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Wednesday, September 17, 2008

Speculation and Oil Prices

We’ve heard a lot about how speculation has caused volatility in oil and other commodity prices recently, and there are calls in Congress to put constraints on speculative activity in order to stabilize prices and markets, so let's go back to the issue of whether speculative activity has been the driving force behind commodity price movements, oil prices n particular.

To begin, it's important to recognize that not all speculative activity is the same, and not all of it is bad, and as we look into how to better regulate these markets, we need to keep the types of speculative activities separate so that we don’t stifle the good type of speculation as we try to eliminate the types that cause us troubles.

First, speculative activity can arise from attempts to profit from manipulating the price of a good, and some people believe this type of manipulative activity can explain much of the volatility in oil prices we have seen recently. This, obviously, is a bad type of speculation and we should prevent it to the extent possible.

Second, moral hazard combined with easy money can lead to an undesirable type of speculation. If market participants have ready access to funds, and if they believe losses will be covered, say, through a government bailout, then they may be willing to invest far more than is optimal in speculative ventures. If they hit it big, they win. If things go sour, the government covers their losses.

A third type of speculation we’d like to avoid is speculative bubbles, and this is probably what most people have in mind when they hear the term speculation. Speculative bubbles occur due to “bandwagon effects” where rumors or some other force causes prices to deviate from their underlying fundamental values in a self-feeding frenzy that drives prices upward in a bubble, or downward in a crash.

Fourth, speculation allows us to insure against expected future changes in supply or demand, that is, anticipated changes in the price. If we expect higher demand or lower supply of a good at some point in the future, that is, if we expect a higher future price, then speculators will take some of the good off the market today, store it for the future, and then sell it after the price rises. In this way, speculation provides insurance against the future fall in supply or increase in demand by having the good available to meet those changes.

Finally, there is stabilizing speculation, for example selling short near peaks in anticipation of price declines can dampen natural market volatility, and this is generally desirable. This type of speculation - short-selling - is under considerable scrutiny right now, but in general this dampens rather than enhancing market volatility and we ought to encourage the dampening variety.

So yes, by all means, limit the bad type of speculation through regulatory changes. But be sure to keep the types that help.

Moving next to commodity prices and speculation, I've taken the stance that there is little evidence of the first and third types of speculative activity, manipulation and bubbles divorced from fundamentals, and I don't think the second type - moral hazard - made a large contribution. I've argued fundamentals are the most likely source of most of the price variation, and by fundamentals I mean any new information that causes people to change their expectations of supply and/or demand, and I've taken a lot of criticism here over that stance, the stance on speculative bubbles in particular. So let me add this to the debate (see also See You Later, Speculator - WSJ.com):

Scott Irwin takes down Michael Masters, by Jim Hamilton: Econbrowser is pleased to host another contribution from Scott Irwin, who holds the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois. Today Scott offers a critique of a recent report by Michael Masters on the role of commodity speculation.

The Misadventures of Mr. Masters: Act II
by Scott Irwin

The impact of speculation, principally by long-only index funds, on commodity prices has been much debated in recent months. The main provocateur in this very public debate is Mr. Michael Masters, a hedge fund operator from the Virgin Islands. He has led the charge that speculative buying by index funds in commodity futures and over-the- counter (OTC) derivatives markets has created a "bubble," with the result that commodity prices, and crude oil prices, in particular, far exceed fundamental values. Act I of the Masters farce was his testimony to the Homeland Security Committee of the U.S. Senate in May of this year. Act II is now upon us in the form of a lengthy research report co-authored by his research assistant, Mr. Adam White, and his testimony this week to a subcommittee of the Energy and Resources Committee of the U.S. Senate.

My purpose in writing this post is to show that Mr. Masters' bubble argument does not withstand close scrutiny. He first makes the non-controversial observation that a very large pool of speculative money has been invested in different types of commodity derivatives over the last several years. The controversial part is that Mr. Masters concludes that money flows of this size must have resulted in significant upward pressure on commodity prices, which in turn drove up energy and food prices to consumers throughout the world. This argument is conceptually flawed and reflects a fundamental and basic misunderstanding of how commodity futures and related derivatives markets actually work. It is important to refute Mr. Masters' argument since a number of bills have been introduced in the U.S. Congress with the purpose of prohibiting or limiting index fund speculation in commodity futures and OTC derivative markets.

The first and most fundamental error Mr. Masters makes is to equate money inflows into futures and derivatives markets with demand, at least as economists define the term. Investment dollars flowing into either the long or short side of futures or derivative markets is not the same thing as demand for physical commodities. ... These are zero-sum markets where all money flows must by definition net to zero. It makes as much logical sense to call the long positions of index funds new "demand" as it does to call the positions of the short side of the same contracts new "supply."

An important and related point is that a very large number of futures and derivative contracts can be created at a given price level. In theory, there is no limit.  This is another way of saying that flows of money, no matter how large, do not necessarily affect the futures price of a commodity at a given point in time. Prices will change if new information emerges that causes market participants to revise their estimates of supply and/or demand. Note that a contemporaneous correlation can exist between money flows (position changes) and price changes if information on fundamentals is changing at the same time. Contrary to what Mr. Masters asserts, simply observing that large investment has flowed into the long side of commodity futures markets at the same time that prices have risen substantially does not necessarily prove anything. Mr. Masters is likely making the classical statistical mistake of confusing correlation with causation. One needs a test that accounts for changes in money flow and fundamentals before a conclusion can be reached (more on this later).

Mr. Masters' second error is to argue that index fund investors artificially raise both futures and cash commodity prices when they only participate in futures and related derivatives markets. In the very short-run, from minutes to a few days at most, commodity prices typically are discovered in futures markets and price changes are passed from futures to cash markets. This is sensible because trading can be conducted more quickly and cheaply in futures compared to cash markets. However, equilibrium prices are ultimately determined in cash markets where buying and selling of physical commodities must reflect fundamental supply and demand forces. This is precisely why all commodity futures contracts have some type of delivery or cash settlement system to tie futures and cash market prices together. ...

It is crucial to understand that there is no change of ownership (title) of physical quantities until delivery occurs at or just before expiration of a commodity futures contract. These contracts are financial transactions that only rarely involve the actual delivery of physical commodities. In order to impact the equilibrium price of commodities in the cash market, index investors would have to take delivery and/or buy quantities in the cash market and hold these inventories off the market. There is absolutely no evidence that index fund investors are taking delivery and owning stocks of commodities. Furthermore, the scale of this effort would have to be immense to manipulate a world-wide cash market as large as the crude oil market, and there simply is no evidence that index funds are engaged in the necessary cash market activities.

This discussion should make it crystal clear that Mr. Masters is wrong to draw a parallel between current index fund positions and past efforts to "corner" commodity markets, such as the Hunt brother's effort to manipulate the silver market in 1979-80 . The Hunt brothers spent tens of millions of dollars buying silver in the cash market, as well as accumulating and financing huge positions in the silver futures market. All attempts at such corners eventually have to buy large, and usually increasing, quantities in the cash market. As Tom Hieronymus noted so colorfully, there is always a corpse (inventory) that has to be disposed of eventually. Since there is no evidence that index funds have any participation in the delivery process of commodity futures markets or the cash market in general, there is no logical reason to expect their trading to impact equilibrium cash prices.

A third error made by Mr. Masters, and unfortunately, many other observers of futures and derivatives markets, is an unrealistic understanding of the trading activities of hedgers and speculators. In the standard story, hedgers are benign risk-avoiders and speculators are potentially harmful risk-seekers. This ignores nearly a century of research by Holbrook Working, Roger Gray, Tom Hieronymus, Anne Peck, and others, showing that the behavior of hedgers and speculators is actually better described as a continuum between pure risk avoidance and pure speculation. Nearly all commercial firms labeled as "hedgers" speculate on price direction and/or relative price movements, some frequently, others not as frequently. In the parlance of modern financial economics, this is described as hedgers "taking a view on the market." Just last week, when commenting on new survey results of swap dealers and index traders , the CFTC stated that, "The current data received by the CFTC classifies positions by entity (commercial versus noncommercial) and not by trading activity (speculation versus hedging). These trader classifications have grown less precise over time, as both groups may be engaging in hedging and speculative activity." (p. 2)

What all this means is that the entry of index funds into commodity futures markets did not disturb a textbook equilibrium of pure risk-avoiding hedgers and pure risk-seeking speculators, but instead the funds entered a dynamic and ever changing "game" between commercial firms and speculators with various motivations and strategies. Since commercial firms have the considerable advantage of information gleaned from their far-flung cash market operations, they have traditionally dominated commodity futures markets and speculators have tended to be at a disadvantage. ... In this light, entry of large index fund speculators has the potential to improve competition in commodity futures and derivatives markets, particularly as index funds become smarter about moving in and out of their positions.

I believe the points made here already build a persuasive case against Mr. Masters and his bubble theory. But there is more. It is possible to conduct a formal test of the hypothesis that money flows from index funds aided and abetted the recent boom in commodity prices. This can be done by running what are known as "Granger causality" tests... The CFTC has conducted thorough Granger causality tests in the crude oil futures markets, and guess what? They found absolutely nothing using non-public data on the daily positions of commercial and non-commercial traders. I am working with a Ph.D. student here at the University of Illinois to extend this testing... As you might guess, I do not expect to find much...

While it is always possible to dither over the power of Granger causality tests or whether the specifications adequately control for changing fundamentals, I think most unbiased observers will reach the same conclusion: there is virtually no hard evidence to date of a link between index fund investment and commodity price changes. Isn't it about time for Mr. Masters to exit stage left?

    Posted by on Wednesday, September 17, 2008 at 03:42 PM in Economics, Financial System, Oil | Permalink  TrackBack (0)  Comments (16)

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