Is the Commodities Boom Driven by Speculation?

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The question above may seem foolish. Oil has just passed $124 a barrel despite improvement in the dollar. Commodities prices are moving less in lockstep than before (gold and wheat in particular have backed off significantly from their highs) suggesting that buying is not the result of the basic materials version of a land grab. Opinion among economists, at least those polled by the Wall Street Journal, is unusually united: 89% think that skyrocketing commodity prices are the result of fundamentals, not too much cash chasing too few raw materials.

Yet bubble-like enthusiasm abounds. Tim Iacono pointed to a Money Magazine cover as proof that the end of the commodities run was not too far away. However, we have yet to see the storied counter-indicator, a Business Week cover story. In fact, Business Week ran an op-ed by Ed Wallace, “There is No Gas Shortage,” that pointed out that inventories were growing, which in combination with rising prices, suggests some speculative hoarding:

Gasoline reserves on hand are at the highest levels since the early 1990s, which is remarkable considering the nation’s refineries have been cutting back on the production of gasoline because their margins have declined. In fact, average gasoline reserves on hand have risen since this past October, while oil reserves in this country have gone up virtually every week this year—and only fog in the Houston Ship Channel that kept oil tankers from unloading their crude one week kept it from being every week…..

In January of this year, the U.S. used 4% less petroleum than we did a year ago. (Oil demand was down 3.2% in February.) Furthermore, demand has been falling slowly since July of last year. Ronald Bailey of Reason Online has pointed out that worldwide production of oil has risen 2.5% in the first quarter, while worldwide demand has grown by only 2%. Production is expected to increase by 3.3% in the second quarter, and by as much as 4.1% by the third quarter. The net result is that the U.S. daily buffer for oil production against demand, which was a paltry 1.5 million barrels as recently as 2005, is now up to 3 million barrels in excess capacity today…..

“The [oil] fundamentals are no problem. They are the same as they were when oil was selling for $60 a barrel, which is in itself quite a unique phenomenon.” — Jeroen van der Veer, chief executive officer, Royal Dutch Shell; Washington Post, Apr. 11, 2008.

But what is intriguing is that commodities veterans are distressed by recent market action. They seem more inclined than outsiders and newbies to point to the role in the bull market not of fundamentals but of new cash and perhaps more important, new vehicles, such as ETFs.

Reader Michael e-mailed us an paper and a series of posts by Michael Frankfurter, a commodities industry analyst (the article was co-authored with Davide Accomazzo of Pepperdine). The posts are broader in focus and discuss the “financialization” of commodities. As we will see soon enough, this development has worrisome parallels to recent history in real estate, with an asset intended primarily for use increasingly treated as an investment vehicle.

An old Wall Street saw illustrates the dangers of this approach:

On a slow afternoon, trader A decided to open a market for a can of sardines. Bidding started at $1. B bought it for $2 and sold it to C for $3. D and E decided to get into the act, with the result that E became the owner for $5.

E decided to open the can and discovered the sardines had gone bad. He went back to A to get his money back, protesting that the sardines were rotten. A smiled broadly, and said, ” You don’t understand. Those were trading sardines, not eating sardines.”

The paper, “Is Managed Futures an Asset Class? The Search for the Beta of Commodity Futures,” has some disconcerting findings from the standpoint of investors. It says that the normal risk/return paradigms of securities markets do not operate in commodities markets, nor do the pricing models for commodities offer an adequate substitute:

Our research indicates that these models have inherent shortcomings in being able to pinpoint a definitive source of structural risk premium within the complexity of the commodity futures markets. We hypothesize that the classic arbitrage pricing theory contains circular logic, and as a consequence, its natural state is disequilibrium, not equilibrium. We extend this hypothesis to suggest that the term structure of the futures price curve, while indicative of a potential roll return benefit, in fact implies a complex series of roll yield permutations. Similarly, the hedging response function elicits a behavioral risk management mechanism, and therefore, corroborates social reflexivity. Such models are inter-related and each reflects certain qualities and dynamics within the overall futures market paradigm.

With respect to managed futures, it is an observable materialization of behavioral finance, where risk, return, leverage and skill operate un-tethered from the anchor of an accurate representation of beta. In other words, it defies rational expectations equilibrium, the efficient market hypothesis and allied models – the CAPM, arbitrage pricing theory or otherwise – to single-handedly isolate a persistent source of return without that source eventually slipping away.

The article provide a nice survey of the issues surrounding CAPM and its successors, and then reminds us of why commodities are traded:

The secondary benefit provided by the futures market is that it functions as a mechanism for transparent price discovery and liquidity, which therefore mitigates price volatility. The primary benefit provided by these markets, however, is that it allows commercial producers, distributors and consumers of an underlying cash commodity to hedge. This reduces the risk of adverse price fluctuations that may impact business operations, which in turn theoretically results in increased ‘capacity utilization.’

And bear in mind, there are more prosaic reasons to be cautious about commodities. From the first in a series of three posts by Frankfurter,

Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated.

Derivatives are risk management tools, a “zero-sum game,” fundamentally different from the “rising tide raises all ships” concept of the capital formation markets. While, there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, the same cannot be said about commodities.

With that as a backdrop, let’s then turn to Frankfurter’s third post, “The Mysterious Case of the Commodity Conundrum, Securitization of Commodities, and Systemic Concerns.” His case is straightforward: financialization of commodities, including the growth of OTC markets, is pushing prices well out of line with fundamentals (note I have excerpted his key points; the piece provides far more evidence):

Rising prices and a widespread bull market in commodities should indicate that there is a growing scarcity of hard assets. However, traditional forces of supply and demand cannot fully account for recent prices.

To be precise, the normal price-inventory relationship has been altered. This is the assertion of an expanding list of bona fide hedgers, commodity professionals and economists. Specifically, dynamics have changed because securitized commodity-linked instruments are now considered an investment rather than risk management tools. Of late, this has been causing a self-perpetuating feedback loop of ever higher prices.

That means a bubble. Back to Frankfurter:

In a statement to the CFTC, Tom Buis, president of National Farmers Union, testified, “If [farmers] can’t market their crops at these higher prices, we’ve got a train wreck coming that’s going to be greater than anything we’ve ever seen in agriculture.” Billy Dunavant, head of cotton merchant Dunavant Enterprises, was more blunt, “The market is broken, it’s out of whack—someone has to step in and give some relief.”

Even CFTC Commissioner Jill Sommers acknowledged charges that speculators are skewing the market, in an apparent turnaround from the CFTC statement of April 21st which implied that commodity markets are functioning properly…..

the predominant view is currently biased to commodities as an investment hedge against inflation and speculators as an easy scapegoat for all the world’s commodity woes.

Unfortunately, this thinking is a self-fulfilling prophecy which ultimately may feed into a negative economic cycle where legitimate commercials are squeezed out of business thereby reducing supply, protectionism gains traction, trade breaks down, hoarding ensues, riots occur and wars erupt over access.

This may sound alarmist, but industry insiders are not buying into the one-size fits all answer that emerging economies are the primary factor driving up prices from the demand side, reinforced by supply-side shocks and peak production fears. In a slowing global economy hit by a major credit crisis and reeling from a falling dollar, it is likely that money flows seeking safe haven in hard assets is the key driver of recent volatility…..

Even if one accepts all the arguments that there is an economic shift in fundamentals which has resulted in rising commodity demand in emerging economies, as well as arguments that there are supply-side constraints bottle-necking commodity production, it is imprudent to deny that this perfect storm has been accompanied by a paradigm shift in how the commodity markets have historically operated.

We’ve been hear before… Economic problems related to OTC derivatives first occurred n 1994 which included the bankruptcy of Orange County , in 1998 with the collapse of Long-Term Capital Management, then during the California electricity crisis of 2000 and 2001 due to market manipulation by Enron, and most recently the credit crisis as a result of mortgage securitization repackaged into complex derivatives.

This history should not be misconstrued, however. Derivative products in themselves are not necessarily the problem. Rather, it is the unregulated environment in which such instruments are traded, and the lack of a cohesive infrastructure to manage the trading, clearing and mark-to-market pricing of such instruments. The regulated futures industry, on the other hand, provides a robust alternative model for trading derivatives.

An aside: perhaps I have been asleep at the switch, but aside from a mention in a New York Times article of a AIG, which manages commodity funds, entering directly into a contract with a farmer, I have not seem any mention in the mainstream media about OTC commodity trading, yet Frankfurter indicates this is a significant and growing factor. I wonder if this oversight is leading to incomplete analysis.

Back to Frankfurter:

Unfortunately, the most important tool of the CFTC to monitor potential market manipulation and excessive speculation, the Commitment of Traders (COT) report, was materially impacted by the CFMA [Commodity Futures Modernization Act of 2000]. In fact, this cornerstone of market surveillance has been so severely damaged as to make reliance on it nearly useless, and those who cite COT as justification for a balance between speculators and hedgers, not credible…..

The CFTC’s ability to monitor the commodity markets was further eroded when the CFTC permitted the Intercontinental Exchange (ICE) to use its trading terminals in the United States for the trading of U.S. commodity futures contracts on the ICE futures exchange in London . Subsequently, ICE Futures allowed traders in the United States to use ICE terminals in the United States to trade its synthetic futures contracts on the ICE Futures London exchange. This allowed unregistered funds to effectively bypass registration.

According to the U.S. Senate Staff Report, “Despite the use by U.S. traders of trading terminals within the United States to trade U.S. oil, gasoline, and heating oil futures contracts, the CFTC has not asserted any jurisdiction over the trading of these contracts. Persons within the United States seeking to trade key U.S. energy commodities… now can avoid all U.S. market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York.”……

In addition to the issue of index funds accumulating long positions and thereby imputing an upward bias to commodities, there is another opportunity for market manipulation with respect to the construction and rebalancing of prominent commodity benchmarks such as the Goldman Sachs Commodity Index (GSCI).

As reported by the New York Times on September 30, 2006 Goldman Sachs significantly readjusted in August of that year the GSCI’s gasoline weighting. Index products tracking the GSCI, and representing an estimated $60 billion in institutional investor funds, were forced to rebalance their portfolios resulting in an unwinding of positions. Originally, unleaded gasoline made up 8.75 percent of the GSCI as of 6/30/2006 , but this was changed to just 2.3 percent, representing a sell-off of more than $6 billion in futures contracts.

As a result, gasoline fell 82 cent in the wholesale market over a four-week period, an unprecedented move; and crude oil, which in July 2006 traded over $79 per barrel for August delivery—at the time an all-time record—subsequently fell to around $56 by January 2007.

Many at the time argued that these moves were due to fundamentals, but… it should also be noted that the U.S. was in the midst of mid-term elections with Republicans facing a major fight to retain control over both Houses. According to a Gallup poll at the time, 42% of respondents thought that the Bush administration “deliberately manipulated the price of gasoline so that it would decrease before the elections.”

We’ve also discussed other games Goldman plays with the GSCI, most notably “date rape“, which costs investors in that index a stunning 150 basis points a month.

Frankfurter again:

There are, however, three concerns as a result of the securitization of gold, which can also be applied to commodity-linked ETFs generally:

The first is that increasing gold prices act reflexively upon investor sentiment as an indicator of inflationary pressures, therefore resulting in more gold accumulation and dollar dumping—a vicious feedback loop.

The second concern, while an indirect case in point, is that the securitization of gold bullion demonstrates how easy it is for a cash commodity to be hoarded, effectively taking the supply of that hard asset off the market. Theoretically, forward contracting by investors is causing the perception of inadequate supply due to perceived increase in demand…

Third, the StreetTracks gold ETF broke the mold and open the floodgates for additional securitizations of commodities in the U.S…..these vehicles ended up doing an end-run around the CFTC by exploiting the loopholes in the CFMA.

This is only a fairly small sampling from the posts (see parts one, two, and three) which includes citations at the end of the final offering.

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  1. Anonymous

    I am one of those foolish investors who think that rising demand from some two billion people on a resource that is very likely to be reaching production limits (oil) in an age of weakening currencies would be a rational formula for rapidly rising prices. To some degree, this can also be extended to other “things” (rice, wheat, coal, zinc, copper, land). From what I can tell, blaming the “speculators” for creating of fueling inflationary expectations when the central bank of the world’s reserve currency is keeping interest rates at levels below the rate of misleadingly measure of inflation is reversing cause and effect. Finally, the difference with the housing bubble is that rising prices in this country was not the result of people who did not have shelter suddenly deciding to quit sleeping under bridges and move indoors, nor was it the result of our population demand rising from 300 million to 500 million people with a stable housing supply. Financialization corrupted and distorted the housing market in this country, of this there can be argument. Financialization of oil is but a minor matter when it comes to that shrinking global resource.

  2. Yves Smith

    Anon of 5:54 AM,

    Did you read the piece or just react to the headline? Frankfurter is a commodities analyst and point to regulatory gaps and failings which lead to incomplete and misreported data, ample opportunities for market manipulation (he provides examples) and evidence of disconnect of commodities prices from fundamentals.

    Commodities markets are small in size relative to bond and stock markets. It would not take much of a reallocation to produce distortions.

    That isn’t to say that some of the price rise is not due to fundamentals, but when market participants, the producers themselves, say prices are distorted, I suggest they are closer to the action than the rest of us are.

  3. rahuldeodhar

    Dear Ms Smith,

    It is great that you highlighted this. I believe there are two forces here.

    First is the global concentrated wealth exploiting the regulatory differences in global markets. Crudely speaking we can imagine world markets are connected at the top – where capital can flow in and out easily – and disconnected at the bottom in terms of benefit percolating into the population. Global wealth moves in chunks between these markets leading to illogical movements in the market. Moreover, this happens between asset classes (commodities, currencies, etc) and between economies or class of economies (OECD, BRIC, GEM etc). This is one force affecting the commodities markets.

    The second is driven by commodity manufacturers beginning to realize how much is the real bargaining power of their products. Therefore, when Oil trading takes it to $120/barrel the producers sit up and take notice of how world reacts. If world does not end – prices of $120/barrel seem ok to them. I believe many producers, too fragmented earlier, are discovering the limits to which they can price their products. This may bring out a second wave of inflation.

    Third is just a hypothesis I am trying to word please bear with me. Over years of inflation targeting we have actually suppressed the prices of certain commodities (food mainly). Therefore, some part should be fundamental increase. In addition, fundamental commodity prices generally tend to adjust in steps rather than smooth upward line. This event, occurring concurrently with the first force, could have set up a positive spiral in motion.

    Of course, over course of time – the other forces from Porters five forces model (mainly threat of substitutes) start creating a downward force.

    Do you think this makes sense?

    P.S. Your blog is amazing and something I read daily. I am amazed at how much you are able to put together each day and all of it absolutely top-class. Kindly accept my sincere compliments.

  4. Anonymous

    “This issue of The Petroleum Economics Monthly begins with a short discussion of the difference between this commodity price cycle and the six earlier cycles noted since 1970 … [they] suggest that the current price rise is being driven by cash from investors, not market tightness.”

    “…half to three-quarters of all commercial long positions in agricultural commodities are now held by “index funds,” the term used to describe investors who take and hold long-term positions in commodities.”

    “The phenomenon is quantified for agricultural futures because CFTC data provide hard information on activity. It is extended here to energy…”

    “Calculations presented in the third section of this report suggest that up to three-quarters of the long-side positions in the WTI crude contract may now be held by such investors. This conclusion has important implications for the future trend in oil prices.”

  5. HBL

    What happens when real but hard to measure trends of diminishing supply and increasing demand meet in the public mind?

    Supply: “The world is running out of resources!”
    Demand: “Two billion new consumers are reaching for middle class lifestyles in China and India!”

    Supply: “They aren’t making any new land for building houses!”
    Demand: “The population is growing! There’s never been a nationwide fall in housing prices!”

    Supply: “Companies with first-to-market advantage will dominate the new markets!”
    Demand: “The new economy has done away with the business cycle and need for profits and a ‘long boom’ has begun!”

    Once the vast majority of people (even economists!) become sure that prices at any level are fundamentally driven and can only go up, and that they are a “sure thing” investment, then a speculative bubble seems inevitable no matter what the underlying supply and demand trends are.

    I think that when this one turns (this year, say Soros and some others?) it will deflate much faster than the housing bubble, and perhaps with similar speed to the NASDAQ bubble since it will likely be paired with a negative demand shock. The consequences of potentially rapid adjustment seem likely to be more complex and far reaching (both positive and negative) than the previous two bubbles, since commodities are inputs to every industry on the planet (when you include energy) and factor so heavily into trade flows between countries.

  6. pepster

    I too have been feeling that the current price spike in commodities, esp. oil, is bubblicious, but I’m actually hoping it lasts a little while longer. I work in the alternative energy field and these prices are providing great incentive to keep doing the research I do.

    On a different topic, I second rahuldeodhar’s comments at the end – great blog Yves.

  7. Michael

    Here are some quotes from a post last week by Dan Dicker, a contributer over at, he has been a floor trader at the New York Mercantile Exchange with more than 20 years’ experience and is a licensed commodities trade adviser:

    “The bottom line has been clear to me — speculation has been the key driver of the oil market for the past two years and will continue to be the single most important factor going forward. As crude makes new highs seemingly every day, figuring out why this destructive rally inexorably continues becomes almost more important than the rally itself.

    I hope that cold-bloodedly parsing the true causes for this rally will give us the insight to predict how high oil might go and even more, how oil will trade going forward. As a floor trader of oil for 25 years, I have, I believe, a unique perspective on this rally — after all, I was immersed in this market, almost exclusively, every day of my trading life.

    …the growth of commodities as an asset class is unprecedented. We need no litany of numbers to prove this point. We can merely look at the volume numbers being posted by all the major commodity exchanges over the last few years.

    In oil, I will draw upon numbers from my previous trading home, the New York Mercantile Exchange. At the end of 2007, Nymex reported average daily volumes of 1.485 contracts per day, an increase of 25% over 2006. So far in 2008, growth has continued at an astronomical pace: January volumes increased 6% over the same period in 2007, February was up 28% and March increased an astounding 62%.

    We don’t need to be geniuses to recognize where most of this growth is coming from. It’s not new commercial interests looking to hedge exposure to the ramping oil markets. Whether from managed futures, algorithmic programs, hedge funds or individual traders who are widening their repertoire from just stocks, it all represents an enormous increase in flow of speculative trade.

    Second, the energy complex can give us a clue as to how deeply speculative action has skewed the markets. Along with the crude barrel, other oil products are traded alongside, most notably heating oil (HO) and reformulated gasoline (RB). I have written often about these in regard to the refiners — the price of finished products, particularly gasoline, have been outstripped by the quick rise of the crude barrel.

    In essence, speculative action in crude is swamping out other fundamental factors, while gasoline prices are being arrived at still using fundamental measurements.

    …As my old trading mentor used to tell me, “In an up market, all news is bullish.” He’s right — analysts are forced to find reasons to fill time on CNBC every day for the inexorable rise of the crude barrel and reach for fundamental reasons that are simply insufficient.” ($)

  8. serinitis

    I suspect we are at the beginning of a bubble here. Baby boomers are in their peak earnings and savings and they need a high rate of return in order to retire. The first couple of years of a bubble fundementals are not that far out of whack. But when others see the rates of return they pile on and it goes through the roof. I believe this is what happened in both the tech and housing markets and there is still a lof of money out there looking for a high rate of return.

  9. Anonymous

    Absolutley the most revealing set of posts that I have read in a long time.
    More evidence, if any were need, as to why the corporate journalists despise the bloggers.
    Keep up the good work.

  10. Anonymous

    Bubbles are a form of a legalized robbery. They are designed into existence by tremendous amount of money chasing purely speculative returns. This time around we also have a currency which seems to have lost its value store property. It forces people to search an alternative, making it even easier for the speculators to ride this trend. Speculators, using newly invented financial instruments of robbery, have a unique ability of monopolizing he prices even when there is no underlying monopoly. There is no chance of returning to normal for as long as the official currency keeps loosing its value.

  11. Anonymous

    A lot of this data is dicey, Yves.

    First, the oil production data provided by Ed Wallace is misleading. Worldwide oil production went up a very little bit in January/February 2008 (no way it was 2.5%–more like 0.2% in each of those months–he is completely ignoring the decline rate in existing wells, and counting only new production). And that was why the price went into that trading range we saw in January and February. But production has been dropping roughly 200,000 barrels per day, per month, since then (March and April), and the strikes in the UK and Nigeria knocked about 400,000 barrels per day out of May supply. Saudi Arabia brought a new 300,000 barrels per day online at the end of April that would have given us about two months of price stability, but this was more than wiped out by the strikes and the ongoing 200,000 barrels per day per month decline rate.

    Some people point to the adequacy of current gasoline supply as “proof” that fundamentals are not behind the rise in oil price. But the gasoline supply doesn’t matter right now, because the product shortage is in diesel, which is now being used to power electric plants in the Middle East because of a shortage of natural gas there. Gasoline is now basically a by-product of diesel manufacture, and is being sold for whatever you can get for it. ( But diesel spreads more than make up for the lack of profits on gasoline. That means the price of oil will stay high, even as gasoline inventories grow, at least for the foreseeable future.

    Regarding the ICE issue–it’s pretty bogus, Yves. I can see manipulation in a very small market, like silver. But no way in a market as big as oil, which is traded in many markets all over the world. If the price of WTI gets out of line on NYMEX or ICE, we would have a flood of oil coming to the U.S. from all over the world. The inventory reports would soon take care of matters.

    I think the reports that farmers can’t sell their crops is also bogus. Farmers can sell on the spot market or futures exchange to a speculator whenever they want to. There is no evidence whatsoever of farmers selling en masse to speculators, and then letting the corn rot in the fields because no one wants to take delivery!

    I agree that Goldman successfully manipulated gasoline prices for the 2006 elections with the forced rebalancing. But gasoline has just about recovered its prior weight in the year and a half or so since then. Goldman was “forced” to sell the GSCI to S&P after that scam, and I don’t think the markets would accept another scandal like that. If you want to make a point about regulation of the markets, I’d agree that Goldman should have been prosecuted for market manipulation.

    Blaming speculators for the supply and demand imbalance in energy is very unfortunate, because it stops investors and citizens from dealing effectively with the problem. It’s a form of denial.

    And I would recommend taking industry analysts with a grain of salt. The longer these guys have been in the biz, the more difficult a time they seem to have dealing with the reality of the current situation. They’re all stuck in the 1980s, when the price collapse hit. But even CERA’s Daniel Yergin came out a day or two ago with a statement that said we needed to start gearing up alternative energy sources pronto because of problems with oil supply, and this was after years of wrong predictions that the price was about to fall.

    Moe Gamble

  12. Anonymous

    This is Moe Gamble again. Before anyone panics and rushes out to buy oil, I did want to say that I expect the price to enter a trading range in June, because we will see a small amount of production gain then. But the price will resume its rise by the fall.

    I also fully expect a Soviet style approach to oil prices in the U.S. within a couple of years. It will only make things worse, but it is clear to me that people in the U.S. will not deal with reality until they have run out of people to blame.

  13. HBL

    If we are in a commodity bubble, then the question of whether this is the early or late stage of the bubble is very interesting… I can think of three big factors that have the potential to derail commodity price increases sooner (within 1-2 years) rather than later:

    1. Real demand shock (i.e., consumption) due to high commodity prices and slowing or recessionary economies

    2. Regulators seeing evidence of speculation and perhaps finally leaning against a bubble due to its real world harm, rather than cheering it on

    3. The “great deleveraging” actually playing out in the near term (and consequently reducing broad money supply despite the best efforts of central bankers to pump up base money supply)

    Clearly we do have long term resource constraints and we do have to find sustainable sources of energy, encourage closed loop systems that emulate nature, etc, but with respect to what fundamental prices should be, it’s all a question of degrees and timeframe.

  14. Anonymous

    “It’s a form of denial.”–Moe Gamble

    I think the biggest thing Americans–and especially major oil company executives–are in denail about is the diminishing importance of the United States in world affairs.

    One can only laugh when Ed Wallace talks about the fall in gasoline consumption in the U.S.–as if that had some great importance in the grand scheme of things. There WILL be demand destruction in the United States, but not because Americans want it. What an incredibly arrogant and parochial attitude that man has! The U.S. has 4% of the world’s population, but uses 25% of its petroleum. As time goes on we will undoubtedly see that figure drop to 20%, then 15%, then 10%.

    And the executives of publicly traded major oil companies? They’re little more than spectators. They control a piddling 10% of the world’s reserves.

    No, the real power resides in OPEC, home to 40% of world oil production and almost 3/4 of reserves. OPEC claims to have 3 million barrels per day of excess capacity, so I suppose if it wanted it could drive down world oil prices.

    So here’s a simple thought that flies in the face of all those incredibly complex models and theories the quants are so enamored of: If Saudi Arabia wants the price of oil to go down, it will. If Saudi Arabia wants the price of oil to go up, it will.

    But some even doubt that. They believe OPEC’s claim of excess capacity is a lie. If that is so, then OPEC too has been relegated to spectator status, and can do nothing but stand back and watch as this things plays itself out on the world stage.

  15. Anonymous

    Saudi has excess supply, but it’s in oil nobody wants because it’s less efficient for making diesel. Again, see this important article:

    But Saudi Arabia has also made clear that future production will do nothing but make up for their own decline rate. They really cannot increase worldwide oil supply beyond what they’ve done.

    I agree with anonymous 1:01 that demand destruction in the U.S. will not be enough to bring down prices, and that the U.S. and its Anglo allies need to wake up to the fact of other people in the world who will be competing for resources. Demand destruction will not bring prices down because the decline in production will be faster.

    Regarding a bubble in energy prices, I don’t think so, and believe me, I’d be glad to short a bubble. But I just don’t see anything like the speculator interest we’d have to be seeing to have a bubble, or anything close to the inventory build-up we’d have to have.

    Prices are maybe a couple of bucks over the “correct” price right now, and that couple of bucks is due to fear of shorting in the face of supply declines due to the UK and Nigeria strikes. Still, you can see commercials holding back any major buying for June, and you can see speculators taking profits. Saudi’s Khursaniyah production should bring those shorts back in soon, and we should see a price stabilization for a bit. But only a bit.

    I think people should get hedged against rising energy prices, and you don’t have to do it by speculating in oil. Your next car should be chosen for fuel efficiency. You should be checking out your state’s incentives for adding solar panels, and adding them now.

    You should not expect the prices of things like solar panels to come down, because even though we can expect a price decline due to volume and manufacturing efficiency, it’s unlikely from this point on to overcome the increased energy costs of manufacture. (I do not own any solar stocks, by the way, so I’m not trying to pump my own book.)

    And people should be careful about investing in oil-related stocks. The oil companies are producing less each year, and costs for new production are skyrocketing due to high energy costs and difficult geology. If you invest in an oil or natural gas producer’s stock, understand that what you are really buying is their “good” reserves–the reserves that can be produced cheaply.

    Moe Gamble

  16. Anonymous

    Regarding analysts, and how much cred you should give to their analysis, from Bloomberg:

    “This is the 18th straight week that analysts have forecast a drop in [oil] prices.”

    In only four of those weeks, however, did we actually see a drop in prices.

    “The oil survey has correctly predicted the direction of futures 50 percent of the time since its introduction in April 2004.”

    Oil analysts, as a group, have the record of a monkey throwing darts.

  17. Anonymous

    I published some articles in NYT and the Baltimore Sun on energy in 1979 and have followed that market on and off since then. I liked the following piece in The Daily Telegraph even if it is a couple of months old

    Far be it from me to argue with NYMEX floor traders but with some trepidation and humility I second the comment about people fighting the Battle of 1981– expecting oil prices to collapse because they did so in previous cycles. We have had oil prices trend steadily up for six years while supply flattened out two years ago. That would point to a supply constraint in my opinion. Note there has been no embargo or politically driven supply disruption in all this time as in the Seventies — even though supply has been hurt at the margin by above ground problems in places like Iraq and Nigeria. Could financialization be a part of the price rise? Who am I to say? But given the realities on the ground, who wouldn’t want to get interested in oil as an investment? Full disclosure — I have positions in Suncor (the leading player in the Canadian tar sands) and Encana (the Canadian natural gas producer) both of which have long lived reserves. I would go with players like this (at the right price, judge for yourselves please) or with the oil services group — the international oil majors simply can’t replace their production with new reserves, as the Daily Telegraph correctly states. That problem would also point to emerging physical scarcity in my opinion.

    As for gold: as you have pointed out, we are not close to closing either our trade deficit or fiscal deficit, so we are debasing the dollar. Investor interest in gold is fed by justified distrust (in my opinion, anyway) of dollar denominated assets. So yes, the interest of ETFs has added a dimension to a market that was once dominated by commercial hedgers. But I have difficulty seeing a reversal of gold’s longterm uptrend, unless you can make a case for renewed soundness in the dollar.

    I too am a naked capitalism addict and thanks so much Yves for all the effort.

  18. Michael

    Look…a few of the anonymouses are missing the point of the post.

    The point was that there is a structural problem with our futures markets and the regulation that is in place for those markets. Futures markets were designed for hedging. There is an economic benefit for producers and consumers because they can plan and make the proper capital investments in order to produce and consume.

    Speculators are present solely to provide liquidity…with arb players keeping them in check.

    But when too much money chases too few paper assets…your market breaks down and ceases to provide accurate pricing. Producers are dropping out of futures markets because they don’t want to get leveled by margin calls (selling futures)…that doesn’t mean they let their products rot…it just means they don’t hedge themselves anymore…so what’s the point of the hedging market if the participants it was initially designed for are dropping out?

    Peak oil, demand, supply, saudi arabia aside — there is a problem with the capacity and regulation …like a 300lb person riding a big wheels instead of a harley problem.

    and RE: “I can see manipulation in a very small market, like silver. But no way in a market as big as oil, which is traded in many markets all over the world. If the price of WTI gets out of line on NYMEX or ICE, we would have a flood of oil coming to the U.S. from all over the world. The inventory reports would soon take care of matters.” – that’s just it, thre is no oil moving…the OTC/ICE allow trading of “sythetic” futures contracts that are hedged by real contracts…so the synthetic contracts expire and the real contracts are rolled. No oil really ever makes delivery. You will never see this trading show up in inventory reports…cushing every now and again, but not often.

  19. JJ

    Nobody has a frickin clue. Go read Matt Simmons. He has been warning of peak oil for years.

    Why are we focusing on high U.S gas inventories or high U.S crude oil inventories?

    The reality is that global crude oil production is stuck at 85 million barrels/day, while global consumption is 87 millions barrels/day.

    So please stop with talks of a bubble, it is not a bubble.

    Its peak oil, accept it. The longer we make faulty excuses for high oil prices the longer it will take to transition to alternative energy sources. The population will think oil is rigged and that prices will come down shortly, when in fact they should be told they are never coming down into we move to alternatives and consume less fossil fuel.

    Russia, Mexico, Norway and others have likely seen peak oil production

    On the flip side, fuel subsidies in China, India, Iran, and Venenzula continue unabated.

    So with the majority of developing world subidizing oil demand, it will fall on the developed world to use less oil, which means lower economic growth.

    So yes we can get lower oil prices, but it will happen at the expense of a steep US recession.

    The days of goldilocks are over, we have the inverse. A little bit of growth produces horrible commodity inflation and horrible growth produces low inflation.

    I almost forgot. Weren’t we blaming the weak U.S dollar for high oil prices. That proved to be BS as well. THe dollar has firmed and crude has taken off to a new high.


  20. Lune

    I used to think oil prices were driven by demand but as oil crossed $100 and passed $120 in record time even as U.S. demand declined, I’m thinking much of the current price increases are driven by speculation. For people who argue it’s all demand driven, oil has now doubled in about a year: have India and China really grown that fast to justify such a stunning rise? Especially in the absence of significant supply disruptions?

    2 other points:

    1) It’s funny that every time oil reaches a new record, someone points to some supply disruption somewhere in the world as proof that it’s legitimate. The fact is, with a commodity produced, transported, and consumed worldwide like oil, there will be problems in the supply chain all the time. Were there no hurricanes or civil wars or exploding pipelines 10 years ago? Such explanations reek of finding evidence for a pre-conceived conclusion rather than a real analysis of supply and demand fluctuations.

    2) In previous posts, Yves, you’ve mentioned how the spot price for many commodities on the contract closing day is often significantly lower than what the contract settles for. In other words, actual buyers/suppliers on the spot market, are valuing the same commodity at significantly less than the price set by investors in the exchanges. This is happening because the enormous volume of contracts traded has overwhelmed the physical delivery systems that are supposed to tie contract prices to actual prices. That to me is almost prima facie evidence for speculators overwhelming the system.

    While I agree that we’ll never go back to gas being $1/gal, I highly doubt that demand has risen so fast in the past year to justify the incredibly rapid increase in prices we’ve seen.

    Perhaps in a few years, when peak oil hits and India and China have significantly higher demands, then perhaps oil will legitimately be priced at $120 (or $150 or whatever). But today? I doubt it.

  21. Anonymous

    Regarding michael’s comment:

    “But when too much money chases too few paper assets…your market breaks down and ceases to provide accurate pricing. Producers are dropping out of futures markets because they don’t want to get leveled by margin calls (selling futures)…that doesn’t mean they let their products rot…it just means they don’t hedge themselves anymore…”

    Oh, puh-leeze. Con-Agra can’t afford to hedge anymore??? You really think it was small family farmers hedging their crops all these years?

    Besides, the thing that has everyone bitching is that prices are always going UP. If prices can be expected to go up, there is no need for Farmer Joe to hedge.

    And how can there possibly be too much money chasing too few paper assets, when you can always create more paper assets? You can just as easily sell a contract for which you have no intention of delivering the commodity as buy a contract for which you have no intention of delivering the commodity, and producers speculators both routinely do exactly that to make trading profits.

    As for michael’s comment “the OTC/ICE allow trading of “sythetic” futures contracts that are hedged by real contracts…so the synthetic contracts expire and the real contracts are rolled. No oil really ever makes delivery. You will never see this trading show up in inventory reports…cushing every now and again, but not often”, it shows a complete lack of understanding of the markets. Both contracts MUST BE CLOSED. If I have a contract to buy 1000 barrels of oil, I can close it out by taking delivery or I can close it out by taking out a contract to sell 1000 barrels of oil, but either way it must be closed. “Rolling it over” requires you to first close out one contract. The party who agrees to buy when I close out this contract has to be someone who either needs the commodity or needs to close out his own contract.

    Regarding jj’s comment, “On the flip side, fuel subsidies in China, India, Iran, and Venenzula continue unabated”, it should be noted that the U.S. subsidizes gasoline prices as well, only the U.S. does it through the subsidization of ethanol. Since we get little to no energy gain from ethanol beyond the fossil fuel inputs, this amounts to little beyond subsidizing consumption of fossil fuels.

    lune asks if demand in China can really account for current prices. The answer is that, in addition to growth in demand from China, we have an oil production decline rate–in other words, even if worldwide demand was constant (which it’s not), prices would have to go up because supply is going down. Even the recent supply plateau was not really a plateau, because it has taken so many extra rigs (and so much extra energy) to extract the oil we’ve been extracting.

    The second part of the answer to lune’s question is that China and the Gulf states are consuming an awful lot: Emerging Market Oil Use Exceeds U.S. as Prices Rise (

    lune also says “you’ve mentioned how the spot price for many commodities on the contract closing day is often significantly lower”… First of all, it was never significantly lower. It was a little lower. Second, it turns out that this was essentially a small premium charged by middlemen (grain silo people) to producers (Farmer Joe, who can’t afford to hedge) for taking on price risk in slightly more volatile markets.

    lune points out, correctly, that problems in the pipeline can’t account for the price rise in oil because there are always problems in the pipeline. But that’s a problem with reporting on commodity prices, not the market for commodities. Essentially, reports never have a clue why prices are going up or down, and so they assign the event of the day to explain things.

    Last week we had a significant increase in oil inventory, yet the price of oil went up. This was due to significant commercial buying in anticipation of a lack of supply coming this month from Nigeria. What had happened was that commercial buyers put off buying in April as prices rose, because they expected a better price in May due to some production coming online. And at the end of April, producers jumped on prices, likewise expecting this production, and drove down the price about $9. The price should have then settled down into roughly 2-3 months of trading range between $110ish and $120ish. Unfortunately, we then saw strikes in the UK and Nigeria that wiped out such a large amount of May supply that the price had to go up. Commercial buyers who had held off buying in April were suddenly aware that the price wouldn’t be coming down any further in May, and jumped to buy.

    Moe Gamble

  22. Anonymous

    that should say “as buy a contract for which you have no intention of taking delivery of the commidity”

    Moe Gamble

  23. Bushwood

    Call me naive, but when I’ve been watching CNBC the most seemingly most common hedge they talk about has been the short dollar/long oil and/or commodities. Of course, this trade is based on the believe that the dollar will continue with its fall and commodities will continue with their increases, and the net position will be protected due to the offsetting positions. (note to claim that the dollars climb vs. the euro debunks oil prices are not speculative, see the recent Brad Sester article on the possibiliity of China dumping their Euro positions, )

    This trade in itself is speculative in its nature and while those who make the trade may state that it is based on market fundamentals the end result is speculation. Just think blackjack and imagine everyone at the table taking an insurance bet based on the dealer showing an ace. This movement will result in a lot more money being thrown on the table.

    Please note, that I am still bullish on oil, and I believe that it will likely continue due to negative real interest rates and the lack of other notable investments. But don’t fool yourself to believe that oil prices are solely based on demand/supply variables. Money is cheap and oil/commodities is the largest publicized growth sector in the economy.
    For a recent case study on how everything will end, please go back and read all the garbage being written in 2003-2005 about the housing market and also note the lack of investment options and the negative real rates at that time.
    However, I believe this cycle may differ a bit from the last, I believe inflation and not growth will force the fed to increase rates and thusly deflating the oil/commodity bubble.

  24. Anonymous

    One last comment: It’s actually extremely important that blame not be incorrectly assigned to speculators for the energy price increases. If we hurt the markets, we increase the control of the few over energy prices and supply, and more important, we distort price signals. This is exactly what we saw going into the 2006 elections, when Hank Paulson arranged for Goldman to reweight gasoline futures out of the Goldman Sachs Commodity Index.

    With one mark of the pen, Goldman was able to crash the price of gasoline and oil roughly 50%. Consumers were happy, and it probably boosted the economy for a while. But we’re paying the price for that manipulation of the price signal now. Consumers bought an entire extra year of Hummers they shouldn’t have bought, etc., and the price rise now is unnaturally fast and sharp.

  25. juan




    As Simmons has long argued, production data has been of questionable quality. I would note that accurate data requires a very unlikely access to proprietary information, equally, access to strategic planning. Simply, there is no way to avoid selection bias and its relation to, lets say, induced and historic social psychologies.

    Neoclassical economics contains particular axioms to do with methodological individualism and equilibrium. Efficient market theory is a derivative of the neoclassical and, as such, is inherently biased against artificial price.

    Nevertheless, there is a long history of price movements deviating from such wonders as supply/demand curves and, when price discovery for a physical commodity is determined not through arms length trade in that commodity but, instead, by financial markets, it is worth considering that price and fundamentals might differ, even over longer periods.

    Herding behaviour is not a new phenomenon nor is it manipulation and can, at the individual level, be perfectly rational even as, at the macro level, it is not. But this leads into a critique of neoclassical economics and its offshoots, so out of place here.

    OK, in re. “the thing that has everyone bitching is that prices are always going UP” did not apply to the same Matt Simmons who, in a January 1998 paper, argued against what he took to be a too low price, stating:

    Our intention in this report is to highlight that in the NYMEX crude oil market, price is not the beacon for fundamentals. Rather, it reflects the psychology of a small group of financial players.
    (Is Another “MG” At Work? (Or, What is Driving Down the Price of Oil?, 27 January 1998))

    Admittedly, Simmons is not ‘everyone’ but has been an important ‘peak oil’ opinion creator.

  26. Rootless Cosmopolitan

    I actually don’t understand the argument mentioned in Yves’s post and used in some of the comments that commodity prices were driven upward, since newly created cash/capital flows into the commodity (future) markets or because traders/investors move cash/capital from other asset classes into the commodity markets. Like the different markets were containers in which money can be poured or from which it can be taken out or between which it can be shuffled. While an individual trader/investor certainly can sell assets of one class to buy assets of another class, therefore, moving his/her cash, every buyer meets sellers who sell the same asset for exactly the same cash amount for which the buyer is buying. Summed over the cash flow of both buyers and sellers in the market of this asset there isn’t any net moving of cash/capital in or out of this asset market at any point of time. There are only traders/investors willing to buy the asset at increasing prices. This hasn’t anything to do with moving of cash/capital into the market. I think there is a quite common false perception about what is happening when assets are traded, about an alleged “money flow” in and out of assets.

    Therefore any explanation which uses the cash flows into the commodity markets argument, whatever the specific cause for the alleged cash flow is given, which treats markets as containers of cash in the economy, is based on a logical fallacy and can’t be true.

    Or what am I missing here?

  27. S

    Critical point in this article is the psychological sign that gold price sends. In looking at the gold oil ratio, it is screaming reversion (7x vs. 12x historically). That reversion whether oil goes up or down means gold goes up longer term. Note that gold started to break 10 days or so before the G7 meeting. It shrugged off the Treasury Dept. reversal on IMF gold sales earlier on, but when the market basically decided that intervention on the dollar was coming, they sold the metal off. Just this week we got the FT confirm article but several weeks ago we got the Canadian Finance minister musing about how the market wasn’t listening to the G7 on $. Oil may or may not be speculation, but like copper it has a relativily believable supply demand proposition. Thus it has the appearance of underlying fundamental support, plus it bolsters the longed after thesis of the global growth story. On the other hand gold is either Jewelry or inflation. Since there is really no “fundamental” story, aside from those believing a sound currency matters (hard one at that), it is far more subject to coordinated attack. It is also a threat, albiet a weak one now, to fiat. It is unimaginable that at this stage GCBs keep buying garbage treasury paper instead of gold.

    We are clearly engaged in a massive game of chicken. The i-banks and their assets with the Fed. The commerical banks with the Fed/Treasury. The Treasury and Fed are trying to hold it together long enough for banks to recover. If for some outlier reason, depositers begin to withdraw their deposits, it would mark the end of the Fed. The perverse game of cramdown. Perhaps it is just wishful thinking to hope that the American people are educated before the full fleecing occurs.

    Reload that short dollar long gold trade – and look for a nice spike when the Fed comes back to the confessional

  28. Anonymous


    Look out the window. If what you said was valid, there would be no such thing asset bubbles.

    What you are missing:

    1. Trading prices set at the margin, but every asset holder revalues based on marginal prices. If everyone tried to realize those prices at the margin, they’d swiftly find they were unattainable.

    2. High use of leverage. Futures are intrinsically highly geared

  29. Rootless Cosmopolitan


    “Look out the window. If what you said was valid, there would be no such thing asset bubbles.”

    Define “asset bubble”. Of course, there can be price increases of assets, anyway. It just doesn’t have anything to do with cash “flowing” into the markets. As I said, markets are no cash containers. Every buyer meets sellers who sell the same asset for exactly the same cash amount for which the buyer is buying. The net cash flow summed over both buyer and seller is Zero. The same money amount which is put into the market by the buyer is taken out by the seller. Buyers are just more eager to buy than sellers to sell, therefore higher prices.

    “1. Trading prices set at the margin, but every asset holder revalues based on marginal prices. If everyone tried to realize those prices at the margin, they’d swiftly find they were unattainable.”

    True, in their mind, asset holders will put new price tags at the assets which they are holding, when prices increase (or decrease). It’s a change in the book value of the asset. But this doesn’t have to do anything with my argument that there isn’t any net money flow in or out of the asset market due to buying/selling of the asset.

    “2. High use of leverage. Futures are intrinsically highly geared”

    In what way is high leverage supposed to invalidate my argument that each buyer meets sellers who sell the asset for exactly the same money amount? Whether the money is borrowed or not which is used for buying the asset doesn’t matter for the argument.

    I still say there is a common mis-perception. In up markets, markets seem to be seen from the buyer’s perspective, who invests money to buy the asset, in down markets from the seller’s perspective, who realizes cash by selling the asset, as if the counterpart of the trade didn’t exist who exactly does the opposite.

    Think about it.

  30. Michael

    Anonymous…you’re nuts. 7% collateral is obscene leverage. And that’s not even using REAL leverage. Imagine borrowing 2x (or 30x in BSC’s case). This game gets outta hand really quick. That’s the whole point of the post. Futures markets aren’t designed to handle this type of trading. They were designed for producers and consumers to hedge…speculators were merely liquidity providers.

    Producers and consumers are dropping out b/c the asset prices do not reflect their information sets.

    And Apparently,the market belives Goldman Sachs has better information than do the people that actually produce the products. Amazing how that works.

    But please, continue listening to “$100 trillion of infrastructure still needs to be built” Matt Simmons…he’s not batt-*hit insane, i promise.

  31. JJ

    Micheal— Why would producers drop out in an asset bubble? If indeed oil prices are inflated, producers have every incentive to maximize profit by selling an extra barrel into the market. They sell the futures at a price at deliver into it with physical supply.


    Please don’t tell me that every single oil producer woke up this morning with the intent to lengthen the production cycle, but at $20 barrel, they were happy to rapidly deplete reserves.

    When prices get crazy, as you say, producers respond by selling more crude. Its that simple.

    Just like when stocks get expensive, insiders sell out en masse.

  32. Anonymous

    “but at $20 barrel, they were happy to rapidly deplete reserves.”
    Oil producers were very unhappy about those prices and they don’t want a return of that time. So many new actors piled into the oil markets in the 80s that prices were severely depressed. Even OPEC members were forced to break quotas just to cover their own spending and trade deficits. Now prices are high again and the biggest worry of most oil exporters is how to efficiently handle all that surplus income. The OPEC cartel has teeth again and they see little point in cranking the taps to the max.

  33. Richard Kline

    I could believe oil at $90-100 on demand fundamentals—but $125 in a global environment of economic downtrend at the moment? Chickpeas shooting higher: in relation to . . . soaring population, what? Naw, not credible. There are clearly ‘speculative’ processes in play in commodities, but not all speculation is created equally.

    Much of the discussion of potential commoditiy speculation at present is made in regard to ‘hedges against inflation.’ Surely some of that is in play, but I don’t think this is the main story. Consider: the hedgies were many of them major issuers of credit default swaps to the mortgage security market, both internally to the securities themselves in some cases by apparently more actively as counterparties to major _holders_ of CDOs. [Clarification on this issue by knowledgable parties is most welcome.] This means that the hedgies or the hedgie-like i-bank arms must all be miles down on many of their CDSs outstanding. Other CDS issuers are taking a bath in carbon tetrachlorhyde at present; look at AIG’s losses in Q1. Why aren’t more hedgies stone dead?

    Wellll, they all putatively carried counter-hedges of their own. Earlier on, many of these were in gold and shorting the $ for other currencies. Other hedges were clearly in commodities, specifically oil. Well, gold and the $ both came under pressure of intervention or other counter-momentum activities . . . just about the time that commodities of all sorts went vertical in their price lines. Not surprisingly as the Frankfurter says above, commodities futures markets have been ‘wired’ so that shadow players can get in without being observed, and these markets are significantly susceptible to market manipulation. For hedgies looking to offset their CDO driven CDS losses, it matters not what the intrisinc ‘value’ of soybeans, oil, or rubber is, to anyone, anywhere; all that matters is that the momentum stays up until they clear their positions for a profit. Or for the CDO market to return to ‘normal,’ i.e. balloon up again. The mystery to me for most of ’08 so far has been, “Where are the losses from the huge paper asset declines?” I think we see the answer: In the wallets of everyone buying ballooning commodities. . . . The world will be a better if noisier place when we line the hedgie boys up against the wall, click off the safties, and close out their positions in our lives, speaking figuratively or otherwise. Or so I’d like to think. They are NOT value-added to our society.

  34. Ingolf

    Rootless Cosmopolitan, in a strict sense you’re right about the money flow issue (although net flows do occur whenever there are changes in the outstanding stock of a commodity or security) and it’s a point worth making. But only, I think, in passing.

    I don’t see that it helps us much in trying to understand price changes and how well founded they may be. As someone has already noted, prices are made at the margin based on the relative eagerness of buyers and sellers. If a whole new class of relatively uninformed and price insensitive buyers turns up in a market, prices will be pressed much higher than they would otherwise have been. If you like, the ecology of that market will have been profoundly disturbed.

    By the way, jj, your assumption about the reactions of sellers doesn’t necessarily hold true. It certainly hasn’t in stocks. Through much of the last decade, US corporations have been huge net buyers of stock. It’s been a bit like a long running short squeeze.

  35. Anonymous


    Money transformed to claim F
    Claim F transformed to money

    is not just MoneyX-MoneyX

    but contains transforming mediations which help determine price change of both Claims and from this the underlying. Balanced reciprocity between futures and spot can become imbalanced with the former becoming determinant.

    To say a purchase is a sale and a sale is a purchase hence circulation takes place
    is a tautology that fails to account for
    asymmeteries within a still not instantaneous process infected with not-so-perfect information and irrationalities.

  36. Rootless Cosmopolitan


    “(although net flows do occur whenever there are changes in the outstanding stock of a commodity or security)”

    Yes, there is net cash/capital flow between households (private, corporate, government) in the economy. No one could get rich, if it were otherwise. Here, that would be a net cash flow to the producer of the commodity or the issuer of the security from the unlucky ones who only will be able to re-sell the commodity/security for lower than the purchase price. There is also a net cash flow from those ones to the ones who aren’t the producer or issuer, but are able to re-sell higher than the purchase price w/o a change in the size of the stock even necessary. The market for the asset intermediates the cash flow between households, like a boundary between buckets, but the asset market itself is not the bucket to which or from which the cash flow takes place.

    In the case of things that are consumed, there is also a permanent net cash flow from the consumers, the sink of the good, to the producer, the source, w/o a change in the size of the stock even necessary, either. The market of the good just intermediates this cash/capital flow also.

    What goes into a boundary at one side comes out of the boundary at the other side. Markets are like boundaries. Boundaries don’t have sinks or sources. Commodity prices can’t increase because cash/capital allegedly flows from other asset markets to the commodity markets. Those capital flow explanations are bogus.

    Perhaps the term “asset bubble” used for irrationally increasing prices of assets both results from and re-produces the false perception of what is going on. It supports a false association that price increases are a function of an increased volume of something. But prices are better compared to a variable like the temperature, measuring the “hotness” for the asset. Maybe the term “asset fever” would be more appropriate than “asset bubble”. High fever also can lead to delusions which can be observed quite often while watching market participants. :)

  37. Richard Kline

    So Rootless:

    Most markets have intermediaries, who take fees; that’s a sink any way you count it.

    Also in that argument, you treat commodities units as if they are of uniform expression regardless of where they are in ‘market space.’ For some assets, this is true; for others, their form changes/is changed as they pass through the market in ways that re-paramaterize their value without affecting physically or directly the asset itself. For one example securitization of sub-assets. For another example the entailment of derivatives tied to an asset unit. For a third example, a change in the currency in which they are priced. For a fourth example, a change in the exchange or clearinghouse in which the transaction is settled. Markets are not a zero-dimensional vacuum in the way that your example suggests. I’m not disputing the broad validity of your comments in saying that, only adding a layer of complexity to the picture. : )

  38. Ingolf

    Rootless, sorry about the delay. I haven’t checked in to the site for a few days.

    You said: “The market for the asset intermediates the cash flow between households, like a boundary between buckets, but the asset market itself is not the bucket to which or from which the cash flow takes place.”

    That this isn’t always so was the very point I was trying to make, all the while accepting your more general point about money flows.

    To take the share market as an example, stock buybacks and cash takeovers on the demand side and IPOs, secondary issues, option exercises and other insider sales on the supply side change the number of shares outstanding. The “bucket’, to use your term, becomes either more full or less so. In most established and deep markets, of course, such changes in stock outstanding will be small and incremental. Still, the distinction is worth noting both as a general principle and because such net changes in stock outstanding can at times become very important indeed.

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