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Monday, June 30, 2008

New Oil Scenario; Or, "My Bad, Tyler"

Well I've been pretty smug with my fellow economist bloggers on the oil speculation issue. But I think my sweeping pronouncements before were too strong (strident?), and that it's possible for speculators to drive up spot prices, without leading to inventory buildup and without forcing oil prices to be in contango. Rather than trying to give more general rules for what can and can't happen, let me just tell a little story, and you tell me if it sounds plausible (or even true!).

The Fed has been doing CRAZY stuff trying to resuscitate the credit and real estate markets. And yet many traditional measures of irresponsible monetary policy aren't giving off warnings. (E.g. M1 and M2, long-term bond yields, CPI, and PPI.) So, to put it simplistically, where has all this new money been going?

Let's say that the Fed really is injecting hundreds of billions, and that it hits the financial big players first. Where are they going to put it? Real estate? Stocks? Bonds? Heck no, those are all terrible investments right now in the U.S., and they're not so hot in the rest of the world either.

But commodities is pretty attractive. They will always be in demand, even during recessions; it's not like you're investing in sushi restaurants in Boise. What's really nice is that the nature of your "bet" (i.e. investment) liquidates itself fairly quickly. With a stock or bond you are (in theory) betting on a stream of events well into the future, whereas you can take a position on silver in four months and not be nearly as tied down.

OK, so suppose all these hundreds of billions are bypassing the larger economy (and hence not showing up in official aggregate statistics) and going right into commodities futures.

Perhaps (mis)led by the boost in futures prices, Saudi Arabia becomes convinced that there will be a huge surge in demand for oil in, say, the latter part of 2009. So they cut current output, in order to expand their capacity in 2009.

Because of Saudi Arabia's cut in current production, the spot price of oil shoots way up. In fact, it goes up so much that backwardation is restored in the oil yield curve. I.e., even though the sudden influx of speculators with hot Fed money has caused futures prices to double (let's say), once everyone adjusts, the new equilibrium will have a spot price that doubled too.

Now because Saudi Arabia was willing to substitute oil output so much (i.e. they had originally had so much excess capacity slated for 2009), the spot price was able to rise and mute any incipient incentive to hoard physical oil. So inventory data wouldn't show any signs of this massive Fed distortion of the oil market, and as we already showed, there could be backwardation in the oil yield curve.

==========

Well gee whiz, I've gotten into this so much that I almost convinced myself. I should probably sleep a night on this one.

In any event, I looked at my inner economist and discovered that I very well may have been too flippant with Tyler Cowen. Even if it turns out not to fit the data, the above story is certainly theoretically possible.

Dang.

8 comments:

  1. That was good stuff.

    I would quibble with this: "But commodities is pretty attractive. They will always be in demand, even during recessions;"

    Many commodities may be scarce today but I think historically there have been massive over-supplies in many and bankruptcy...they can be a very risky investment (now if you meant 'this time'...yes, they seem pretty good right now).

    With your hot money do you think we could be in a Keynes "Greater Fool" with oil?

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  2. Well, I meant commodities aren't a luxury good that could be wiped out during a major recession. People are always going to want commodities, though obviously one can still overinvest in them.

    I'm not sure about the "hot money" stuff. To be clear, I am not saying that the scenario in this blog post is what's going on.

    I just spelled it out because I realized that Tyler's point was valid, namely that the two measures Krugman has been relying on (inventories and oil yield curve) wouldn't necessarily tell us if speculators were driving up oil prices.

    Has world oil output fallen significantly since last September? If not, then I don't think this story works.

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  3. And yet many traditional measures of irresponsible monetary policy aren't giving off warnings. (E.g. M1 and M2, long-term bond yields, CPI, and PPI.)

    Say what? Have you looked at M2 lately? Oil? The CRB Index?

    What's really nice is that the nature of your "bet" (i.e. investment) liquidates itself fairly quickly. With a stock or bond you are (in theory) betting on a stream of events well into the future, whereas you can take a position on silver in four months and not be nearly as tied down.


    Say what? Let's say that I think McCain will be bullsh for the stock market and Obama will be bearish. The election this year is on November 4. What is to prevent me from buying stocks on Nov. 3, if I think McCain is going to win,and liqudating them on Nov. 5?

    That sounds like a pretty quick stock liquidation to me, and I can think of hundreds of other examples.

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  4. Mr. Wenzel:

    I promise to answer your incredulous questions after I have recovered from them. (I might be sarcastic if I do it now.) But just to give you a preview, yes, I have looked at the price of oil lately--in fact it was a prerequisite to this very blog post, which offers a theory for record oil prices.

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  5. Perhaps my subtle sarcasm with regard to oil was a bit too subtle. Maybe I should have really hammered my point home and should have written:

    Given that you are studying the oil price, you may have noticed that over the last 5 years oil has climbed from under $40 to above $140. Do you consider this a signal of deflation, along with a record high CRB and M2 money supply growth that continues to increase at an 8.0% annualized rate over the last six months? At what level, in your mind, would these begin to flash an inflationary warning?

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  6. Mr. Wenzel,

    OK I have composed myself and can give you answers in an appropriate tone:

    Say what? Let's say that I think McCain will be bullsh for the stock market and Obama will be bearish. The election this year is on November 4. What is to prevent me from buying stocks on Nov. 3, if I think McCain is going to win,and liqudating them on Nov. 5?

    Well, for one thing, I'm pretty sure most other traders are aware of the date of the election, etc.

    But anyway, my point wasn't that if you buy a stock, you have to hold it for the rest of your life. Just as I realized the price of oil was high, I am aware you are allowed to sell stocks Mon - Fri for most weeks of the year.

    In this blog post, I was trying to come up with a plausible story to explain how there could be a bubble in commodities, despite the absence of typical warning signs (in oil inventories etc.). So I had to give a sentence or two to explaining why investors would rush headlong into another bubble, when they had gotten burned in the dot coms and now housing.

    I could see an investor being much more afraid of a stock falling 20% in a month, than in his 4-month forward oil future contract having a similar drop. If you buy a stock, you are exposed to everything that is expected to happen to that company. Yes, you can sell tomorrow, but if the bad news has already hit, the stock price will reflect it.

    (I know, I know, news about the oil market next year can affect the price today.)

    Given that you are studying the oil price, you may have noticed that over the last 5 years oil has climbed from under $40 to above $140.

    I'm talking about the Fed's "CRAZY" actions since September 2007. So the oil price from 5 years ago isn't that relevant (except insofar as oil traders in the past anticipated the Term Auction Facility etc.).

    Do you consider this a signal of deflation, along with a record high CRB and M2 money supply growth that continues to increase at an 8.0% annualized rate over the last six months? At what level, in your mind, would these begin to flash an inflationary warning?

    Look at this chart. Just eyeballing it, I'd say the current annual percentage rate of M2 growth is about the average it's been over the last 30 years.

    Of course it is inflationary, but my point is, plenty of us are thinking price inflation could be over 10% in 2009. But certainly the bond market isn't predicting that, and certainly that has NOT been the level of price inflation corresponding with today's level of M2 growth, if you look back over the last 30 years.

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  7. Bob,

    Thanks for the reply.

    Well, for one thing, I'm pretty sure most other traders are aware of the date of the election

    Actually, I didn't know the exact date and had to look it up. My guess is that most people know the election is in early November without knowing the exact date.

    I could see an investor being much more afraid of a stock falling 20% in a month, than in his 4-month forward oil future contract having a similar drop.

    Why would an investor be more concerned about a 20% drop in a stock than in the future's market. I don't get this, I don't think it holds.

    I'm talking about the Fed's "CRAZY" actions since September 2007.

    Actually, it appears that the Fed is neutralizing a lot of its special operations like the Term Auction Facilty. They may pump $75 billion in through a Term Auction, but they simultaneously drain elsewhere.

    certainly the bond market isn't predicting [inflation]

    I don't get how markets "predict" stuff. Futures markets reflect the current opinions of the players in the market, that is all. Those opinions can be right or wrong, but they don't "predict" anything. They possibly may sometimes provide clues, when there is unusual activty--that is all.

    Actually, in the case of the dramatic spike in oil, it may be provdng a clue---though I never see it mentioned in the press.

    Suppose Israel plans to bomb Iran. If you were an Israeli planner in on the scoop, or a CIA intelligence officer monitoring Israel and you believe an attack will occur, then you would both be mortgaging your house to the hilt to take advantage of the spike in oil that would surely come from an attack.

    This by the way is real insider trading---with serious ramfications. If you are a major player that is long oil futures, with every penny you have, then if you see an opportunity for peace--whch could cause your bankruptcy, are you going to persue that peace opportunity?

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