Michael Masters' testimony regarding the role of speculation in commodity prices has drawn a lot of comment since last week. [See, for example, Cassandra, James Hamilton, Tim Iacono, John Mauldin, Michael Shedlock, Yves Smith.] According to Masters', portfolio investors' increasing participation in commodities via futures markets has been driving a speculative price boom, over a period of years.
I have to say, I am very skeptical of Masters' view. Perhaps I have drunk too deep of the Kool-Aid of orthodox finance, but, as the saying goes, "for every long there's a short", and Masters does very little to explain who is taking the other side of what he presents as a one-way bet, a virtual cornering of the commodity markets. We'll come back to this, because the shorts are the most interesting characters in our story. But before we go much further, we might as well opine a bit on the debate du jour, is "speculation" driving commodity (and especially oil) prices?
This question annoys me, because people rarely define what they mean by "speculation". Are you concerned about...
Traditional speculators, making active predictions about future supply and demand, and determining that commodity are underpriced relative to other goods and services.
Nervous hedgers, who respond to recent price volatility by taking larger-than-usual precautionary positions in order to manage operational risk.
Portfolio diversifiers, who allocate some fraction of their portfolios to commodities in a price-insensitive way, as it becomes ever more convenient to do so, and the investment profession comes to view commodities as an attractively uncorrelated "asset class".
Momentum investors, chasing recent price rises into a classic speculative bubble.
Inflation hedgers and monetary skeptics, who view the purchasing power of financial assets as increasingly volatile, or who expect a decline in the purchasing power of financial assets, but who do not view commodities as undervalued relative to other goods and services.
Corporatist governments, who seek to shed market risk by obtaining non-market access to commodities (vertical integration), or whose policies amount to speculation on future market conditions. Examples include countries that restrict food or commodity exports in response to high prices; China, whose state-affiliated firms purchase stakes in suppliers of essential commodities; Saudi Arabia whose purchase of GE Plastics looks to capitalize on preferred access to petrochemicals; oil producers generally, when they produce below capacity; and the United States with its strategic petroleum reserve. All of these practices have the potential to reduce supply to unaffiliated commodity users who rely on public markets.
It takes all kinds to make a market, and I think that we've got the whole menagerie. Also, we shouldn't forget this story, from Jeff Matthews (ht WSJ):
...the fact that a) world oil demand is up 12 million barrels a day since 2000, and non-OPEC oil supply is up only 4 million barrels a day since 2000, and b) America decided to convert food into ethanol at the very moment that c) China's demand exploded.
See James Hamilton for a fuller exposition of the case that oil price fundamentals are driving prices.
Masters fingers as the villain "index speculators", a Frankenstein combination of Types 3 and 4 above. There outta be a law agin' them, he suggests to Congress. Pension funds should be barred from commodity investing, loopholes that have undermined speculator position limits should be closed, and the increasingly meaningless distinction between commercial and noncommercial traders should be resurrected in CFTC reports. Okay.
But what if the price-setting speculators are not momentum-driven index funds, but "traditional speculators", correctly predicting that prices are below long-term fundamentals? Then limiting commodity speculation would prolong the mispricing, and cause us to waste resources that are kept artificially cheap. Alternatively, what if (as I suggested in the previous post) commodity prices are being driven by monetary fears? Then banning pension funds from commodities would amount to barring the exits, forcing workers to watch helplessly as their retirements are devalued away. If "fundamentals" are driving prices, or a flight by official actors from market to non-market means of resource allocation, limiting speculation would do no good, but would obscure the news by interfering with price transparency. The only circumstance under which limiting "speculation" might be a good idea is if the dominant tale is a momentum-driven speculative bubble. Which could, of course, be the case. Or not.
Which brings us back to the shorts. "Irrational exuberance" isn't enough to cause a speculative bubble. There needs to be something else that discourages rational traders from taking irrational traders' money when they buy overpriced assets, "limits to arbitrage" in the lingo.
Now, this is an old conversation in academic finance, especially with respect to the stock market. Heck, go chat with Brad DeLong and Robert Waldmann about noise traders, they're right here in the blogosphere. We'll dispense with the details here, and recite the pithy Keynes quote...
The market can stay irrational longer than you can stay solvent.
If a stock is overvalued, to correct the mispricing, you must sell it short. Even if you are right that it is overpriced, if the speculative mania continues, red ink on your short position might drive you out of the market and into poverty long before your foresight is vindicated. On the stock market, unleveraged "longs" can safely buy and hold, but "shorts" are forever at the mercy of the lunatics, hoping and praying that starry-eyed optimists don't go even more batshit insane. Sane people sit on the sidelines, allowing enthusiasm to run unchecked, for a while.
But there's a problem with applying this story to commodities. At least in theory, shorts in commodity futures needn't face the same risks as stock short-sellers. Commodity futures are time-bound and perfectly hedgeable. If you are a commodity producer, and know that futures prices are way too high, you can sell your own product forward into the market. If prices move irrationally against you, your only cost is the foregone opportunity of a speculative gain. If cash prices are out of sync with inflated futures markets, then anyone (in theory) should be able to get into the act, purchasing physical commodities and storing them for future delivery, thereby locking in a certain gain, a perfect arbitrage. If you think that the commodity boom is a speculative bubble, then you have to explain not only who is buying, but why all that speculative interest doesn't attract knowledgeable sellers who hold the price to "fundamentals".
A while back, Yves Smith pointed out the possibility that...
the volume of futures contracts is so large relative to the actual deliverable commodity that arbitrage (via taking physical delivery) won't force convergence of futures prices to cash prices at contract maturity.
In other words, in this messy real world, speculative interest could overwhelm the arbitrage mechanism designed to tether futures prices to fundamentals, for a while. But that begs another question. If you buy Masters' story, then we are in the midst of a speculative bubble that has been building over a period of years, not a sudden spike. So why haven't arbitrageurs increased their capacity to store and deliver goods, as speculative demand has slowly ramped up? The opportunity to profit is tremendous, especially if there are hordes of paper speculators who have no choice but to liquidate or roll their positions every few months. People with access to the physical commodity could profit from more than the ordinary arbitrage. At every roll, they have the entire community of "index speculators" over a barrel. Shorts are under no obligation to let speculators close out their positions at inflated "market prices", or even estimated "fundamental values". They can force longs to accept prices that overshoot downward, exacting a price for release from obligations that paper speculators are incapable of fulfilling, the obligation to accept delivery. If you think Masters is right, you have to explain why, year after year, those taking the short side have been willing close their positions at a loss rather than forcing more deliveries. Why haven't shorts entered the market who are capable of calling index speculators' bluff?
Hmm. Let's turn once again to Smith:
Remember, you can arbitrage futures to physical only if you are permitted to do so (only certain traders, known to have access to the storage and transport, are allowed to take or make physical delivery) and can actually obtain the relevant commodity.
So, there are potentially barriers to entry for bluff-callers. So, who are these "certain traders" permitted to make delivery? I don't know, but one would imagine that commodity producers would be prominent among them. So, for the conspiracy-minded among you, here's a theory: Producers' core asset is not the stock of goods they have for sale today, but their potential to produce and sell a stream of commodity out into the indefinite future. It might be worth it for producers to bear an opportunity cost by not exploiting futures trades aggressively — that is by letting specs close positions at artificially bid-up prices — in order to inflate the apparent value of their enterprises, especially when producers intend to borrow funds, sell equity, or make stock-based acquisitions. Managers whose compensation is equity-linked might be particularly enthusiastic. Depending on how numerous and competitive the community of enterprises capable of physical delivery on prominent contracts, there might be a tacit cartel on the producer side, accommodating speculative futures prices, while managing spot supply so that cash market prices (which are less consistent and transparent than futures prices) are not outrageously out of line with futures market benchmarks.
Is this really going on? I have no idea. As I said initially, I can see all kinds of reasons why commodity prices might be rising, besides "irrational speculative bubble". But I do know this. If it is the "index speculators", if it is a speculative bubble, then those who blame workaday money managers asset-allocating into commodities are buying the con and blaming the patsies. If there's a speculative bubble, the mystery — and the target of any reasonable policy interventions — lies on the short side. Sooner or later, the lemmings going long will take care of themselves.
This article has 12 comments:
"There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell."
If you buy a calendar spread you have effectively taken both a long and a short position, else no spread. Saying they never sell may be correct on some level, but ultimately, when you need to be both long and short in order to create a spread, saying you never sold seems a distinction without a difference.
Market manipulation.
Was this supposed to be part of Goldman Sachs supposed "super spike" that they were reporting last week? Sorry GS, the market is getting too smart for you now. Were are the reports showing that we imported 16 million less barrels in the last 4 weeks than over the same time last year. Can you say Demand destruction.
Where will oil be next week when all of those tankers, 2 million barrels each, have to unload. Surplus of 15, 20 million for the week? Let's see what happens to oil prices then. Get ready for the crash and short oil.
The bottom line is that this is not going to end well. As we have seen numerous times in the last 10 years or so speculative bubbles eventually run out of steam. The problem is that they have a tendency to expand further than we originally anticipate. The price will move forward until the speculators begin trying to cash out and they all move for the cash register at once.
It is worth remembering that if this is all marker manipulation, it will correct.
GDC
The key to every bubble is not the actual moneyflow, it is the EXPECTATION of higher prices. The hypothesis is no different here -- Index speculators are not buying houses to live in them, they are buying them on the expectation of perennially greater prices. That someone would sell oil futures (or be short) makes perfect sense as long as the fools remain solvent.
For example I am willing to go short oil here because I think it's hit a top. I may lose, as short have in previous contract months for quite a while, but as long as I don't develop the expectation that crude prices will be perennially higher every contract expiration I will be willing to take the sell side once and a while.
What you're seeing with the passage of time is fewer people willing to take the sell side. The bids on the contracts keep going up, up, up, to convince people like myself to write contracts -- because we don't want to! The skyrocketting price of oil is the result of a TON of PERMA-LONG money dragging reluctant sellers into the market by the only way they can: jacking up their bids.
So too with the housing bubble. As prices ramped up and up speculators were willing to buy, for instance, 3 condos in florida, with bank money, before the condo's had even been built, on the expectation that they could liquidate them for certian profit. There was a buyer and seller for EVERY housing transaction -- except the last one. That's how bubbles work.
There needs to be strict regulations as to who can trade the food and energy commodities. Manipulating stocks is one thing, but manipulating the commodities leads to famine and death. The commodities can't be allowed to be manipulated.
Much more has been found,where as workers at Comex,in the past had directly,or by proxy,traded in silver,takeing hugh gains. Insider trade info, useless regulators,price fixing,is the norm now & in the past. Investment banks have been caught,chargeing fees for storeage,where there was no physical metal to deliver.Investors where paying for a paper promise,that the bank,could not deliver, & all they got was a slap on the hand. Now the ETF's,are nothing but paper promises,that are ripe for the pickens.
It is well noted,that the U.S.,Canada,Perth Mints,have all run out of silver,& now the U.S.Mint has put limits, on Bullion dealers,& the publics Silver purchases.Shortage in scrap recovery,mineing,90% junk, has lag times,that have sent prices higher,but they get shot down,by the Big nameless 4 or more traders, that stand to lose all. It is like who wrote,that if their bluff was called, prices would return to true form, of supply & demand.
Outside,looking in,if CFTC's rush to report there is no manipulation in the Silver market, most likely there is. That would apply to other commoditys.With all of the huge losses by the Giant investment banks,& more to come,would it be a consorted effort,by those same entities,to go any means,to stop there demise,& Oil & Energy ,PM's,Food is a source they, sence housing has dried up. It's sad, Americans will pay hard & long.
Don't forget the Fed,it sells false data to the media,cooks inflation readings,sells out BS,what a crook of crap,that we arein for.
We all tend to be comparing past commodity bubbles (oil, silver, etc) to the present situation. But, is the present the same as the past? We are looking at it from a very insular POV. From the end of WW2 to about 1970, the US was the only game in town. Between 1970-2000, we saw the rise of rival economies, but small potatoes on the whole... they had neither super populations, nor super wealth based on a commodity the world needs.
Is this really deja vu all over again, or have the super-population countries now begun to have a major sucking sound & are the growing appetites of oil-producing countries limiting the amounts of oil they wish to part with?
Someone above said that with US use declining, those supertankers would be sitting offshore waiting to unload. Is that still true? Or do they now have a girl in every port? Have we reached the point where whatever we don't use, someone else will?
Then, we come to the question of how long can the world economy bear the inflation that this will cause? The single thing that the global economy depends upon is cheap & easy transport of goods.
Some will say, that we will simply pull back to local production of foods & goods. Somewhat maybe. However, one of the reasons we went to a global economy was in order to provide resources or goods made from resources to areas that did not have those resources.
At some point, the scale must tip, but then what?
1 United States 13,843,825
2 Japan 4,383,762
3 Germany 3,322,147
4 China 3,250,827
5 United Kingdom 2,772,570
6 France 2,560,255
7 Italy 2,104,666
8 Spain 1,438,959
9 Canada 1,432,140
10 Brazil 1,313,590