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Tuesday, June 24, 2008

More Speculation

Thomas Palley takes a contrary position on speculation and oil prices:

Beating the Oil Barons, by Thomas Palley: Over the past eighteen months, oil prices have more than doubled, inflicting huge costs on the global economy. Strong global demand, owing to emerging economies like China, has undoubtedly fueled some of the price increase. But the scale of the price spike exceeds normal demand and supply factors, pointing to the role of speculation – and underscoring the need for policy action to clean up the oil market.

Reflecting their faith in markets, most economists dismiss the idea that speculation is responsible for the price rise. If speculation were really the cause, they argue, there should be an increase in oil inventories... The fact that inventories have not risen supposedly exonerates oil speculators. ...

But, contrary to economists’ claims, oil inventories do reveal a footprint of speculation. Inventories are actually at historically normal levels and 10% higher than five years ago. Furthermore, with oil prices up so much, inventories should have fallen, owing to strong incentives to reduce holdings. Meanwhile, The Wall Street Journal has reported that financial firms are increasingly involved in leasing oil storage capacity. ...

Whereas oil speculators have gained, both the US and global economies have suffered and been pushed closer to recession. In the case of the US, heavy dependence on imported oil has worsened the trade deficit and further weakened the dollar.

This sobering picture calls for new licensing regulations limiting oil-market participation, limits on permissible trading positions, and high margin requirements where feasible. Sadly, given the conventional economic wisdom, implementing such measures will be an uphill struggle.

But some unilateral populist action is possible. A major form of gasoline storage is the tanks in cars. If people would stop filling up and instead make do with half a tank, they would immediately lower gasoline demand. Given lack of storage capacity, this could quickly lower prices and burn speculators. [uncut version]

Paul Krugman might respond with:

Iron Resolution, by Paul Krugman: Chinese steelmakers have agreed to a 96 percent increase in the price they pay for Australian iron ore.

One interesting point about this case is that, as I understand it, iron ore isn’t traded on an international exchange; trade takes place through bilateral deals between producers and consumers. In other words, there isn’t any easy way to speculate on future iron ore prices.

Yet ore prices are surging like oil prices. A bit more evidence against the speculative frenzy hypothesis.

Arnold Kling says:

Oil Speculation: Paul Krugman Mis-speaks, by Arnold Kling: Paul Krugman writes,

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

He can't mean that. Think of the foreign currency market. If speculators bid up the future price of Japanese yen, then the spot price of Japanese yen will go up. And you won't see any particular pattern of inventories among currency dealers. The inventory issue is much closer to a red herring than to the decisive empirical data that Krugman maintains it to be. ...

My views on the oil market are almost the exact opposite of Krugman's. I believe that the futures price has to be the key determinant of the spot price. Because oil is a non-renewable resource, the oil market has to reflect expectations for demand and supply over the entire future time horizon, and those expectations ought to be embedded in futures prices. ...

I agree with Krugman that blaming oil speculators for the high price of oil is unhelpful. The politicians make it sound as though there has been a sudden outbreak of greed among oil speculators. Instead, there has been a change of expectations about future supply and demand. From what I can tell, there was no real news to cause this change in expectations. Either speculators were badly wrong six months ago or they are badly wrong today. It is more likely that they were wrong six months ago, but the probability that they were closer to correct then is far from zero. [Full Post]

Paul Krugman might follow this up with:

Various notes on speculation, by Paul Krugman: First, Friedrich von Schiller was right. ... Right now I see well-trained economists getting ... hung up on the financial relationships between spot and futures. Whatever you say about the futures market, it can only drive up the spot price by causing physical hoarding of physical goods.

Second, some ... have asked me why my inventory argument didn’t apply to the housing bubble. The answer is that a house is a durable good, which unlike oil, which you have to burn, isn’t used up by the consumer; what we consume are housing services — in effect, consumers rent houses, from themselves if they happen to be homeowners.

To see the equivalent in housing of what the oil bubble types think they’re seeing in oil, we’d have to have seen a sharp rise in rental rates. It didn’t happen. [graph]

Third, some people have asked what I said about the California energy crisis of 2000-2001, perhaps history’s greatest example of market manipulation. I first broached the manipulation issue in California screaming, written in December 2000. I didn’t really figure it out, however — I was still giving too much credence to the conventional wisdom about underinvestment — until The Price of Power, published in March 2001. The Real Wolf, published a month later, pulled it all together.

During that whole period, I was pretty much the only voice in a major news outlet even suggesting that market manipulation might be a central factor.

And here’s the thing: I applied pretty much the same reasoning to that crisis that I’m applying now. The only way market manipulators could have been driving up prices was by keeping physical supply off the market. And they were in fact doing just that: there was huge unused generating capacity, consistent with the idea of deliberate withholding. Some years later we would actually get hold of control room tapes in which Enron traders called plants and told them to shut down, and boasted about cutting off Grandma Millie’s power.

I’m still waiting for evidence that physical withholding is going on in the oil market.

Update: And Paul Krugman might also respond with:

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.

    Posted by on Tuesday, June 24, 2008 at 12:15 PM in Economics, Financial System, Oil | Permalink  TrackBack (0)  Comments (60)


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