Speculation and the Price of Oil: An Unfriendly Note 25 comments
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Not too long ago I took the liberty of publishing several short papers on speculation and the oil price. Needless to say, I felt it necessary to publish them in more than one place, and also to exploit my beliefs in this matter in several lectures, both formal and informal. My opinion – or perhaps I should say my often-repeated opinion – is that speculation is of secondary importance for explaining other than transitory movements in the oil price, and instead the key explanatory factors for oil price ‘trends’ can be derived from orthodox economic logic associated with the buying and especially the selling of physical oil.
One of my favorite daydreams features me standing in front of a blackboard somewhere, discussing e.g. speculation and the oil market, and suddenly hearing a sturdy, confident voice from some corner of the room informing me that I don’t know what I am talking about. It has been so many years since something of that nature happened, that should it take place in the near future, I probably would find myself immediately reaching for a double dose of aspirin or smelling salts, or asking if there was a doctor in the house who could check my hearing. The problem – as the late president Lyndon Johnson once pointed out – is that very few individuals possess an extensive knowledge of financial or financial-like markets, although in my teaching in half a dozen countries, I have never had the slightest problem explaining to first year students how speculation works in commodity markets.
In my investigation of the present oil market picture, the first thing I noticed was that the elite of academic economists were unable to see any value at all in the contention that speculation was behind the oil price rise of the last few years. I see no harm at all in ignoring the judgement of prominent academicians, since many of those ladies and gentlemen occasionally operate in cloud-cookoo land, but the issue here has to do with the interior logic of a very simple financial mechanism. Professor Ben Bernanke, boss of the US central bank (The Federal Reserve), obviously has little or no knowledge of what the oil futures market is all about, however I am generous enough to believe that he could correct this shortcoming in a very short time, and would immediately be able to draw the correct conclusion about what might be called the ‘force of speculation’ in oil derivatives (i.e. futures, options and perhaps swaps). As far as I know he hasn’t expressed himself on this topic, but the US Secretary of the Treasury has, and it warms my heart that Mr Paulson’s verdict matches my own.
A DEFECTIVE POINT OF VIEW
One of my favourite publications was – was – the OPEC Bulletin during the many years in which when they accepted a large number of my articles and comments. They changed their format however, and so now I am in the same position with them as I am with the journal Resources Policy, which I helped to launch with many articles, notes, comments and reviews, but where eventually my humble efforts were judged unworthy, and my name was removed from the list of editors.
In the most recent issue of the Bulletin, there is a long discussion of a song-and-dance for a US congressional committee by Mr Michael Masters, a portfolio manager operating out of the Virgin Islands. According to that seasoned veteran of the financial wars, “While some in my profession might be disappointed that I am presenting this testimony to Congress, I feel that it is the right thing to do.” What he apparently wants is the banishment of a certain component of oil market speculation – identified as oil “index funds” – from the face of the earth.
Unfortunately I am not in his profession, but I definitely am disappointed that the United States Senate Committee on Homeland Security and Governmental Affairs would have the slightest interest in the theories of someone whose reading of the oil price differs so drastically from that of a consensus of financial scholars. Most of the latter have pointed out to academic forums and sometimes to the media that two of the avenues for speculation in commodities are speculation in futures (or paper) markets, which DO NOT lead to the (sizable) accumulation of physical inventories, and speculation in physical (i.e. actual) markets that DO lead to the accumulation of physical inventories.
The latest BP Statistical Review of World Energy shows in a single simple diagram that there has not been the accumulation of physical inventories implied by Masters. I would like to make it clear however that it doesn’t make any difference to me what that or any other diagram or exposition or anything else shows, because Masters and other persons designated by the Bulletin as “energy analysts” have not presented a credible review of how physical inventories influence speculation. Instead they have fixed their attention on ‘open interest’, which is a readily available though for this topic largely irrelevant statistic that measures the volume of transactions in the ‘paper’ market. Moreover, they have misunderstood this item, in that they have failed to take into consideration the frequency of turnover in futures contracts. A contention that an accelerated build-up of non-physical (i.e. paper) inventories is responsible for injurious speculation in the physical market is a concept that would hardly be viable in the finance department of a storefront university, and the same is true of the attempt by the Bulletin’s commentator to tie index speculation to the swaps market.
I have attempted in my new textbook (2007) to clarify these matters, and I can also mention that one of academia’s superstars – Professor Paul Krugman of Princeton University – correctly identified the behaviour taking place in futures markets as analogous in some respects to that taking place in a casino. Incidentally, this is not a bad thing, because this ‘sham’ buying and selling – as it has been called by Professor Michio Morishima – is necessary for providing the liquidity that allows transactors in physical oil to hedge their positions.
A question that might be pertinent here concerns the motivation bringing Mr Masters to Washington in order to make his expertise available to our political overlords. The difficulty seems to be his pique with ‘index speculation’ which, according to the Bulletin article, , has led to the “stockpiling”, via the futures market, of 1.1 billion barrels of oil. My comment here is that anyone who believes this would believe anything. According to the Bulletin, the US House of Representatives has passed legislation directing the Commodity Futures Trading Commission [CFTC] to use its authority to “curb” excessive speculation. This is interesting , because earlier the CFTC unambiguously denied that ‘excessive’ speculation is responsible for the high price of oil.
SEVERAL CONCLUDING OBSERVATIONS
The reason for the Bulletin article about Mr Masters and his crusade against speculation can almost certainly be attributed to the desire of OPEC to convince importing countries that high oil prices are caused by speculation, and not the strategy employed by oil exporters exercising their market power as well as an increasingly impressive knowledge of how the oil market functions.
Here I can repeat something that I published earlier, which is that instead of increased investment by OPEC oil producers, what we are going to witness is the adoption of an optimal development economics scenario by many OPEC countries, with profits from high oil prices being used to promote diversification out of oil. I am certain of this because it is the kind of thing I taught at the African Institute for Economic and Development Planning (in Dakar, Senegal) a few centuries ago. Moreover, the higher the profits the more intensive the diversification. Perhaps the best examples of this can be found in the Gulf.
Can we justify this kind of behaviour with conventional economic theory? The answer is yes, because oil is a wasting asset, and (ceteris paribus) it makes all the sense in the world to preserve it as long as possible. Thus it can happen that a fall in demand for oil will be met by a decline in its output, because regardless of what you may or may not have heard, the value of oil in the ground will not suddenly decline due to the modest availability of e.g. alternative motor fuels.
In the discussion of the influence of speculation on physical prices, it may be easy to believe that a frenzy of speculative buying (in the paper market) will be followed by behaviour in the physical market that will bring about a substantial increase in the price of physical oil. This may of course happen to a certain extent, although there is no scientific reason for the correlation. What about going in the other direction, with a frenzy of speculative selling leading to a price decline. According to the economics and finance that I teach, this will not happen – although, ironically, it could be witnessed at any time, because to a certain extent the real world is different from the one described in mainstream economic theory, though in the matter of oil, at the present time, not so different as many observers believe.
REFERENCES
- Banks, Ferdinand E. (2007). The Political Economy of World Energy: An Introductory Textbook. London and Singapore: World Scientific.
- Banks, Ferdinand E. (1980). The Political Economy of Oil. Lexington and Toronto: D.C. Heath.
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This article has 25 comments:
you are smart like hell. But you are suffering from logorrhoea. Your message gets lost in the self indulgence of your verbiage. Be concise and stay on message in your next post.
Unknown
modernenglishusage.blo...
That's rather ironic, Mr. Prominent Academician... Boasting about yourself makes it hard to believe you. You don't have to try so hard. Just tell us your point of view.
Please learn to write clear and concise articles. and GO TO
www.stopoilspeculation.../
and sign the petition. And then, read the article by Ed Wallace at:
www.star-telegram.com/...
Then retract your false statement about there being no price manipulation in Commodity Futures Trading.
too many commitees/too much government oversight[oops! oxymoron?]/too little working knowledge on most subject matters. one would think, absent term limits, performance/capabilit would improve. it must be the disincentives in gov't.
any opinionon queueing being partial driver behind price volitilty in tight market? [ref K. Cobb 8/11/08 321energy article [further references- Deffreyes, Sachs]]?
Fred
On Aug 27 11:08 AM Umm, yeah wrote:
> "I see no harm at all in ignoring the judgement of prominent academicians,
> since many of those ladies and gentlemen occasionally operate in
> cloud-cookoo land,
>
> That's rather ironic, Mr. Prominent Academician... Boasting about
> yourself makes it hard to believe you. You don't have to try so hard.
> Just tell us your point of view.
You said that I didn't believe that there was price manipulation in the commodity futures market. I think that you should read my finance book. What I say in that book is that there is more than ever.
But if you read my 'note' , you should be able to draw the conclusion that the futures market has only a marginal significance for the oil price.
Fred
On Aug 27 01:11 PM jjason wrote:
> I can't remember where you lost me...it could have been at coocoo-land
> or when you needed aspirin.
>
> Please learn to write clear and concise articles. and GO TO
>
> www.stopoilspeculation.../
>
> and sign the petition. And then, read the article by Ed Wallace at:
>
>
> www.star-telegram.com/...
>
> Then retract your false statement about there being no price manipulation
> in Commodity Futures Trading.
That's the first time I've been called that. What I call myself is a great academic energy economist and teacher. And teaching is the reason for these contributions of mine. Yes, speculation has some effect on expectations where the oil price is concerned, but as prominent financial scholars will inform you if you ask, the story in the oil market where the price is concerned is the tendency for demand to outrun supply.
Fred
On Aug 28 03:24 AM Fred Banks wrote:
> Let's see now. Usually my papers are about 15 pages long. This one
> was four. Maybe I should just get a mobile phone and limit my remarks
> to 30 seconds.
>
> Fred
I make a point of staying away from false statements. In fact I dont know of any academic who makes fewer false statements than my good self. The reason is that hardly anybody has studied these matters to the extent and with the intensity as myself. Of course, I have certain advantages that other people don't have. I failed college algebra twice in engineering school and as a result was expelled for poor scholarship. That concentrated my mind.
My new textbook is being reprinted, and I must admit that in going through it I found more than a few slips and misunderstandings. But as for false statements...I think that you can take my opinion of speculation and oil to your local bank and draw...draw the attention of security on it.
Fred
On Aug 27 01:11 PM jjason wrote:
> I can't remember where you lost me...it could have been at coocoo-land
> or when you needed aspirin.
>
> Please learn to write clear and concise articles. and GO TO
>
> www.stopoilspeculation.../
>
> and sign the petition. And then, read the article by Ed Wallace at:
>
>
> www.star-telegram.com/...
>
> Then retract your false statement about there being no price manipulation
> in Commodity Futures Trading.
I like this article. As soon as readers have returned from their holidays I intend to spread if all over the place. Please believe me when I say that I would never do that if I thought that it was "crappy". But I confess that I have published many articles - and a few books - that should never have seen the light of day.
George Best, the great soccer player, once said that when people tried to make a fool of him, he didn't get physical with them but just made them feel so inferior that they never wanted to get near him again. I practice the same thing in seminars and conferences, Crappy? Can we get a show of hands on that?
On Aug 27 08:33 AM Ax wrote:
> I suggest you publish your articles (papers) here, instead of this
> crappy article which consists of cheap advertisements for your already
> published works. We need data, charts and the rationale that is derived
> from that data... This is not an ad campaign.
Your Treas Sec, who not too long ago came over from GS, would in NO WAY say that the OIL Pricing Problem was a result of "SPECULATION"...WHY? well, 1)- He would Be Kicked of the Team as this goes against the B/C Regime's Promise to BIG OIl for Drill, Drill Drill!...and his time is running out.(Although Bush finally mentioned that there was a little bit of that in there..)
2) But more interestingly. It amazes me just how many of the 'educated pundits' - educational, media and political are so blind to reality. MM did not invent "This New Passive Long Investor" and the concept of Commodity Index Funds that ignore the principles of supply and demand in the futures markets. NOPE - he didn't jusut make this theory up.... Guess who INVENTED these new players... If you didn't guess the Golden Boys, then you got ti wrong. And more interesting, the whole idea of this and its first major promotion was done during the years that your boy, the Treas Sec, was at the head of GS.
Do you think for one moment with all the heat coming down on GS and the CFTC, which is not under a DJ investigation for whether or not their "INTERIM REPORT" on Speculation was so benign and released inappropriately as if perhaps it was done so by pressure from the top, that Paulson WOULD SAY ANYTHING ELSE BUT THAT the extreme price run-up was a result of anything other than - Duh, "Chinese Demand"...Wake up my friend!
Follow the money trail and see who needs to protect/cover up something and you will always find the parties responsible for the problems.
G
(sorry)
Try to do this task: Try to read your article every day for a period of 10 days... and ask yourself this question: "What are the things I could have left out, and still would deliver the main points to the reader?"
I mean in this article you have a sentence that begins with: "Needles to say..." If it is needless leave it out!
What is the purpose of this paragraph:
"One of my favorite daydreams features me standing in front of a blackboard somewhere, discussing e.g. speculation and the oil market, and suddenly hearing a sturdy, confident voice from some corner of the room informing me that I don’t know what I am talking about. It has been so many years since something of that nature happened, that should it take place in the near future, I probably would find myself immediately reaching for a double dose of aspirin or smelling salts, or asking if there was a doctor in the house who could check my hearing. The problem – as the late president Lyndon Johnson once pointed out – is that very few individuals possess an extensive knowledge of financial or financial-like markets, although in my teaching in half a dozen countries, I have never had the slightest problem explaining to first year students how speculation works in commodity markets."
Is there any value added here about oil speculation? You could have said it in one sentence, if you wanted - the problem is the lack of knowledge of financial markets. Why you couldn't do that? The paragraph is aimless in regard of the topic you are writing about, but is it absolutely NECESSARY to show the true nature of your self.
What it shows is your need for confrontation as you put it: it is your favorite daydream!
I suggest you try some creative writing where you will be able to express your true emotions. You will also get some tips about being articulate. Otherwise your readers will need aspirin in massive dozes and they will not be daydreaming about that.
As for your footballer story let me tell you one. Heidegger was laughed at and considered a clown by his critics. And yet, today everyone knows who Heidegger is, and no one knows the names of his critics.
There's a story you can tell to yourself after critics will tear you apart. Because if no one will tear you apart, then you really haven't written anything important at all.
But you like your article. So you will not improve your apparent lack of writing skills. You are just perfect.
A Chinese architect once said to me: "My aim is to work 6 hours and a half if my competitors work 6 hours. And if my competitors make 6 mistakes, my aim is to make only 5 of them."
So, yeah this is a crappy article. It could have been shorter by 2/3.
But that's all I'll say about that, because I suspect that you and I agree on more than we disagree.
Fred
you can be a brilliant economist and a wonderful teacher. I am not saying you are not, because I have never read any of your works and I never attended your lectures. But this article could have been shorter and have more content. That's all.
Have a nice day.
So there is your 3 sentences, but personally I think that 300 would be more suitable.
Fred
Now all an uneducated reader as myself needs is the answer to:
"The question is how much, and I say that because of the mechanics of the paper markets, not much at all."
I don't know what are the mechanics of the paper markets, and I don't know where the "not much at all" comes from... so that is what a reader in the land of the darkness needs an answer to.
Now you get the 297 sentences and explain.
I mean, I don't need an explanation here, since I never invest in commodity markets due to the crazy speculative gambling casino that it has become. But that is how an article should be written in my opinion. At least in a non scientific journal as seeking alpha.
I'm pretty sure you would get better reviews from the investors community.
I wish you all the best.
Regards.
Ax
Fred