More on speculation

by on June 29, 2008 at 7:03 am in Economics | Permalink

Here is Paul Krugman’s model, Mark Thoma covers related ground.  I view this as an intertemporal Hotelling model and not as analogous to a currency model as Krugman suggests.  In the bottom right hand graph of the four graphs in Krugman’s post, I don’t understand what institutional force hinders a market-clearing price.  More concretely, if expected future price goes up (or interest rates fall), the supply curve in that graph should shift back to the left (wait and pump more later for the higher price) and/or the demand curve in that graph should shift out to the right (buy now rather than later at the higher price).  Measured inventories will rise to the extent the demand curve does the shifting; if the supply curve does the shifting the "excess inventories" stay in the ground.

It is possible to derive Krugman’s desired result through another and indeed simpler channel.  Define speculation as the desire to hold more oil because of the perception that oil now has a greater convenience yield.  As Jeffrey Williams points out, a big part of convenience yield is the option value of selling the oil on favorable terms.  If you’re guessing that option value will pay off, it’s not unreasonable to call that speculation.  We now have a one-line proof: because of "speculation" the demand to hold oil goes up, and so the stocks of oil held will rise.

This again illustrates the value of starting with Holbrook Working when analyzing futures markets.

And it’s fair to say, as Krugman still does, there is no evidence that this mechanism is what is driving the higher oil prices.  Of course the people who are blaming "speculation" don’t seem to have any coherent definition of the concept in mind; that’s another problem with their argument. 

Ward June 29, 2008 at 7:20 am

I always thought speculators were both buyers and sellers attempting to guess the short term direction of the price of whatever they were speculating on, however, in this debate, it appears to me that the institutions who are allocating large sums to the futures markets and thereby taking contracts out of circulation are being called “speculators” even though that is the exact opposite of what they are trying to accomplish. I do think its likely that their actions have reduced liquidity in these markets and thus added to volatility but that is because they don’t sell so we actually need more speculation not less.

Matthew C. June 29, 2008 at 9:29 am

I think there is entirely too much talk about theory in these posts on oil prices and whether or not they are being driven by speculation.

At the bottom line, those who endorse the “speculation” hypothesis believe that oil is behaving like other bubble markets, and that the price of oil will “crash” soon. Those who propose that the current price of oil is rational believe that the price of oil will continue at or near the current level for many years to come, or even continue to increase.

I belong to the former camp, I am nearly certain that the huge price increases in oil are due to flows of hundreds of billions of dollars chasing returns, having left behind the equity and real-estate markets.

The way to determine who is right is to revisit this question in three years — if the price of oil has dropped significantly from today’s price then this was a typical bubble, whereas if the price of oil remains at current levels or increases then the oil price was driven by fundamentals.

Bob Murphy June 29, 2008 at 10:34 am

In the bottom right hand graph of the four graphs in Krugman’s post, I don’t understand what institutional force hinders a market-clearing price.

Tyler,

I apologize if you were just saying that rhetorically, in order to setup your subsequent points. But in case you really don’t get what Krugman is doing there:

The price is market-clearing, when you consider the demand for oil by both flow users and speculators (who are accumulating inventory). But the right hand graph just depicts the demand from flow users (refineries, etc.).

So this just illustrates Krugman’s point all along, that if speculative demand is holding oil prices above the “fundamentals” of supply and demand by end users, then there should be a surplus (when just viewing the “fundamentals” of the market) and that’s why there should be growing inventories.

So it’s like when you’re doing international trade, and draw the domestic supply and demand curves, and a world price above their intersection. That leads to a surplus in the domestic market, which is then sold abroad.

odograph June 29, 2008 at 10:42 am

I don’t really understand these graphs, but I assume they cannot disprove the idea that “investors” (does that word avoid “blame?”) helped drive price discovery, without changing production, consumption, or inventory.

I assume that this price discovery idea is rejected because it is like the proverbial $100 bill on the street, no economist will bend over to pick it up, because it cannot be there.

tt June 29, 2008 at 12:33 pm

I think it’s a mistake to bring physical inventory into thisdiscussion. Very few players in the futures market will end up delivering or taking delivery of the oil. In fact, very few of them are even looking at the price of the futures they are buying. Traditional buy-and-sell speculators aren’t the problem. It’s the buy-and-hold long term investors that are sucking up all the liquidity in the market.

oops June 29, 2008 at 6:33 pm

as i understand it, none of the prices of publicly traded oil companies reflect a current oil prices. most do not reflect $100+ values of their reserves. it would be easier for specualtors to just buy these. they don’t expire monthly like futures prices.

Bob Murphy June 29, 2008 at 8:03 pm

Oh, Tyler, one other thing: I wouldn’t bet my life on this, but in the context of Congress and Masters’ testimony, doesn’t the supply curve need to stay still? I.e. let’s say the expected future spot price of oil goes up, and so (per your suggestion) the supply curve in Krugman’s bottom right graph shifts to the left.

Well if that’s what’s going on, then it’s clearly not Goldman Sachs causing the spot price of oil to go up. It’s rather that the Saudi ministers changed their views about the future, and so cut output today.

Do you get what I’m saying? In order for today’s spot price of oil to be due to institutional investors, then you have to use a demand story to get the price up. E.g. Goldman Sachs buys oil futures, that pushes up futures price, and so Saudi Arabia shifts some marginal barrels out of current output and into future output.

So in summary, I think that Krugman could say if you are right about the supply curve moving, then that’s not an example of “speculators causing oil price to rise.”

RN June 30, 2008 at 9:16 am

No, unfortunately Krugman’s right. He even clarifies on his blog this morning.

I love your work, Tyler. But I think you’re playing out of your league on this one.

odograph June 30, 2008 at 10:53 am

Shorter: but by all means let’s draw some graphs that convince us otherwise.

Dem Agog July 3, 2008 at 9:37 am

I’m with Tyler. I find the logic used by Krugman, Thoma (and James Hamilton) to argue increasing current inventory levels are a necessary condition for speculation and/or bubbles uncompelling, especially in the presence of a futures market.

Bob Murphy said:
“Well if that’s what’s going on, then it’s clearly not Goldman Sachs causing the spot price of oil to go up. It’s rather that the Saudi ministers changed their views about the future, and so cut output today.

Do you get what I’m saying? In order for today’s spot price of oil to be due to institutional investors, then you have to use a demand story to get the price up. E.g. Goldman Sachs buys oil futures, that pushes up futures price, and so Saudi Arabia shifts some marginal barrels out of current output and into future output.

So in summary, I think that Krugman could say if you are right about the supply curve moving, then that’s not an example of “speculators causing oil price to rise.”"

In this example, it seems one could still argue that Goldman Sachs’ speculation is the root cause of price increases. Marginal speculation in futures markets raises the futures price relative to the spot. The Saudi response (or any other marginal oil producer’s decision) is purely an endogenous response to incentives: they would want to take the other side of Goldman’s bet by committing to deliver the futures contract at the expense of oil production today. As oil demand is very inelastic in the short run, the spot price of oil will rise, which will significantly reduce the motive to cut back supply. Thus, we have a purely speculative move, with large impacts on price but virtually no short-term impact on inventories or production.

Of course, like any sane economist, I don’t really believe that a conspiracy of speculation is driving up oil prices. Current commodity pricing trends merely reflect the recessionary flight to quality dynamic we’ve seen many times in the past. It’s not like oil is the only commodity booming right now…

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So it’s like when you’re doing international trade, and draw the domestic supply and demand curves, and a world price above their intersection. That leads to a surplus in the domestic market, which is then sold abroad.

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