Krugman, Commodity Prices, and Speculators « naked capitalism

Tuesday, February 8, 2011

Krugman, Commodity Prices, and Speculators

Paul Krugman was gracious enough to acknowledge our past differences on the matter of commodities speculation, which was specifically about oil markets. It was the subject of a long running ~~argument~~ conversation between his blog and mine in spring 2008, which I recapped in ECONNED.

In brief, Krugman contended that the skyrocketing oil prices of early 2008 were the result of fundamental factors (and we pointed out that we were puzzled by his stance, since he, unlike the vast majority of Serious Economists, has been willing to call some past bubbles in their making). As he reiterates on his blog today, if the prices exceed the level dictated by supply and demand in the real economy, a standard microeconomic analysis would expect there to be inventory accumulation, aka hoarding.

Ironically, a reader has a guest post near completion on the oil markets, and we want to briefly recap our prior work here. Our objection to the standard textbook analysis was that it does not take market structure into account. As we detailed then, there are ways to store oil that do not show up in the official inventories, which have very limited capacity and are actually not terribly convenient. In addition, Krugman has maintained that those (like Mike Masters) who point to the volume of money flowing into commodity indexes just don’t get it. Since futures prices eventually converge to cash markets prices, you need to tell a story that involves the physical markets to make a case on speculative impact that sticks.

In oil, however, that is not how the futures markets work. Most of the oil sold is not based on spot market prices (which have been manipulated successfully in the past) but under long term contract based on futures prices, with the most widely used formula a weighted average of futures prices. So at least over the intermediate term, demand for most of the oil traded is inelastic and the futures market determines the price at which most oil is purchased.

I’m glad that Krugman is weighing in with a revised take and narrowing his argument to agricultural commodities. It’s big of him to take criticism and incorporate it into his work. I am a teeny bit troubled, however, that the construction of his post might lead his readers not familiar with our work to think our past objection was based on a weight of money argument.

Note finally I have not yet come to a point of view on the ag complex. There are clearly some commodities where supply drops are significant and a large price increase is not hard to understand. However, this is far from universal, and I want to dig a little deeper into how some of these markets work.

74 Comments:

Greg says:

February 8, 2011 at 2:27 am

I doubt Krugman ever got past the first chapter of Macroeconomics 101. His Rijksbank award was given because they needed a Useful Idiot to provide cover for the massive money printing that was being set in motion. He continues to fulfil his role perfectly.

Paul Repstock says:

February 8, 2011 at 2:31 am

You should use your full name if you want to call someone an idiot!
- Anonymous Jones says:
  
  February 8, 2011 at 3:00 pm
  
  Knowing Greg’s last name is not going to be useful to me at all; it is not going to make his comment less idiotic or less distant from any reasonable sense of facts, reality and logic. He evinces a clear and unmistakable inability to understand how the world actually works. He has seemingly no sense of his own limitations and thus will probably never examine how unlikely his suppositions are (or even that they are suppositions in the first place).
  
  By the way, good post by Yves. This is what happens when intelligent people communicate in a reasonable manner. They start to understand that the world is complex and that they might just both have reasonable points to make.

Paul Repstock says:

February 8, 2011 at 2:29 am

Yves: I trade a bit, occasionally oil. However, at this time I will not touch oil. It has manipulation written in every line of the quote pages, and in the spreads between grades and sources,eg. I’m sure you have noted the differential between Brent and CL?? Traditionally $2 got it shipped accross the Atlantic to reap the spread. Also, note the ‘captive’ NG prices??

I don’t know what is happening, but, I’m reasonably certain this is not demand driven pricing.

I suspect that the United States is preparing for war.

Deus-DJ says:

February 8, 2011 at 9:18 am

It is illegal for WTI to be shipped overseas

QED says:

February 8, 2011 at 3:02 am

It’s not that hard to prove it’s speculation.

1. wide ranging of commodity is raising and collapsing without any connection to production need, production type, supply and industrial demand.

2. They all have same thing in common: a) can be purchased b)non perishable. This is why now you see cotton, sugar, copper, wheat price exploding while milk/meat/egg are following energy price rise.

3. if you look at industrial activity in “weekly/monthly” resolution, that is, people has to order raw materials months ahead to supply seasonal market consumer need, it doesn’t jibe with 2008 bubble rise/collapse. Specially true for Rice, copper. I mean, people don’t need 120% more rise one month, and when the bubble collapse they stop eating and start selling. (eg. it’s just bunch of guys buying and selling for speculative need in huge quantity.)

4. I already predicted that ultimately Saudi will have to abandon dollar peg due to hyper inflation hitting their relatively tiny society. The Real cannot hold the flood of mispriced dollar. Unlike china. So what we see, the poorer arab countries are dying first. Then it spreads.

This year they are going to print TWICE as many dollar as last year. (that is, the dollar US is issuing is not followed by increase production of goods) Pure Weimar style money printing.

Like I said before. US economy doesn’t exist anymore. Inflation has killed normal productive economy. It is now all speculative and arbitrage. (Do you want to invest in $500m plant in unstable commodity/dollar cost while not having the advantage of china’s momentum? Can you calculate over 10 years the labor cost increase due to inflation in US?) It’s guarantee lost.

Paul Repstock says:

February 8, 2011 at 3:10 am

Yes, I feel very bad for the sub $2/people…I suppose our turn will come..:(
rjs says:

February 8, 2011 at 4:19 am

yep. destruction of 1/3 the russian wheat crop, half the pakistani wheat & cotton crops, 1/4 of the chinese cotton, south african fields flooding, a weather related poor crop in canada, and flooding covering an area the size of texas & california combined in the agricultal part of australia had nothing to do with it…

to say nothing of 170 million tons of our corn being diverted to ethanol, which enough to feed 330 million people at what the UN considers a sustainable level…

US monetary policy sure is powerful…
- Tom Edwards says:
  
  February 9, 2011 at 3:12 am
  
  Until you look at the increases mapped over the Fed’s “easing”, pause, then “easing”.
Cedric Regula says:

February 8, 2011 at 5:50 pm

I’m not a commodity trader, so I’m all ears for informed opinion, but I think there has to be a positive feedback loop between end user and speculative demand.

Meaning that when any words hit the news like “firm demand”, “tight supply”, “bad weather”, or “supply disruption”, it’s like ringing the dinner bell for the vultures. Of course the end user already fears rising prices and probably fears vultures as well. So now both try and lock up supply.

The reason that this isn’t supposed to cause any long term price effect above real demand is because inventory capacity is supposed to be small and fixed.

But we saw in the last oil spike that supertankers get leased for storage and governments begin flexing their muscles too, like China decided to have a strategic oil reserve. Then OPEC could always leave oil in the ground if government finances permit.(not the case in Venezuela right now, I hear). When this happens during one of our Central Bank Wall of Liquidity periods, it just means leverage is that much cheaper and banks have cash burning a hole in their pockets. So all the stars are aligned and prices go thru the roof.

With relatively non-perishable food maybe we see the Indian government convert the Mumbai Soccer Stadium into a great big rice bowl?

Just wondering.
- Hank says:
  
  February 9, 2011 at 5:21 am
  
  Dry bulk ship capacity is bigger than a stadium. That’s how they transport grain around. largest grain ship is 50K. largest dry bulk is about 300K tons.
  
  volume world wheat shipment is about 20-30m tons/yr.
  
  If some crazy decide to convert mining dry bulk to store grain. half a dozen ships is enough to store 1-2m tonnes of grain. that’s some 10% of volume trade. At 200% profit, It’ll be some of the most profitable speculation ever. More so than storing oil. You know, if you are into starving the poor and making buck.

Andrey Subbotin says:

February 8, 2011 at 3:36 am

The only people with ability to really hoard oil are oil producers – by not producing as much as they could and leaving oil in the ground.

So the speculation scenario would go like this – an oil producing company is producing and selling oil at Brent-5. For wehatever reason futures speculation drives prices up $10. Consumption shrinks, and the company cannot find buyers for all the oil it produces. At this point the company can either sell at Brent-15, or reduce production. It reduces producton, supply meets demand, price stays $10 higher.

Yves Smith says:

February 8, 2011 at 3:41 am

Exactly, that is why I think the case for speculation is strongest in oil, no one has the foggiest of what “inventories” really means.
- Jib says:
  
  February 8, 2011 at 12:09 pm
  
  It is not just inventories. No one knows what the true market price of oil is on any given day. The true price is the total amount of money paid for oil actually delivered divided by the amount of oil delivered. As you say in the article, very little oil is actually traded over the spot market. Oil refining is a continuous process, supply to the keep the process running is critical. No one runs billion $ refineries based on what they can pick up on the open market.
  
  Only the North Sea and North America oil is traded on anything like a market. Much of that oil is contracted but the markets do have a major influence on the price. Every where else is by negotiated contract. And different grades of oil have different prices, usually determined as a offset from the base mark price. There are a lot of grades of oil. Different offshore platforms in the Gulf of Mexico have there own grade.
  
  So now we throw an ETF on a benchmark price that accounts for a small sliver of the worlds production. The amount of money invested in the ETF greatly exceeds the amount of actual product the price represents. But we ignore that and pretend that some how, by magic, the ETF tracks the true value world wide.
  
  Yeah, that will work.
  
  Contracted oil does form a real market. The people who do this know what the current price of oil really is. But it is very, very loosely coupled to WTI or Brent. There is little visibility on the true price of oil for the outsider.
  
  Want to know the true price of oil? Look at the gas pump. Because gas demand is inelastic over the short / mid term, no one looses money on gasoline. Take the pump price, remove the taxes, work your way back from there through refining and transport costs to get how much they paid for the barrel of oil.
  
  Honestly, anyone who applies standard free market thinking to oil does not understand how it works.
  - dakinikat says:
    
    February 8, 2011 at 1:59 pm
    
    There’s some evidence coming out of academic researchers showing that an increase in derivatives trading reduces spot price volatility but it also reduced trading efficiency. So, you may stabilize a market, but you also reduce its efficiency which indicates that spot market will misprice the underlying assets more frequently. A lot of financial engineering is done synthetically so the actual amount of underlying assets wouldn’t be relevant to those deals, hence, the actual amount of supply wouldn’t be a factor in the market for the derivative.
Paul Repstock says:

February 8, 2011 at 4:01 am

Andrey, what about the SPR and million ton tankers?
- Andrey Subbotin says:
  
  February 8, 2011 at 5:34 am
  
  SPR has been static for years, and cannot be used to explain recent price surges.
  
  Hoarding oil in hired tankers by traders arbitraging the difference between current oil price, future oil price, and tanker cost happens now and then. But to explain long-term disconnect between steady production, and high prices depressing demand you would need a large and ever-increasing number of tankers accumulating excess oil. This would be noticed, isn’t happening, and the fact it is not happening is Krugman’s central argument.
  - Paul Repstock says:
    
    February 8, 2011 at 5:46 am
    
    I’m sure you are right, If itis a factor, it is only one of several. I do not discount speculation, I just get tired of traders being the scapegoat for the ills of the world. lol
    - Deus-DJ says:
      
      February 8, 2011 at 9:43 am
      
      It’s not the traders, it’s the system. It’s the institutional investors that have come in and thrown everything out of whack.
  - grayslady says:
    
    February 8, 2011 at 5:00 pm
    
    To test your theory, I called a friend of mine who was born in Rotterdam, knows the harbor intimately, and is extremely knowledgeable in ships and shipping. We pulled up the Google map for Rotterdam harbor. There are currently 21 large tankers docked at Geulhaven in the harbor, right between the harbor facilities for Shell and Esso. There are no dry dock facilities there, according to my friend, so the ships are not in for repair. They are also berthed so close together that they are not positioned to be easily moved in and out. Without using Google Earth we couldn’t tell how high they were riding in the water, but if they are storing petroleum, according to my friend (based on his estimated tonnage of the tankers) it would represent a substantial amount of petroleum. Just saying.
Mark says:

February 8, 2011 at 6:27 pm

“At this point the company can either sell at Brent-15, or reduce production. It reduces producton,…”

This makes no sense. Why would the producer reduce chose to reduce production rather than selling at the high price?
- steelhead23 says:
  
  February 8, 2011 at 8:05 pm
  
  Inadequate demand at that price. It was in the scenario.
  - mark says:
    
    February 9, 2011 at 1:43 am
    
    Inadequate demand? That makes zero sense. If you’ve got speculators rolling contracts, they are providing plenty of demand.
    
    And what kind of evidence is there that producers ACTUALLY DID cut back production because there “wasn’t enough demand”.
    
    The only reason a producer would cut back production is if the price FELL TO LOW to justify the cost of extraction.
    
    This whole idea is absurd.
    - Deus-DJ says:
      
      February 9, 2011 at 2:22 am
      
      Mark,
      
      The fact is that we don’t know. That data is known only to the producers themselves.
      
      Less than 2% of all futures contracts actually have delivery…meaning they have no direct impact on creating demand on the physical market(they do however have an indirect impact, in that the price they come up with effects whether we decide to fill up at the pump)
Fed Up says:

February 8, 2011 at 7:15 pm

Try here from krugman:

http://web.mit.edu/krugman/www/opec.html

“So there is a definite possibility that over some range higher oil prices will lead to lower output. And given highly inelastic demand, as Cremer et al showed, that means that you can have multiple equilibria. Figure 1 illustrates the point: given the backward-bending supply curve and a steep demand curve, there are stable equilibria at both the low price PL and the high price PH.”

See figure 1. Or, better yet, draw a Y. Now draw an upside-down Y attached to the first Y.

Can there be a “line” between Plow and Phigh where the supply and demand curves are vertical or are almost vertical allowing speculators the ability to price manipulate?

What about subsidies in countries when prices spike in oil and/or food?
- Fed Up says:
  
  February 8, 2011 at 9:33 pm
  
  EDIT: “See figure 1. Or, better yet, draw a Y. Now draw an upside-down Y attached to the first Y.”
  
  “See figure 1. Or, better yet, draw a Y. Now draw an upside-down Y attached to the first Y ‘at the bottom of the first Y’.”

gerold k.b. weber says:

February 8, 2011 at 3:49 am

This is an important debate for our understanding of the global economy, and the current revolt of people angry due to the soaring costs of living. Yves Smith, Paul Krugman and other bright minds are joining in, and we have the pleasure of being educated and stimulated to contribute.

To the point: The ‘structure of the market’ seems to be important for the price discovery mechanism, and Paul Krugman’s ‘accumulation of inventory’ argument as a sign of speculation didn’t look that convincing in the past conversation which focused mainly on oil markets.

Part of the market structure are busy robo traders (software) on financial and commodity markets which are contributing to exaggerations (bubbles and bursts) on the few exchanges relevant for price discovery.

Do such ‘technologically supported’ price discovery mechanisms amount to monopolies or cartels? Don’t we have a seemingly single global price discovery mechanism for commodities acting like a monopoly or cartel in its relation to the final consumer, who can only choose between a more expensive commodity in one shop or another?

Market mechanisms with perfect competition should ensure commodity prices close to the cost of production, with some markup to achieve an average rate of profit. But commodity producers and investors (speculators) clearly are doing much better those days.

The low price elasticity for basic goods doesn’t help: if people ultimately are paying every price to get just enough to live, ‘technologically induced’ monopolies will have their way with them – and us.

Is is really necessary that this sorry state of the world has to be changed by revolution, or will reason catch up?

Paul Repstock says:

February 8, 2011 at 4:41 am

Gerold; that diagram only holds true in a non derivative world. For all commodities, the number of ‘contracts’ far exceeds supply and consumption.
Paul Repstock says:

February 8, 2011 at 4:54 am

Also, don’t envy the speculators too much. Most of the “winners” are offset by loosers. And the producers are not that much better off: there are many ways of manipulating supply and prices. During the high energy prices a couple of years ago, some Canadian producers could not ship their product through the “gates” at the border??
- gerold k.b. weber says:
  
  February 8, 2011 at 7:09 am
  
  Paul: I tried to develop an argument in which the price discovery (price increase) on commodity futures exchanges is functionally identical with the setting of a price by a monopolist.
  
  Like a monopolistic price-setter the commodity price originating from the futures exchange layer tries to find out the maximum price consumers are willing (or forced) to pay. For example, in the US the price elasticity of demand for breads and cereals is 0.04 — ‘that is, it would take a 25 percent rise in price to induce a 1 percent fall in consumption’ (Krugman).
  
  Thus, in this view the commodity price resulting from the future exchange layer is seen as a ‘technologically induced’ functional cartel or monopoly, independent from the micro-observations that in every futures contract there is a buyer and a seller, and that futures markets might be zero sum games (but obviously not in times of rising prices).
  
  Besides, as Yves Smith and others mentioned, at least in the oil markets producers and owners of oil have a considerable interest in soaring futures prices as they also determine the price of the physical good. Thus it would be reasonable for producers and intermediate owners of physical commodity, if they continuously try to move the futures prices up, even without hoarding, as long as the final consumer has no other choice than to pay – or revolt.
  
  Alltogether a completely different market structure and mechanism than in textbook models of free markets with perfect competition, in which cost of production and the average rate of profit are important variables for price discovery.
  - decora says:
    
    February 8, 2011 at 9:12 am
    
    so basically you’re saying that Hugo Chavez is manipulating oil prices?
    - gerold k.b. weber says:
      
      February 8, 2011 at 11:36 am
      
      No, trading on financial and commodity markets shows a tendency to become increasingly automated using highly sophisticated algorithms (bots), implementing trading strategies of their masters in the ‘shadow banking system’. I have no reason to suspect Chavez to be such a bot master.
      
      My argument was structural, not personal. On commodity futures markets uniform prices for ‘paper’ are generated, which subsequently determine uniform prices for ‘physical goods’.
      
      This mechanism shows strong signs of market distortions like in cases of monopolies and cartels. Consumers have no choice or bargaining power, when all vendors of cereals or heating oil offer their stuff for practically the same soaring price, and they have to buy anyway.
      
      We should refrain from blaming actors as a proxy for developing insight.
Hal Horvath says:

February 8, 2011 at 11:26 am

“s is really necessary that this sorry state of the world has to be changed by revolution, or will reason catch up?”

After Enron/California electricity, and after the mega-bank subprime loan fiascos, people are getting just a little wary of markets without law, but it will probably take a big food price spike, while supplies visibly sit in storage and people starve to really wake us up.
- Paul Repstock says:
  
  February 8, 2011 at 12:39 pm
  
  Hal; even people starving while food sits in warehouses is not enough if the people are sufficiently down trodden and powerless. That very situation occured a few years ago in Haiti. Aid groups had sent in huge amounts of food but were unwilling or unable to pay Aristede’s extortion,,I mean ‘import tax’. So it sat and rotted in warehouses dockside, while the people went hungry??

Dark Entropy 646 says:

February 8, 2011 at 7:52 am

Well,

I can add another factor. Consumer’s momentum to keep his diet habits. Example: I do like a Milka chocolate. Here in Greece, they do cost about 1.5 euro/each. For the financial crisis we do face, they aren’t cheap, but since I find them tasteful, I’ll continue to buy them, probably sacrificing some high-end electronic gadget, I could buy from the extra money I can save by consuming cheaper chocolates or no chocolates at all.

Now, since cocoa and sugar prices do increase, the same chocolate may end costing 1.7 euros/each. Shall I continue buying them? And which is the stop price, where I would stop buying chocolates, 2 euros/each?

Now, back to the major scale. Every consumer has a momentum of trying to keep his level of consumption (even by borrowing money, as the last financial crisis indicated), no matter his available income.

Since China / India become more wealthy, resources and especially food, would shift from other poor countries to China / India, because simply they do have more money to acquire them. Also American and European people would continue to consume (up to a level), no matter how much the prices would go up.

So there’s room for speculators and real reasons in parallel. If you inspect FAO’s statistics, meat became 50% more expensive since 2005, while sugar became 350% more expensive since 2005 and cereals had became 250% more expensive since 2005.

Weak economies around the world would face the problem of climbing food prices, just because of China’s needs and it’s able to buy more, India the same and so on.

Now speculators just do their short-term game. But especially for food, I don’t think they are the real cause. We need more crops, probably forgetting about bio-fuels for a decade+ and more agricultural production.

Last but not least. Farmers do need lots of chemicals, fuel for their tractors and other stuff which originates from crude oil. When oil prices climb up, production costs go up and the game is lost for poor nations. The problem is that most of the Arab nation’s regimes where unprepared for such food shortages or “income bleeding” upon food prices.

mikefromArlington says:

February 8, 2011 at 10:27 am

When you’ve got a small percentage of the world with a huge percentage of wealth looking to invest that wealth, it’s not some crazy leap of logic to believe those few individuals don’t have the ability to create their own bubbles and shape the global economy and create wealth off of others misery.

flow5 says:

February 8, 2011 at 10:32 am

I can’t explain all the price surges, from say, undervalued to overbought, but most prices usually follow monetary policy trends. Today’s commodity price appreciation seems to follow the same kind of speculation that occurred when the dollar’s exchange rate fell sharply in 2008.

The carry trade & the prudential reserve Euro-dollar markets are still operative & unregulated. We read about more capital controls, higher reserve ratios, etc. being imposed by Central Banks on virtually a daily basis.

Hot money and speculative buying has been induced by the new marketeers of ETFs, etc. The proliferation of financial innovation has increased the leverage behind these transactions and amplified these movements.

Obviously the expectation of profiting from price fluctuations without taking ownership, rather than from producing anything has changed speculative weights. The economic environment is more uncertain and more volatile. The bringing together of “greater fools”, & colorful “tulip bulbs” has raised the volume of all speculative fever.

We can still blame the FED & financial deregulation.

Cynthia says:

February 8, 2011 at 11:01 am

I won’t go so far as to say that Fed Head Ben has got blood on his hands for cranking up the printing press to the point where it’s causing the price of wheat and other foodstuffs to shoot through the roof. But I will say that he is most at fault for making this bloody situation even bloodier!

Hal Horvath says:

February 8, 2011 at 10:37 am

We don’t know if Krugman reads past a few naive posts typically, but on this post he got a large number of expert responses, and if he read even 15-20 comments he would run into an expert comment on the futures market by someone that actually knows how the price signals work.

I did not see a retraction by Krugman regarding oil, and won’t hold my breath. There is usually some amount of ego in academics, unfortunately. It’s a real handicap they often have.

Hal Horvath says:

February 8, 2011 at 10:43 am

ok, actually 25-35 comments….though a few readers that weren’t experts actually guessed correctly in the first 20 comments, Krugman would have needed to read down to at least comment #25 to notice that someone clearly knew more than himself on the subject.

Yossarian says:

February 8, 2011 at 11:09 am

http://www.msnbc.msn.com/id/21134540/vp/41414080#41414080

What a wild coincidence that in this year of massive money printing/liquidity-enhancing exercises the weather just happens to be causing prices to spike due to a supply-side shock! There have always been abnormal weather patterns in the past but rarely have they engendered enough interest to warrant a headline in a non-business section of the papers. In the last decade+ Paul Krugman has gone from talented economist to political hack…

leftback says:

February 8, 2011 at 12:07 pm

Krugman didn’t understand, and still doesn’t understand, the distortion of commodities futures markets by large speculators using leverage – it is the unequal degrees of leverage on long and short sides that is usually the cause of bubbles, and forced short covering that creates a blow-off top.

It really doesn’t take a genius… I have tried to educate him. Repeatedly.

Deus-DJ says:

February 8, 2011 at 10:08 pm

It’s not as much the leverage as it is everyone jumping into the same ship around the same time traveling the same way. Leverage actually has little to do with the effects the futures market puts on the spot market. Even if someone were to do a trade over just 1 barrel of oil, for example, but do it at a price higher than anyone else on the market than that bid and ask price for that split moment. Other trades will then work around that new price.

Flakmeister says:

February 8, 2011 at 12:35 pm

Time to pipe in…

Let’s look at the data:

1) Recent Roll data suggests 1% effect, most institutional investors at the mercy of the market at that time.

2) Recent storage data on tankers show that off-shore storage is about 60-80 m bbls. To put this number into context, it is about 1 day of demand or 2 days or net oil exports from producers.

3) Net Oil exports from producers peaked in 2005. There is simply less oil on the market. This chart is the tell:

http://www.theoildrum.com/node/7327#comment-756659

4) Sometime in 2008, the forward oil curve went into contango for the first time. They was a lot of debate about what this implied. My take is that the smart money figured out that demand would be outstripping supply into the foreseeable future. In essence, it now trades like a currency.

5) Breakdown what is called oil into its real components

C+C, NGL, Other liquids

Now, generously give an EROEI of 6 on “other liquids”, in other words from an energy perspective multiply by 0.85, otherwise you double count the oil to produce the liquids.

NGL is 65% of the energy density of crude

Ignore Refinery Gains, that is simply increasing the volume for the same energy content…

And fold in existing fields are decling at 4.5% per annum
and that new fields are barely keeping up.

http://www.theoildrum.com/node/7385

Liquid energy production has been flat for 5 years

They are playing the same games with oil production accounting as they are with any financial “asset”, is a new take on “Three Card Monte”

Paul Repstock says:

February 8, 2011 at 1:44 pm

Thanks Flake, a very nice post. I’m a bit late but, here is my two bits fwiw

Personal disclosure: I have been a part time “trader” for most of past 30 years. I have not made ‘A lot of money’, so if you want investment advice talk to Yves..J I believe though that I’ve seen several very different factors which are as important and sometimes more important than the manipulation we all complain about. There is even at times a God like force, which can frustrate even the best manipulations.
……………………………………………………………………………………………..
Thirty years ago a man told me the most important thing I ever learned about the markets, this was also the only good information I ever got for free.

The Market fact being:
“No price is ever too high or too low.” Some aspect other than an individual’s preference will determine the ultimate level.
………………………………………………………………………………………………
Factors influencing oil prices:
-Weather in major production areas.???
-Ditto for political stability (lots of unrest right now)

-Peak oil expectations??
-Prospects for alternative energy in the near future??

-Level of economic activity and expectations for the next year+.

-Natural disasters. Happily we haven’t had much in that regard yet.

-Various actions and activities of the government of the country in question. This is very important because the prices are often seen in terms of the cost in a particular country. In terms of the Canadian dollar crude prices have not risen nearly as much, even though our gasoline price is much higher because of regulation and other things.
…………………………………………………………………………………………..
-Expectations for the base currency. This may be “The big one” for oil right now. Very few traders have an expectation of the dollar rising. If producers and brokers have an expectation that in a few months or a year, that the base currency (US dollar) will be worth much less, that will put significant upward pressure on the price.

In conclusion, I suggest that if there is major manipulation in the oil price (quite possible), then the mechanism may be found in currency manipulation as much as in the oil market.
- Flakmeister says:
  
  February 8, 2011 at 2:14 pm
  
  Thanks…. BTW, that’s Flak :)
  
  I become a student of oil fundamentals back in 2005, and based on fundamentals, I made a quite a bit of money. Any dip in oil is an excuse to buy more.
  - Paul Repstock says:
    
    February 8, 2011 at 2:32 pm
    
    LOL…Just remember to offset with a currency hedge.
    sry about the name “Flak”, not flake..:)

Mark Stevens says:

February 8, 2011 at 1:46 pm

We haven’t seen anything yet as far as prices for wheat and corn are concerned. This is major news.

http://www.nytimes.com/2011/02/09/business/global/09food.html?hp

Paul Repstock says:

February 8, 2011 at 2:05 pm

Just a warning before anyone rushes off to buy grain futures:

The MSM is a notoriously bad source of investment advice. By the time the ‘owners’ of the NY Times decides to share such information with the public, all the important people have had the information for long enough to position their investments accordingly.
–This is just another form of “manipulation”–Stampede the greedy sheep into the wolf’s den.

If you truly want to ‘cover your ass’, just go and buy enough nonperishable grain for your family to eat for 6 months. If things go bad, you will be branded a hoarder. Better a prudent hoarder, than a foolish investor..:)
- Paul Repstock says:
  
  February 8, 2011 at 2:46 pm
  
  Oh NO! Don’t do as I just suggested! If you did that you would all be “filthy speculators”, driving up the commodity prices by your actions..LOL
  - Pathfinder says:
    
    February 8, 2011 at 4:52 pm
    
    Oops. Now what am I going to do with this 50 lb bag of organic rolled oats? Hmmm… at 6 oz per breakfast this should last us… 133 days. Uh oh, I need to go get another bag!

Expat says:

February 8, 2011 at 2:41 pm

The Brent-WTI spread merely reflects the growing problems with Cushing and Capline. Canadian oil is pushing down into the US and causing extremely high inventories in Cushing. Since there is no room and few places to go economically from Cushing, WTI is discounted sharply to “real” oil.

LLS on the water in the Gulf is trading at premiums of around $11-$13 over WTI.

From 2004 to 2008 the amount of investor (non-commercial) investments in commodities (excluding precious) went from $1.3 trillion to about $13 trillion.

During the spike up to $147.50, there was a massive in-flow of money into the futures markets and record volumes traded.

It is not likely that prices were manipulated in the classic sense (a squeeze like Hetco is suspected of carrying out today or what Transworld did in the 80′s), but it was simply a bubble fueled by the credit bubble and GS hype.

Flakmeister says:

February 8, 2011 at 3:00 pm

We all have our pet theories… I don’t disagree that hot stupid money got in close to the top in 2008…But the fundamentals tell me that oil is not going to get cheap any time soon, short of an economic apocalypse.
- Expat says:
  
  February 8, 2011 at 5:13 pm
  
  “pet theory” sounds mildly insulting…but ignore that.
  You might have misunderstood me. I am not saying that oil should have been or should be at $30 a barrel, but that a significant amount of the spike was caused by hot money and a bubble.
  
  Whether or not you are a peak oil theorist, the reality is that new oil is in hard to find, expensive to produce places, so prices north of $70 are the new norm.
  
  Just so you know, I am an oil professional who was at the sharp end of the market during that period.
  - Flakmeister says:
    
    February 8, 2011 at 6:58 pm
    
    Not sure where the first reply ended up…
    
    No disrepect implied…
    
    I will argue the fair top price for crude in ’08 was $125 based on OECD stocks, diesel spreads etc… So the last $22 was hot money, leveraged no doubt, that got burned when the economy went belly up and Lehman et al. imploded.
    
    Twenty percent isn’t much of a bubble, on the other hand buying it back in the 30′s was I think a generational buy. Oil is the alpha asset, essentially all economic activity is levered to oil.
    - Deus-DJ says:
      
      February 8, 2011 at 10:19 pm
      
      Your method of analyzing what the true value should have been is absolutely terrible. First of all, diesel was stockpiled by the Chinese leading up to the 2008 olympics. And OECD stocks? Please, I hope you’re not joking?
  - Flakmeister says:
    
    February 8, 2011 at 7:00 pm
    
    Forgot to add, care to comment on what fundamentally transpired when the forward curve when into contango back in ’08. This was a turning point, IMHO.
- Deus-DJ says:
  
  February 8, 2011 at 10:13 pm
  
  We’ve pretty much had a collapse of sorts. There is no justification for the price where it’s at today. I can say this with accuracy only because I know how the market works. You will also find out how it works when my post goes up tomorrow.
  - dakinikat says:
    
    February 9, 2011 at 1:38 pm
    
    You can’t ever call a market theoretically efficient or perfect when there are so many information brokers and third party risk managers present. That alone creates price distortion. Plus, most of these broker/players are now situated in oligopolistic markets so you need to transfer to a pricing model using game theory in some instances. There’s obviously so much information asymmetry and hidden information in some of these markets that they are always a step away from failure. Recent government policy has just exacerbated the information problems. Just look at the carve ups of AIG assets with Treasury/Fed assists and clear signals to the big players. I’m not sure rational and/or adaptive expectations assumptions are relevant in these instances and that’s the major assumptions in most micro models.
    - Deus-DJ says:
      
      February 9, 2011 at 2:01 pm
      
      well said

Hugh says:

February 8, 2011 at 2:56 pm

A) We know Wall Street is a casino
B) The futures markets are part of Wall Street

Krugman’s conclusion: Futures markets aren’t part of the casino. This probably isn’t as illogical as it looks because for Krugman Wall Street likely isn’t a casino. I guess he was somewhere off-planet in 2007-2008.

What’s funny too is that Krugman uses a graph to dismiss his critics. The problem is that it is all screwy.

He has a demand line and a supply line and his axes are price and quantity. But supply and demand aren’t price over quantity. They are quantity over time. If he wanted to illustrate the classic supply-demand argument via a graph, then he would plot price against the difference in these two. Where demand > supply, the quantity would be negative and the price high. Where supply > demand, the quantity would be positive and the price lower. Where supply = demand, this would be the y-intercept and correspond to the equilibrium price.

This covers cases not only like the rather odd one Krugman uses where he has the supply and demand lines moving against each other, that is as supply increases demand decreases (and vice versa) but also more usual cases where they increase or decrease together just not at the same rates.

Why should we have to explain this kind of stuff to Krugman?

Paul Repstock says:

February 8, 2011 at 3:01 pm

Put it down to “market perception”; the facts are ‘what you can convince people to beleive the are’. The medium is irrelevant.

Leftback says:

February 8, 2011 at 5:55 pm

#Why should we have to explain this kind of stuff to Krugman?#

Because he is a pseudo-intellectual, that’s why. Academic economics is especially full of those who prefer not to let the data get in the way of their theories. The truth has been the most serious casualty of the 21st century.

Cathryn Mataga says:

February 9, 2011 at 12:51 am

Yeah, I’d think that with a future, if you have to actually deliver the oil, that reality does come into play at some point.

What I don’t know, are there bets on the price of oil without any actual oil being involved? I know there’s a GLD for trading gold, but is there an OIL for buying oil, that’s not really oil? How much virtuality has infected this market?

Deus-DJ says:

February 9, 2011 at 2:00 am

Excellent question, Cathryn. Less than 2%(actually, virtually none) of all futures contracts actually have delivery. Combine that with our knowledge of futures price determining spot price, and there you go :)

My article should be posted tomorrow or Thursday, that will have the complete details.

mark says:

February 9, 2011 at 1:58 am

So essentially the idea is that oil producers are ineffective as a cartel, but some speculators come along and buy rolling futures contracts, and they are able to stupidly and unintentionally enforcing a monopoly price that the cartel itself could not? All the while making the cartel members rich from high oil prices, the speculators meanwhile doing nothing for themselves other than the initial ramp up?

Seems the cartel should have thought of this brilliant idea themselves.

God, this is so silly, it’s embarrassing.

Deus-DJ says:

February 9, 2011 at 2:03 am

It’s more a creation of modern finance and specifically the OTC markets. Yet you do point something very peculiar indeed…the cartel could not have dreamed up of something better for their bottom line. Come back tomorrow or Thursday morning for more details when my article gets posted.
- mark says:
  
  February 9, 2011 at 6:31 pm
  
  “It’s more a creation of modern finance and specifically the OTC markets. ”
  
  OTC markets like ICE are just cash-settled “side bet” markets, based on the price of the underlying futures contracts. They can no more influence the price of oil than people making side bets at a craps table can influence the roll of the dice.
- mark says:
  
  February 9, 2011 at 6:37 pm
  
  OK, I’ll check out your article. Back in 2008, I was thouroughly convinced (after believing myself that it was speculators), that it was not possible for speculators to drive up prices on a sustained level, since they had to sell their forward contracts to actual refiners, who had to sell it to actual consumers. I’m open to the idea, and the question is of great importance, but I’ve just seen to many gaps in the reasoning for me to take it seriously.
gerold k.b. weber says:

February 9, 2011 at 3:30 am

Mark: ‘producers’ and ‘speculators’ are probably intersecting groups. It should be very profitable for producers/owners to risk loosing some money in the zero-sum futures market game while driving virtual and real commodity prices up together.

The cartel/monopoly price function could very well be executed by aligned cartel-like behavior of producers/owners in the futures market, all along knowing the demand inelasticity of the specific commodity.

On top of that volatility is arguably induced by quantitative easing waves and increasing hoarding mentality, which contributes to harmful bubbles.

An open question is if food and other commodity markets work in a similar way.
- Deus-DJ says:
  
  February 9, 2011 at 10:08 am
  
  “On top of that volatility is arguably induced by quantitative easing waves and increasing hoarding mentality, which contributes to harmful bubbles.
  
  An open question is if food and other commodity markets work in a similar way.”
  The hoarding “mentality” actually occurs with food commodities much easier than with oil(or the final products from oil).
  
  The quantitative easing argument(that QE has caused those searching for yield to hit commodities), although it is true, is absolute lunacy. The reason for why is that it ignores what we can do to stop it. With no attempt at position limits or other methods we simply allow this to continue and blame it on monetary policy. The real blame should be on us, who have neither the patience to learn that speculation is the real actor in play here or demand our politicians to do something about it.
- Deus-DJ says:
  
  February 9, 2011 at 10:09 am
  
  The hoarding “mentality” actually occurs with food commodities much easier than with oil(or the final products from oil).
  
  The quantitative easing argument(that QE has caused those searching for yield to hit commodities), although it is true, is absolute lunacy. The reason for why is that it ignores what we can do to stop it. With no attempt at position limits or other methods we simply allow this to continue and blame it on monetary policy. The real blame should be on us, who have neither the patience to learn that speculation is the real actor in play here or demand our politicians to do something about it.
attempter says:

February 9, 2011 at 5:36 am

Unlike the speculators, OPEC governments depend on the steady revenue stream for their very existence. So they don’t want much volatility in the markets, and they don’t want to drive prices too high, to the point that it triggers recession and diminished consumption or renders alternatives allegedly economical.

They look for a sweet spot which maximizes that stable cash flow. Indeed, there’s discord within OPEC over what the “correct” price is, with Iran and Venezuela tending to want to drive prices higher than Saudi Arabia prefers.

lambert strether says:

February 10, 2011 at 1:37 am

In the great state of Maine — and I know this comment is about perception — you won’t find anybody who disagrees with the proposition that oil prices are controlled by speculators. And we’re the state that’s most dependent on oil for home heating.

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