Oil splat

by on June 27, 2008 at 6:50 am in Economics | Permalink

It would take too long to sum up the dialogue, by this point you are either following the discussion or not.  A few points:

1. Bryan Caplan asks a good question: "You know now that the price of oil will be flat for five years, then
fall by 10% per year every year thereafter. Everyone else thinks the
price will be flat forever."  Can you profit?  Yes, by rolling over your short positions and constructing a synthetic long-term bet, even if the current futures markets extend for only three years or for that matter one year.  Fischer Black said so, so in other words you do have a chance to put your money where your mouth is.

2. Arnold Kling wonders why so many commodity prices have risen at the same time.  I’ll repeat that fundamental value — and thus the concepts of speculation and bubble — are trickier and vaguer with commodities than in stock markets.  I’ll say that "expectations" have driven the general rise in commodity prices.  If those expectations turn out to be wrong, we can call it all a bubble; if they turn out to be right, then it hasn’t been a bubble.  What should we call it in the meantime?  We’re not going to solve that problem in any factual way.  Make your bets, as they say.

3. Bryan Caplan notes that commodity prices always have fallen back down in the past and argues that is likely to happen again in the future.  I say no, the current price is your best (rough) estimate of scarcity (adjusting for storage costs), don’t expect mean-reversion, future returns (but not prices) are a random walk, and extrapolation is a dangerous method to apply to financial time series.  (For instance every time the stock market has fallen it has bounced back up again but that does not mean you can earn supernormal returns by buying on the downticks; even Shiller finds only small gains here.)  I love Julian Simon too but don’t let him overrule Eugene Fama.

4. Mark Thoma has an exhaustive post on convenience yield.  The models used are too piecemeal and they allow "inventories," "convenience yield," and "speculation," to serve as free-floating, not necessarily attached concepts.  The discussion here pays insufficient attention to Holbrook Working, who knew that convenience yield was front and center of the entire analysis, just as "the demand for money" is the centerpiece of the quantity theory.  Working himself didn’t even think that "speculation" was a well-defined concept in commodities markets; even if he went too far there the concept remains murky.  The current discussions are mixing fundamental conceptual definitions with some broader institutionally-motivated definitions and thus none of the results quite match up.

5. Contra Paul Krugman, invoking convenience yield should not be thought of as an Ptolemaic epicycle or a fudge factor.  The demand to hold oil is the starting point of the whole analysis, see also Jeffrey Williams’s work.  The upshot is that if speculation were driving the current price, it would be consistent with either a premium of the futures price over the spot or vice versa; invoking convenience yield to explain the relatively cheap futures is what you might expect in the first place, speculation or not, bubble or not.

6. Interfluidity has the most careful and accurate exposition of the relevant market relationships, mostly because he sticks closely to the Holbrook Working tradition. 

7. The bottom line is that when it comes to the key substantive questions about the oil market – why are prices so high — the correct answer is the Lachmannian one: "expectations."  If you push one step further on that, and try to evaluate or "source" those expectations, the correct answer is "we don’t know."  Jim Hamilton hints at some of this — and the imprecision of the "inventories" term — in this insightful post.

Addendum: On other practical matters, this new Op-Ed by Paul Krugman is essentially correct, although his claim that speculation is impossible in the iron ore market shows, better than anything else, the oddity of his semantic choices.

Anonymous June 27, 2008 at 8:03 am

We’ve walked a long way down a very twisted garden path, only to find ourselves where we started. What’s going on with oil? We now have several lengthy, insightful, and erudite answers that collectively amount to: Nobody really knows.

meter June 27, 2008 at 8:50 am

I’ve just read a headline this morning en route to work that coffee prices are expected to leap up in the near term. The reason given wasn’t increases in gas prices, but rather a weather-related excuse.

I think this a case where (edible) commodity providers and those in consumable businesses are piling on now that they smell blood in the water.

I doubt there is this much interconnectivity between what seem to be disparate commodities.

Floccina June 27, 2008 at 9:40 am

The first thing to remember when one considers petroleum prices is that we are really buying a certain amount of travel at certain level of comfort and prestige. So there are many possible substitutes and even a change in attitudes toward prestige can reduce the amount used. If saving petrol becomes cool no telling what can happen. (see the BMW c1 200)

So my bet is that though petroleum prices may not return to the mean what we really buy most likely will (this is a 60%/40% for me).

RobbL June 27, 2008 at 10:33 am

Tyler,
Now wait a durn minute. You express (with a 60% certainty) three significant figure predictions about the future of humanity in billions of years, but on the price of oil in a year or two you are all “we don’t know”.

I say your mind works in a funny way….but then that is why I like this blog.

odograph June 27, 2008 at 11:27 am

bb, a lot of answers to the question “where are the inventories” have been given. One that IMO works is that new investment money drove up the price of futures contracts, and as those contracts matured, end users were willing to pay the new price.

As to why it didn’t happen sooner, without the inrush of investment monies … I think the oil producers were not as aggressive about forcing price discovery. Their stated goal has always been a “target price” that in their mind maximized return without driving political or economic response in customer nations.

I suspect that producers might be of two minds now that this has happened. They surely love the money, but might wonder if a collapse in demand is to follow.

Anonymous June 27, 2008 at 8:06 pm

If you add up the Ptolemaic epicycles you get the Fourier series for elliptic motion.

mickslam June 29, 2008 at 1:33 pm

“Tyler (or someone), can you please elaborate? After all, Bryan asked that people spell it out carefully. :) At EconLib people were talking about using forward contracts, but I think that skirts the spirit of Caplan’s challenge. You are saying you can construct it synthetically. OK, how, exactly? What do you mean by “rolling over your short positions”? The whole point is that when the rest of the market discovers what is going on, any short position you hold at that moment won’t overlap with the time where the price forecast has changed. So why would you profit?”

This question is tough to explain. The initial formulation of stable prices and a 10%/year decline in starting 5 years would only occur to an economist.

The answer is that you can in fact roll over your positions with ease, but that this roll might be expensive if you are not extremely cautious. I suspect that it might even cost you more than you could make in the trade.

Note that you only need to be short during the time period where the market adopts your view, not before or after. Additionally, macro style re-valuations of the 10%/year cannot happen overnight, the price movements are too large and will be resisted by significant capital.

One thing that needs to be stressed is that long term trades are rarely worth spending time or money on. Why do you think Buffet only add to his core companies very rarely? It’s because he can’t find enough trades where you make the 50% per year on them. In this trade, you will be compelled to have a trade on for somewhere between a year and a decade before the consensus matches your knowledge. The ability to hold on this long will test the most disciplined investor.

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