naked capitalism

Anonymous says:

And how does this explain the run-up in other markets when they have no such special features?

You have to explain the general run-up in commodity prices in markets with and without speculators, and in markets with and without futures markets. Something like this can explain the departure from the common trend, if, in fact, this argument is correct (that is still an open question), but it cannot explain the biggest part of the story, the trend itself.

Yves Smith says:

I like Soros’ characterization of the oil runup, which is that there was a fundamentally-driven price increase which then has a speculative element in addition to it (and here I mean speculative in the narrow sense: anyone who is not a seller or buy of the raw material itself).

Who in the dot-com era wanted commodities? They were unloved and very cheap. Some investors took note, particularly Jim Rogers (he started on the bandwagon in the later 1990s) and Marc Faber. Then you had some validation by the consultants to institutional investors, who are always looking for a new angle so they can claim to be adding value: commodities as an asset class (there are academic studies that question that concept, BTW).

But even with increased attention, cheap interest rates gave greater preference to leverageable assets, that is, ones that generate cash flow, particularly since agents got clever at how to lard them up with fees and still have the appearance of them being a viable investment.

Then when the credit crunch began, you have reports of hedge funds moving into commodities because they could be levered (contracts have low margin requirements) when their prime broker lines were cut, Not sure how true that was.

On the ag commodities side, it appears to be a combination of bad harvests (Australia in particular is normally a big exporter which has fallen considerably short due to its droughts) but the impact of the oil runup via biofuels appears to be greater than recognized. From a Guardian story today:

Biofuels have forced global food prices up by 75% – far more than previously estimated – according to a confidential World Bank report obtained by the Guardian.

And even there, there have been anomalies, such as increasing failures of futures contracts to converge to physical prices at contract maturity, and high prices for sugar despite large inventories

On metals, gold (and to a lesser degree silver) are inflation hedges. You may have seen stories that gold’s use in jewelry is plummeting at current prices.

Industrial metals ex copper (I’m not certain of fundamental conditions there) are reported to be in considerable oversupply. Metals are cheap to store. Readers have written me saying that companies they work with have four year stockpiles! This fits the Krugman pattern of “prices in excess of supply and demand lead to inventory accumulation.” Big time, apparently.

Thomas Palley argued yesterday that the runup in iron ore is due in no small measure to oligopoly pricing.

PrintFaster says:

This looks more and more like hot money generated by monetary and treasury policies chasing commodities.

Clearly if there is a mania or an imbalance in market opinion, futures prices will get driven up in speculation since those writing futures contracts will demand a higher premium because of the perceived upward momentum risk.

It is this momentum risk premium that is driving the oil and commodities boom. When the momentum stalls, the boom will go boom like 4th of July fireworks.

That is my big gripe with commodity futures is that they represent momentum, not intrinsic value. Their notional value is not representative of actual commodities. I advocate limited commodity futures to a limited multiple of the monthly spot volume at settling. I know that this would be bad for brokers, but it would give farmers all the hedging that they badly need.

Yves Smith says:

PrintFaster,

One thing to keep in mind re commodities futures markets (and I don’t have the data readily at hand, but I have read this repeatedly, so I am pretty confident the statement is accurate) is that the trading volumes on commodities markets are very small compared to that of stock and bond markets. So if you subscribe to the weight of money theory, that it’s too much dough cashing too few assets, it wouldn’t take a very big reallocation by major institutions in aggregate to have a price effect.

In other words, yes it may indeed be hot money, but it would take only a fraction of the action that product the dot com and real estate bubbles.

Juan, no need to apologize. In fact, the point re checking on Google allows skeptics to cross check Palley.

Richard Kline says:

There we have it at last in plain English from JD: in oil, futures prices *are* the real prices. In principal, short sellers would serve as a brake on momentum speculators, but the small size of the crucial oil futures markets relative to the geared speculative money pouring in has sheared the fingers from the short sellers several times during this past Spring, as has been remarked in comments here, and commentary elsewhere. Without the control of shorting futures, refiners are garroted by their limited just-in-time inventories of raw oil into paying the quoted price: they can’t wait, have no alternative sources, and can’t short the market down. We have a forward squeeze on prices playing off the upward fundamental momentum for oil and agricultural prices of recent years, just as you say Yves, following Soros’ summation.

Academic economics and market economics play by entirely different rule books. One is theory; the other is praxis. Guess which one we live by?

Anonymous says:

@tom lindmark

I don’t see many discussion of conspiracy theories, merely people pointing out that commodities prices are in an unsustainable bubble. I don’t think anyone proposes that the dotcom bubble was driven by conspiracies, yet it plainly existed, and burst. Are market economies dysfunctional? I could ask, is a bubble economy functional?

pointbite says:

Let me add further, that anybody who sells anything will also try to set an asking price that maximizes their profit. It’s no different then how Burger King prices hamburgers or Wal-Mart prices vacuum cleaners.

vlade says:

I think I saw a graph in FT today that was showing non-commercial open interest in the oil futures at NYMEX (that is, OI by people other than oil comps and people who actually use oil (petrochems, electricity comps etc.).
The highest was around the $80 mark, and there was a couple of spikes after $100 (each of them lower than the previous), and right now it was pretty low.

How about this theory: There are different qualities of oil. Wouldn’t it make sense for you, as a producer – especially if you think this is relatively unsubstantiatet price – to sell more of the worse oil, for high price, and keep your quality oil in the ground?
That would mean: The price of the quality oil would go up (scarcity), because there’s a marginal price they are willing to pay for the better oil (which, in my meagre understanding is quite high). I speculate that as the lower quality oil is priced off the high-quality oil, it would bring up the sour one up at the same time, making you better gains on this one.

Think about it as apples. You can buy apples only from me. Should I sell my best ones first, and risk that when I will be selling the partly-rotten one someone else will show up with peaches and all I will be left with is a load of composteable stuff; or (assuming that people cannot craving fruit), should I sell the slightly bumped, rotten etc. ones first and keep the best till the last (as a good apple will still be able to compete with a peach)?

Assuming peak oil (at least local), it might be a viable strategy to make the sweet/light oil scarce (and thus expensive), and get the bad oil out first. If you use up your best stuff first, people will have higher incentive to find a better source when all there’s left is the bad one – so you might not be able to sell the bad one. If you sell the bad one first (because, after all, people have to buy it in the end, right now), and then switch to the quality stuff (which you know you will sell much more than the former, and people will have smaller incentive to do something until you almost run out of it).

There you are, a conspiration theory (which I can see as a valid business strategy) on the producer’s side!

Anonymous says:

I do not believe that the current price of oil is high. It think that it is low. I also think that “old” price was ridiculously low and led to the “auto transportation bubble” in the USA. The latter partially was made possible by the effects of dissolution of the USSR with the subsequent looting and dollarization of the region which had driven oil prices down as well as crazy monetary expansion in the decade after that (1991-2001). I
In other words the current price is partially connected with the weakening dollar and fading perspectives of converting oil-producing subset of xUSSR countries into banana republics. Actually both “blowback” policy aspect from looting of xUSSR region and weakening dollar story were so far ignored in the posts. Just compare the dynamic of the price of oil in euro and in gold with the dollar dynamic.

Also Greenspan-inflicted easy monetary policy (with narcissistic and obsessive interest rate masturbation which kept rates below real inflation rates) was another historic aberration that is now being fixed in a very interesting way.

If we assume that oil is limited and is vital for chemical industry commodity, then burning it to heat homes or in SUVs should be stopped ASAP and that’s what market is doing, but very slowly and inconsistently. The current generation have some obligations toward future generations, is not it ? In this sense policy of oil producing countries should probably be more restrictive as this is endowment for the future generations of people in those regions (and the mankind in general).

Actually the absence of rational energy policy on a state level is a crime and punishment might well be lying ahead. I think that the current European price ($8 per gallon) is more realistic from the point of view future generations, then the current USA price and should probably be used as a guidance for the future. At least that might help to fix the bad habit of driving Suburban to the mall instead of driving a bike. the latter also help to cut the amount of useless imports we consume .

Anonymous says:

Krugman probably did make some mistakes in his assumptions about the workings of the oil market. Of course, JD probably did too. Yet the undeniable fallacy behind both their analyses is that this market is subject to simple explanations. The world is almost always far more complex than we give it credit; our heuristics have to be seen for what they are. It’s probably best if the idealogues on both sides of this debate calm down a little. The narrow positions each has staked out are almost certainly incorrect to some degree. The truth is likely some muddled middle ground. I’d like to see some solid policy ideas about the “speculation problem” (if it exists) and then we can weigh the costs of implementing the policies against the potential benefits.

Jonathan Bernstein says:

Hi there Yves,
Peak Oil Debunked completely misunderstands oil supply dynamics and how they apply to oil pricing. In the post of theirs you quoted earlier in the week, POD purported to add up changes in demand and supply across major countries operating in the oil market both as producers and consumers. POD then concluded that since they perceived the net changes in the supply and demand balance appeared (at least in their figures) to be small, they decided that changes in supply and demand were not the proximate reason for changes in prices.

The fallacy in this reasoning is quite serious. POD is saying, in effect, that an increase in oil usage in a net exporting country such as Saudi Arabia of, say 300 kb/d has an EQUAL effect on market prices that a 300 kb/d increase in usage does in a net consuming country, such as India. Absolutely false, and this is crucial.

If the Saudis use 300,000 more barrels of their own oil per day, these barrels are no longer available in the export market. The Saudis use their own oil at subsidized prices. The Saudis are NOT bidding against the Chinese for the incremental use of their OWN oil. The Saudis are subtracting 300,000 barrels from the supply of NET EXPORTS, which is the supply of oil for which international consumers must bid. The key number that determines the international price on the supply side, the price that net consuming countries must pay for their imports, is not total supply but NET exports.

It is crucial to understand that when the Saudis use 300,000 more barrels per day and total world supply is constant, supply that international consumers can scramble for has been reduced by a significant amount, and the price should go significantly higher given crude’s steep price elasticity.

It is proper, of course, sum the net changes in demand among NET consuming countries to arrive at effective changes in demand, for the supply that is available on world markets. One should also sum up the net changes among net exporters, to get the total net export number. But to sum demand changes among net exporters and net importers is highly misleading. To do so is a basic error of summing apples and oranges.

macndub says:

JD is correct about how spot and prompt future prices are related, but appallingly confused about the implications.

Suppose that I’m a producer of Permian basin light sweet crude oil, 42 degree API. I have the choice of locking in next month’s production on Nymex at the contract closing price, or I can market my own production daily based on customer posted prices at the refinery plantgate. In both cases, I’m responsible for transportation to the storage tank at Cushing, OK.

Transacting at Nymex gives me convenience, and that’s worth something. But if the refinery posted price (the spot at a particular location for my specific grade of crude) varies too much from the Nymex price, I can arbitrage the difference PROVIDED I HAVE STORAGE AND TRANSPORTATION CAPACITY, by no means a given.

So, really, the spot is illiquid. It’s determined bilaterally and posted in publications such as Platts’. But that doesn’t matter, because the futures price is an arbitrageable benchmark.

The converse is also true. What happens if “rampant speculation” drives up the futures price beyond the spot price? Well, then I should be shorting the Nymex delivering that crude to the refinery today. The only reason that I wouldn’t do that is if I couldn’t find the transportation and storage capacity to do so.

Does the same hold true for illiquid blends, such as Maya, Lloyd, or Edmonton? Absolutely. I can take the Nymex price less differential, or I can deliver to the plantgate and take my chances.

JD says that because the plantgate is based on Nymex anyway, I have circular price discovery. But that’s not true. If there’s a pipeline break and the refinery has to buy a lot of spot oil to keep running, spot prices in that location for that time period will run higher than Nymex. If the crude quality in a basin changes, as it has in Western Canada, then desirable blends will increase in price relative to undesirable, at least until processing capacity is increased.

So the notion of a spot price differential to Nymex is a mere convenience of notation; it’s not a statement of economic truth.

My long-winded point is that this is how futures markets WORK. They aggregate supplier and consumer behavior into a portfolio of standard contracts.

Here’s the issue: every commodity contract requires a long and a short, and right now the shorts are terrified, having looked stupid for the last 5 years now. This is not the same distinction as commercials and non-commercials: it’s vacant-headed that a trade is any different if put on by BP than by Goldman. So you have producers and other natural shorts refusing to play in the futures market, combined with natural longs needing to lock in prices and gain certainty. Result? Higher prices. Is this “rampant speculation”? Sure, if you think that risk management is speculation.

And yes, you have ETFs and other pure financial players coming in, using their 9 figure portfolio to to participate in a 12 figure market. The thing that conspiracy theorists miss out on is that the financial players MUST SELL OFF THEIR POSITIONS before the contract expiry, as they have no capacity to receive physical barrels. So the Yale endowment goes long July crude starting Jun 1, but it has to sell that position off before contract closing on June 20-ish, otherwise it had better rent some storage capacity. If you can’t hold physical, you can’t move the market. Period.

How does this cycle end? The same way that it always has. High prices destroy demand, faster than people can believe, and the inelasticity of supply and demand start working for the consumer rather than against him. Only producers were crying when oil hit single digits in 1998. We’ll never go back to that, but anything can happen in the next year.

Anonymous says:

Aeon

Great post macndub!

Any info on how much physical storage space is available? Obviously if we had unlimited storage space, the price could go ballistic. It would be interesting to know if there has been a dramatic increase in the building of new storage facilities.

Also, I don’t see any commentary on the fact many governments such as China and Mexico subsidize the price of gas at the pump. Hence there is no demand drop from these consumers as prices rise!

Yves Smith says:

Chicago,

It is not correct that buyers of futures contracts can take or make physical delivery. The only ones that are permitted to do so are those who have demonstrated delivery and storage capability. I am not clear on how that works on a practical level (as in how customers get designated as being able to take/make delivery).

macndub,

The point re index buyers is not that they are participating, but that their aggregate commitment to commodities strategies has increased. A buddy told me two new oil ETFs were announced (launched?) this week. The contention is that increased commitments from passive investors can have a price impact.

The much derided MIke Masters testimony to Congress does provide a good deal of data on the fund flows into these strategies.

Further, there has been a very large increase in OTC activity, which by definition no one can track, but it appears to be considerable. Moreover, there is evidence that the OTC traders are doing deals with commercial buyers and sellers (for instance, the New York Times reported on AIG buying grain from a farmer, paying to have it stored for six months, and selling it back to him at a pre-set price. Thus one cannot assume that all OTC action would be hedged by trading on futures exchanges.

As to the question on physical storage, we have mentioned several times that oil storage is costly and limited. This quote came from Dan Dicker:

…in the world of energy trade, there is lack of fungibility that has always broken down thus: Electricity, non-storable — Natural gas, more storable — Crude oil, mostly storable

This is why, at least in my view, that supply arguments are often overblown in oil pricing theory — supplies remain closely aligned to demand and rarely overrun — as OPEC members have time and again explained but are ignored. This is why President Bush can walk in to a meeting with Saudi ministers and be patted on the head like a silly schoolboy — “you don’t understand, Mr. President — we’ve got nowhere to SELL any more right now” and Bush will run home and talk about increasing domestic supply as if he hasn’t heard a thing

There is also a lengthy discussion in that post from Philip Verlegger on the role of oil inventories, and how producers look at the potential profit of holding inventories versus other uses of funds in deciding how much inventory to carry. I suggest you read the post.

As for the defense of Krugman, in this case, he has explicitly said in his posts that you don’t need to understand how futures in these markets work, you only need to look to inventory levels. If they are high, prices are high. If not, prices are correct. He has offered more elaborate iterations of that stance and has not considered (indeed, appears unwilling to consider) whether there might be structural or behavioral issues that make the market inefficient.

In general, I don’t know why some readers are trying to make the information by JD mean more than it says (I think some people are very put off by his blog’s name).

The discussion in the press and policy circles has assumed, as we said at the outset, that futures prices do not influence spot prices, that spot prices are where price discovery in the oil market occurs. JD provided information from reputable sources that says that is not the case, and gave the history as to why price formation shifted from spot to futures.

I don’t see why this notion is that controversial. You see it in other financial markets. and that development often has unfortunate side effects. For instance, credit default swaps prices now determine the prices at which companies can issue cash bonds. And imbalances in the CDS market HAS led to distortions in the prices at which companies can sell debt, as we discussed earlier this year. This section of the post comes from Bloomberg:

Credit trading models used by Wall Street have gone haywire, raising company borrowing costs even as Federal Reserve Chairman Ben S. Bernanke cuts interest rates.

The higher costs are an unintended consequence of securities that allow investors to speculate on corporate creditworthiness. So-called correlation models used to value them have become unreliable in the fallout from the U.S. subprime mortgage crisis. Last month some showed the odds of a default by an investment- grade company spreading to others exceeded 100 percent — a mathematical impossibility, according to UBS AG.

Michael McKinlay says:

OBTW

The world is now consuming 6 barrels of oil for every new barrel discovered.

Anonymous says:

So everyone’s arguing about whether oil prices reflect speculation or fundamentals.

For consumers, does it matter? In either case, the answer is to use less oil. If the increase is fundamental, then we might as well get used to it. And if the increase is speculative, then a decrease in demand is the first step towards popping the bubble.

Though I’m personally surprised that serious economists are giving so little attention to long-only funds. No one disputes that speculators can influence prices in the short term; any of the usual arguments for how speculators decrease volatility assume that. But these arguments also assume that the speculators are making good decisions. They’re supposed to buy when the price is “too low”, and sell when it’s “too high”, and thus provide negative feedback. But what if they get it backwards? In that case, they become a destabilizing influence. (And lose money, of course.)

A speculator who always wants to go long (i.e., an “investor” in commodities) provides negative feedback on the way down, but positive feedback on the way up. Any fundamental price increase will therefore get amplified. That does not seem inconsistent with what we’re seeing today.

macndub says:

The contention is that increased commitments from passive investors can have a price impact.