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Wednesday, July 23, 2008

Oil Speculation: WSJ Bluffs, Govt Shines

Now that I am a big mover and shaker, I am always on the lookout for my transformation into a giant sellout. (Some of you have aided me in this vigilant effort.) Well, today I found myself rolling my eyes at the Wall Street Journal's editorial on speculation, and nodding my head in morbid excitement while reading the CFTC's report (pdf).

If you have a half hour and really want to get up to speed on the nuts and bolts of futures trading in the oil market, I highly recommend the CFTC report. Now then, let's make fun of the guys bluffing at the WSJ. (And by the way, it takes one to know one. What I mean by "bluffing" is taking a confident position on something where, it turns out, one doesn't quite have the subject's nuances pinned down. It is unavoidable, I think, unless you stick to mathematical proofs. But the only way to keep the incentives right is to rip people when they get caught bluffing.)

Anyway in the July 22, 2008 editorial page (A18), they write:

Even the title of the Senate's bill--the "Stop Excessive Energy Speculation Act"--is idiotic. True, the volume of trading has increased by about sixfold since 2000, but it can't be "excessive." The inviolable law of futures markets is that someone has to take the other side of any option. That is, the value of contracts agreed to by sellers anticipating that prices will fall must equal the value of contracts agreed to by buyers anticipating prices will rise. The overall size of the market is irrelevant.

OK, first bluff: They seem to be classifying a futures contract as an option, when in fact it's a derivative. (An option is a derivative, but a derivative is not necessarily an option.) You don't have any option in a futures contract; if you haven't sold it by the delivery date, you are obligated to buy/deliver the underlying (or settle up in cash). With an actual option, you have the option of doing nothing (hence the name).

OK, but more important: It's not crystal clear, but it seems that the editorialists are arguing that by definition, speculators can't ever drive a price up. Because after all, for every long position there is a corresponding short.

But if this were true, then the futures market would lose one of its virtues; it wouldn't allow experts to communicate their insider knowledge to other people in the market. For example, if people knew that Israel were going to launch an airstrike on Iran next Tuesday, we want them to be "traitors" and start massively buying oil futures. (At least, that's good from the point of view of the oil market. If it tipped of Iran and they beefed up their air defenses, the Israeli pilots could understandably be furious.)

The way I've been thinking about it lately, is to make it analogous to international trade. Imagine that the physical producers and users (what are called the commercial users or "hedgers") have established their own equilibrium futures prices for various months out over the next 5 years. Now enter a bunch of outside investors who also (among themselves) take long and short positions, based on their expectations. They aren't hedging, they are pure speculators.

If the futures price in each closed system is the same, then there are no gains from trade and nothing happens. However, if the speculators end up on an equilibrium futures price higher than the hedgers, then once the two groups can trade, naturally what will happen is you'll end up with a unified futures price in between the two original ones. At the higher futures price, the oil producers will be short more contracts than they were before, the commercial users (airlines, refiners, etc.) will be long fewer contracts than they were before, and so as a group they will be net short.

On the other hand, the speculators as a group will have to be net long, to counterbalance the "international trade" with the nation of hedgers.

Now because the oil producers have sold more promises to deliver oil in the future than originally, they will cut back on current output (probably). Or, depending on the specifics, people might stockpile oil in order to fulfill these additional delivery orders. Either way, the spot price of oil goes up because of the influx of net long speculators.

Now, is this a good thing? It depends. If the speculators are right, and oil prices go up, then yes. If the speculators were wrong, and oil prices go down, then their interference was a bad thing.

So it's the same as with other entrepreneurial actions: Profitable actions coincide with correcting mispricings, while losses coincide with screwups.

Within that context, if you reread the WSJ editorial, you'll see that they probably don't really know what they're talking about. It's true, you could bend over backwards and say they were just harping on that word "excessive," but I think they were saying speculators can't move prices.

If nothing else, I heard Rush Limbaugh explicitly say that a couple of weeks ago. He went through and explicitly said that a futures contract is a zero-sum game, and that since one party is long and the other short, speculators can't move prices. But at least he had the sense to say, "Now I'm sure some economists are going to email me and complain..." when he basically said futures contracts were gambling and had no real effect on the economy.

11 comments:

  1. What I mean by "bluffing" is taking a confident position on something where, it turns out, one doesn't quite have the subject's nuances pinned down ... But the only way to keep the incentives right is to rip people when they get caught bluffing.

    ROFL!!!!!

    If you want an explanation for my treatment of you regarding cap-and-trade, *there it is*!

    (Btw, I made this post without using the mouse, check my blog.)

    ReplyDelete
  2. Now, is this a good thing? It depends. If the speculators are right, and oil prices go up, then yes. If the speculators were wrong, and oil prices go down, then their interference was a bad thing

    I think you have to ask good or bad for whom. Suppose I am a high cost oil producer, say it costs me $140 barrel to produce oil and I have to purchase certain equipment that will allow me to produce X number of barrels over the next 12 months, then the fact that the speculator is out there willng to buy my future production at a price higher than $140, is a good thing for me because I can go on producing my oil knowing I have a stable life and I have transferred my price risk to someone willing to assume that risk.

    Further, even in the cases where speculators may drive up the oil price on a short-term basis, their value as willing risk takers may play an important role in keeping production smooth by absorbing risk from risk averse producers.

    If speculators are wrong on the short side and temporarly drive the price of oil down, then they will have to pay spectacularly for that error by paying up for oil when they need to cover at very high prices thus signalling producers to increase production pronto and the spiralling markets supplyng ideal hedging conditions for them.

    ReplyDelete
  3. Bob said: "What I mean by "bluffing" is taking a confident position on something where, it turns out, one doesn't quite have the subject's nuances pinned down ... But the only way to keep the incentives right is to rip people when they get caught bluffing."

    Silas retorted: ROFL!!!!!

    If you want an explanation for my treatment of you regarding cap-and-trade, *there it is*!


    It really astounds me Silas how you are able to reverse everything into your Bizarro world. What you have been doing with regard to my cap-and-trade op ed is the exact opposite of what I did in this post.

    The purpose of my parenthetical remarks (which you quote above) was to defuse the rip. I.e. I was saying, "Just because I'm accusing the editors of 'bluffing,' I'm not saying they're stupid or evil. Look, we all make mistakes like this in our line of work, but nonetheless we have to correct them when we spot them."

    In contrast, you said my op ed made your blood boil (exact words), and you accused me of purposely writing something I knew to be false because of my employer. Am I accusing the WSJ editors of taking bribes from hedge funds?

    One final point: What exactly is the purpose of your post here? Of course you were attacking me after the cap-and-trade op ed, because you thought I was wrong in my simplistic approach. I didn't think you were flirting with me.

    ReplyDelete
  4. RW,

    OK you're right, even Austrian economists throw around phrases like "good for the economy" when a true subjectivist/individualist can pounce, as you have done here.

    As far as your points about liquidity etc.: I guess we should be clear on what the options are. If the question is, "Would it be better to have a speculator buying futures contracts that are 2 cents off the 'true' equilibrium value, versus having no futures market at all?" then I think the answer is obvious.

    But if we have an initial market with futures in some type of short-run equilibrium (defined however we want), and then a speculator comes in and moves the price, I think there has to be an objective sense in which you can say that his action is either equilibrating or disequilibrating from a long-run perspective. I grant that I am hand waving here but I think you should be able to tell a story like this, or else you can't really say anything except, "Government actions are bad because they're violations of rights," not because you know anything about market processes.

    ReplyDelete
  5. Bob, do you still consider the flooding of 100s of millions of people due to excessive human emissions of CO2, to be not related to scarcity?

    Btw, did you see how I made the post without using the mouse?

    ReplyDelete
  6. Silas,

    I've already told you many times my response to your critique.

    That's interesting about the mouse, but why not link to it from here? A lot of people wouldn't even know where to go to see your blog.

    ReplyDelete
  7. OH! Good point, good point. How to ditch your mouse for web browing

    (Ohterwise, people might have gotten SYNC SUCX as the first post on my bloggy.)

    Alright, so we're clear then: tricking people into believing that impediments to flooding 100s of millions of people, do not reflect scarcity = AOK.

    (What's so devious about Bob is how hard it is to express his evils in a single sentence that is easy to parse.)

    ReplyDelete
  8. Alright, so we're clear then: tricking people into believing that impediments to flooding 100s of millions of people, do not reflect scarcity = AOK.

    I think that law professor should give a lecture on why one should never ever debate with Silas on the internet, even if one is sure he is correct and only utters truthful statements.

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  9. Bob: in case you forgot, you admitted that your goal there was to get people to believe "huh huh, how stupid" about C&T. I encourage people to go to that link, read it, read the context, determine if I'm characterizing Bob's trivialization of the suffering of 100 million brown people correctly. He is, after all, ultra-sensitive about those subtle nuances in his writings that completely reverse the meaning of what he said.

    Keep in mind, for purposes of argument, you accepted that a certain high CO2 emission level would cause 100s of millions of people to be displaced. You gave an example of how market prices *correctly* account for *real* changes in scarcity. You then looked at a case where caps are put in place to keep CO2 use from flooding those people, and said that if the price "exploded" (analogously with that price explosion in the real case of scarcity changing) because of those caps, that would "not reflect scarcity".

    There you have it: if the potential flooding victims prevent you from flooding them in a way that raises your prices, Bob is very clearly saying that those higher prices do not reflect scarcity.

    Bob then looks back and, with a straight face, makes the wildly implausible claim that he REALLY meant the reader to take the passage to mean that if like, uh, HIGH prices resulted, that wouldn't reflect scarcity, but, um, OF COURSE lower prices could, duh, that's totally obvious.

    This is despite the fact that, in context, not a single reader would take that message away and Bob damn well knows that. But it's ALL okay because, uh, uh, UHHHH Silas is a bad person because he thinks a tax on sneezing is a market solution!

    And, let's not forget, this is all while Bob knows there are no property rights (a precondition for markets) in the very resource he's demanding a market solution for.

    Ask yourselves: is Bob more interested in well-defined, solid, principled libertarian property rights, or in rationalizing the suffering of others for his own benefit?

    I defy anyone to show me where I've mischaracterized Bob's views, and if you can find a case, I will give Bob a gold plated apology. That's because I have "ethics".

    ReplyDelete
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