil price backwardations

Abstract

This study examines why firms hold stocks of crude oil, particularly during price backwardations when spot prices exceed prices for forward delivery. Using a stochastic control model, this paper shows that the equilibrium value of inventories contains: the conventional Hotelling principle; the convenience yield from the classical theory of storage; and an option value related to price uncertainty. Our empirical results suggest that a convenience yield and risk premium are important elements of crude oil price backwardations.

Timothy J. Considine and Donald F. Larson

Department of Energy, Environmental and Mineral Economics, The Pennsylvania State University
http://www.sciencedirect.com/science/article/B6V7G-43NT3R5-3/2/3d4a849d6745e2247c4874c321068475

[ddt]

"It seems that since storage costs are generally fixed, whether the futures price is in contango or backwardation is a function of variations in both expected price and expected volatility."

actually that should be "is a function of expected price, expected volatility, and interest opportunity cost"

In our current situation, volatility is high (adds to convenience yield) and interest opportunity cost is at historic lows (deducts from carrying cost)

Could today's high spot prices be a function of high volatility and low interest opportunity cost rather than high future price expectations?

[ddt]

one more thought: what if the yield on depreciating dollars at low interest rates is actually negative relative to holding oil? Negative enough to cancel out the cost of storage.

[bakho]

In commodities trading, the futures market allows producers to lock in a favorable price as "insurance" against too low prices. Storage typically occurs when prices (including futures prices) are below production costs.

The "speculators" are betting that the future price will be higher than the contract price. The speculators are making a lot of money because floods have damaged a lot of the corn crop this year driving prices up. However, the high corn demand is the cause of high prices and why the speculators are making money. Speculators are not the cause of the high prices.

In the current climate, there is insufficient corn for ethanol production and at some point, the ethanol plants will find it more economical to suspend operation than to further bid up the feedstock price. Ethanol becomes competitive when oil hits $46 / barrel. High oil prices and bets that oil will not go below $46 anytime soon has driven a large expansion of ethanol production.

Livestock producers are locked in until they can market their livestock. Many of them have futures contracts as insurance against too high feed prices. This actually prevents the price from being bid up higher. Those not locked in to the lower price are caught in a bidding war. Look for livestock to flood the market as producers cut their losse. After that, meat prices will go way up. This will also affect hay and forage prices as they are alternative feed sources.

Grain inventories are going to be even lower.

[Barry Ickes]

I think those were Krugman's pictures, not DeLong's.

[Barry Ickes]

The correct term for the futures price below the spot price is backwardation. Backwardization is more like what is happening today in Zimbabwe.

[Eric Dewey]

Mark, thanks for taking the time to make this complex subject more intelligible.

Your approach helps non-economists like me follow the various arguments - just want you to know once again how much that is appreciated!

[david]

Is it simplistic to think that what we are seeing is a raising demand curve and a stagnant supply curve, one where we are very close to the maximum amount of available/possible production, so increasing demand (or price) does actually result in a change in the amount of supply (as roughly seen since about 2005)? I guess in some ways the supply is decreasing, as the net exports of oil are decreasing, so it is even more a situation where the demand is increasing (china!) and the supply is either stagnant or potentially decreasing.
Is it not surprising to anyone else that it appears to be almost a logrithmic increase in price?

[zinc]

I'm sorry Dr. Mark, but Brad De Long hasn't had an accurate, long term "economic" analysis for a very long time. He is, IMO, not a creditable economic source.

Brad, hari krisna to you too, buddy. Just stop pretending you are objective.