Inconsistent McCain

by Don Boudreaux on July 23, 2008

in Politics, Prices

Here’s a letter that I sent today to the Wall Street Journal:

John McCain credits the recent fall in oil prices to President Bush’s announced support for more off-shore drilling and, hence, to the fact that the future supply of oil likely will be higher than previously thought. (“McCain Credits Bush For Drop in Oil Price,” July 23).  Sen. McCain also blames the preceding run-up in oil prices on unjustified speculation.

Sen. McCain can’t have it both ways.  Oil prices either chiefly reflect the underlying reality of supply and demand or they don’t.  If baseless speculation caused oil’s price to rise to heights unjustified by supply and demand – if speculators are financial sorcerers who detach prices at will from underlying economic realities – how does a presidential announcement signaling higher future supplies cause lower prices?  On the other hand, if a more promising prospect of greater off-shore drilling really is responsible for pushing oil prices downward (which I think more likely), why would Sen. McCain ever have blamed high oil prices on evil speculators rather than on the underlying conditions of supply and demand?

Note that I’m not saying here that speculators cannot drive prices to heights (or depress prices to depths) that are, on some reasonable calculation, inconsistent with the underlying conditions of supply and demand.  I concede the reality of bubbles, both positive and negative.  My point is that McCain is playing politics (duh!) to scream “evil speculators” when oil prices are rising and then announce “supply and demand” when oil prices are falling.

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Sam Grove July 23, 2008 at 5:32 pm

Politicians can say anything, anytime, about any subject, without any basis in reality.

I just wish this could be explained to 'progressives'.

Danny July 23, 2008 at 6:49 pm

While I agree that speculators aren't evil and aren't the cause of oil price run ups, I don't think Bush had anything to do with the drop in oil price drops. Chart USO or UNG, or any of the oil companies vs the XLF, the ticker that tracks financials. It's pretty clear that oil and gold are a sign of the lack of confidence in not just the dollar, but the worldwide financial system.

Martin Brock July 23, 2008 at 9:48 pm

I concede the reality of bubbles, both positive and negative. My point is that McCain is playing politics (duh!) to scream "evil speculators" when oil prices are rising and then announce "supply and demand" when oil prices are falling.

You don't get it. It's not about the offshore drilling. Opening new, offshore areas to exploration and drilling takes years, even decades, to produce new oil. Oil futures contracts expire in months, not decades. The speculation driving up prices recently has nothing to do with offshore drilling. This explanation is nonsense on its face.

So why does McCain say so? Because the actual speculation driving up the price of oil is speculation over what McCain himself, and men like him, will do in the near future, like bombing Iran's uranium enrichment facilities. McCain clearly can't stand up and say, "Speculators are driving up the price of oil, because I'm constantly rattling sabers at Iran." Then he would be responsible for your $4/gallon gasoline. In fact, he is responsible for your $4/gallon gasoline, but he can't say so, so he must say something else.

And it's not an irrational "bubble" either. The speculation is not based on any calculation "inconsistent with the underlying conditions of supply and demand." The problem is that no "reasonable calculation" of this balance, over the next few months, exists at the moment, because incredibly irrational, individual men, like George W. Bush and Dick Cheney and John McCain, really can radically alter this balance with a stroke of their pens, and they really might, and no one knows what they'll do. The balance of speculation recently has supposed this outcome likely, and since this outcome is likely, a greater scarcity of oil in the near future is also likely.

Michael Miller July 24, 2008 at 12:07 am

I mostly agree with Martin's assessment.

The short term price dropped because consumption decreased in response to rising prices. This is basic supply and demand theory.

I do not believe McCain is being complex. He is playing a simple card that had been dealt to him. The price drop was a gift and he turned it to his advantage.

The saber rattling is the real cause of the sharp price rise, I agree.

The Iranians it should be remembered will have a say in how this little game turns out.

foxmarks July 24, 2008 at 2:39 am

Martinduck begs a question by announcing, “The speculation driving up prices recently has nothing to do with offshore drilling.”

Those grounded in economic principles would not join the anti-speculator pogrom. Speculators are not “driving up prices.” A bubble is inflated by irrational buying. If global politics are reducing certainty about future oil supplies, securing supply today is entirely rational.

Those grounded in the US Constitution would not rattle their sabers against “Dick Cheney”, as the stroke of a Vice President's pen can enact zero legislation and change zero Executive Orders.

Yet, the ’duck might have stumbled into some light when assigning responsibility (note that blame is a judgment, not a fact) to McCain. Senators do vote on Federal legislation. So, yes, men like McCain, Obama, Kennedy, Reid, Boxer, and Clinton all share some responsibility for the exaggerated scarcity of domestic oil supply.

Further, the ’duck demonstrates ignorance on futures markets. NYMEX today trades contracts for crude oil delivery through December 2016 ($126.49/bbl). That's 100 months out.

Martinduck must expend awesome effort to remain impervious to fact. Truly, a marvel of psychological engineering.

Don Boudreaux July 24, 2008 at 5:44 am

May I ask that commenters stop calling each other names? That someone has a different point of view from yours — or from the proprietors of this Cafe — does not mean that they are unworthy of being taken seriously or proper objects of ridicule.

Martin Brock July 24, 2008 at 10:41 am

A bubble is inflated by irrational buying.

Right. If buying is so manifestly irrationally, why aren't many others also selling? Of course, investors are selling oil futures now, because as Michael says, reported consumption is falling and because the U.S. is now engaged in talks with Iran after years of refusing any negotiations without preconditions. The events most directly correlated with the recent fall, and also related in any way to the balance of supply and demand for oil over the next six months, are the events surrounding Iran. The talk of new exploration for offshore oil is not related in any way to the balance of supply and demand for oil over the next six months.

If global politics are reducing certainty about future oil supplies, securing supply today is entirely rational.

Of course, it is.

Those grounded in the US Constitution would not rattle their sabers against “Dick Cheney”, as the stroke of a Vice President's pen can enact zero legislation and change zero Executive Orders.

I wrote "George W. Bush and Dick Cheney". Cheney is a powerful influence on the POTUS, particularly in this area, and his public pronouncements are certainly among the signals that investors watch.

So, yes, men like McCain, Obama, Kennedy, Reid, Boxer, and Clinton all share some responsibility for the exaggerated scarcity of domestic oil supply.

Of course, they do. The current supply is not the issue. The future supply, particularly over a year or less, is the issue, because futures contract trading dominates the price. The scarcity in the near future is not exaggerated. It's uncertain, and it's highly uncertain at this point, because politicians threaten to alter it radically in the near feature.

Further, the ’duck demonstrates ignorance on futures markets. NYMEX today trades contracts for crude oil delivery through December 2016 ($126.49/bbl). That's 100 months out.

According to the Federal Reserve Bank of San Francisco, "The observation that futures prices are more useful in forecasting near-term oil price movements may reflect the fact that the near-term oil futures markets are much more liquid than longer-term futures markets. For instance, the average daily trading volume of the "light, sweet crude oil" futures contracts on the New York Mercantile Exchange over the past two years is about 72,600 contracts for a horizon of one month, 22,000 units for two months, 4,800 for four months, and only 1,000 units for the one-year horizon (one unit represents 1,000 barrels).

http://www.frbsf.org/publications/economics/letter/2005/el2005-38.html

The trading volume for contracts expiring in 100 months is probably less than one percent of one percent of the volume of contracts expiring in less than a year, so the longer term trading is negligible; however, even if I'm betting on the price 100 months out, short term events still matter. A war with Iran wouldn't end in a day, any more than the Iraqi occupation ended in a day. If I see the 100 month contract falling in lock step with the short term contracts, I'm still seeing speculation over near term events, near term events with long term consequences. Expanded exploration for offshore oil doesn't fit this description, although reports of falling consumption might. The elasticity of demand is uncertain.

Martinduck must expend awesome effort to remain impervious to fact. Truly, a marvel of psychological engineering.

To substantiate this assertion, you'll need to find some facts I'm impervious to. Your 100 month price is no lower than the current price. How does your theory account for this fact, ducky?

TIGERSHARK July 24, 2008 at 12:30 pm

Futures contracts are liquid – the traders can offset a position on any given date by entering into the opposite position. Hence, 100-month contract does not require holding out the contracts till the settlement date (100 months from now).

Futures prices on commodities such as oil are determined by spot prices and other observable variables. Otherwise arbitrage opportunities arise and push the price back to equilibrium. If one wishes to blame speculation and irrational prices as the causes for recent high oil price, it is only fair that such claim be supported by economic argument, including the channel through which derivative such as futures contracts affect commodity spot price.

Martin Brock July 24, 2008 at 12:59 pm

Futures contracts are liquid – the traders can offset a position on any given date by entering into the opposite position. Hence, 100-month contract does not require holding out the contracts till the settlement date (100 months from now).

That's right, but buying a contract for delivery in 100 months today is not equivalent to buying a contract for delivery in six months today. The price I pay for the 100 month contract depends on my expectation of the price in the next 100 months. The price I pay for the six month contract depends on my expectation of the price over the shorter term. The longer term includes the shorter term, but the shorter term doesn't include the longer term.

If one wishes to blame speculation and irrational prices as the causes for recent high oil price, it is only fair that such claim be supported by economic argument …

A contract for delivery of a thousand barrels of oil tomorrow differs little from an oil dealer's promise to sell me a thousand barrels of oil today at the spot price for immediate delivery, since I probably can't take immediate delivery anyway. The difference between "immediately" and "tomorrow" in this context is probably negligible in most cases.

A contract for delivery in six months is not equivalent to a promise of delivery tomorrow, so these contracts may trade at a different price. If I don't want to buy and store oil I need in the future until I need it (a costly proposition) and if I expect the spot price to rise over the next six months, more than offsetting the storage cost, I'll pay more today for the promise of delivery in six months. Since my knowledge of the future is uncertain, this higher price is "speculative" by definition. Speculation is not controversial. It's inevitable. We all do it every day.

Martin Brock July 24, 2008 at 1:36 pm

So McCain is saying, "I may speculate about bomb, bomb, bomb, bomb, bombing Iran, and my bombing may disrupt oil deliveries that you need in the future, but you may not pay more for oil deliveries in the future as a consequence, because that wouldn't be just, right, proper and noble. Now, be a good, patriotic American and pay the price I tell you to pay for future oil delivery."

Methinks July 24, 2008 at 1:47 pm

If I don't want to buy and store oil I need in the future until I need it (a costly proposition)…

Martin, you always pay the storage costs, whether you take immediate delivery or not. The futures contract price includes the cost of storage for the length of the contract in the "carry". As a consumer of oil, buying a futures contract for delivery in six months locks in delivery at today's oil price. To lock in the delivery at today's price, you pay the carry.

Martin Brock July 24, 2008 at 5:32 pm

Methinks, Thanks for clearing that up, but the price for delivery in six months can't be the current price plus a storage cost. It must include expectations of rising price; otherwise, I'd just wait and buy my oil in six months. Why pay to store oil if the spot price will remain the same or fall?

"I need the oil in six months" is not the answer to this question. I can always buy oil in six months at some price.

foxmarks July 24, 2008 at 7:05 pm

“That someone has a different point of view…does not mean that they are unworthy of being taken seriously or proper objects of ridicule.”

You assume the ridicule arises from, “a different point of view.” Perhaps the ridicule arises from a non-logical and ludicrous argument regularly repeated, or from annoyance at witnessing willful ignorance. At what point is it appropriate to call flat-earthers wackjobs? Would you maintain that universal gravitation or downward-sloping demand are merely “points of view”?

foxmarks July 24, 2008 at 7:16 pm

Brock, I did not assert a theory. You posted on a flawed premise, and sprinkled in some rhetorical garbage. I called BS, and sprinkled in some abuse to keep myself amused. Now you backpedal. You exhibit the same behaviour as McCain.

I have trouble identifying now what point you are trying to make, or which questions are genuine.

Methinks July 24, 2008 at 7:57 pm

Martin, the carry charges fall into four basic categories of costs: storage, insurance, transportation, and financing. Spot + carry is the no arbitrage price for the future.

Why pay to store oil if the spot price will remain the same or fall?

You have no assurance that the spot price will be the same or fall in the future. The cost of hedging against an possible increase in the price is the carry (the amount it would cost to carry the commodity to the delivery date in the future).

A very simple example: A baker knows that he will need three tons of wheat in three months as an input to his bread baking operation. He's concerned about reducing price swings in his inputs because it effects his budgeting and his net income. He locks in the price of wheat that will be delivered to him in three months by buying a future.

The Farmer is concerned that wheat prices may decline by the time he harvests his wheat in three months. He wants to sell some wheat now for delivery in three months so that he reduces the uncertainty in his future revenue and can budget the next planting season more accurately.

The spot price of wheat is determined by the market's expectation of what will happen to that wheat crop in three months.

Martin Brock July 24, 2008 at 10:06 pm

Brock, I did not assert a theory. You posted on a flawed premise, and sprinkled in some rhetorical garbage. I called BS, and sprinkled in some abuse to keep myself amused. Now you backpedal. You exhibit the same behaviour as McCain.

Can you be more specific?

Martin Brock July 24, 2008 at 10:56 pm

You have no assurance that the spot price will be the same or fall in the future.

Right. I'm speculating.

The cost of hedging against a possible increase in the price is the carry (the amount it would cost to carry the commodity to the delivery date in the future).

I won't pay more than the current delivery price plus the cost of storing oil (including financing, insurance and the rest) for a promise of future delivery.

I will pay less than the current price plus the cost of storing the oil, and a supplier may offer me a lower price, so there is a range of speculation.

A supplier speculates that he won't incur the storage cost (including insurance and the rest), as he's selling every barrel he can produce as fast as he can produce it. I speculate that the price will rise for the same reason.

Neither of us knows the market clearing price in the future, so when we agree on a future delivery price between the current price and the current price plus the storage price, we're both speculating. I speculate that the price will rise. The supplier speculates that he'll sell oil as fast as he produces it at no less than the price he offers.

The longer the term of the contract, the greater is this range of speculation, since the storage cost increases with time.

For both of us, the insurance could be the critical cost. Maybe storing the oil for promised delivery in the future is very risky. Someone selling me a contract may pay someone in Iran to store oil, but stored oil may not be delivered when Dubya bombs Iran's uranium enrichment facilities. Then the seller of my contract must buy more costly oil elsewhere to fulfill the contract. He either pays an insurer to bear this risk, or he bears it himself.

Martin Brock July 24, 2008 at 10:59 pm

The supplier speculates that he'll sell oil as fast as he produces it at no less than the price he offers.

Correction: The supplier speculates that he'll sell oil as fast as he produces it at no more than the price he offers.

jpm July 25, 2008 at 9:10 am

Martin, your flawed logic is that "threating" to bomb Iran causes the price to go up. In as much that bombing Iran's potential bomb making facilities does not affect their oil pumps, Iran doesn't export a drop of oil to the US, 2nd, it is "heavy oil", not the light sweet crude used to refine gasoline, 3rd, Iraq's production actually ceased, and we didn't get the spike in the oil price we are getting today. You can't blame this on Cheney or Bush. The best thing for world oil production would be to take out Iran's mad politico and replace it like we did with Iraq. The threat to bomb Iran should be soothing to oil prices.

If there is any blame to be laid, it is to be laid at the feet of the Dems, in as much as they have always cheered higher prices and done every single thing in their power to stamp out US production. Republicans are only guilty in as much as they have not fought the Dems on this.

The market is experiencing a bubble. We had the exact oposite in the early 90's when oil dropped to $10.00 per barrel. Way below the cost to find and produce it at the level of demand. It's just what markets do from time to time. You can't irrationally blame the people you don't like for it.

Methinks July 25, 2008 at 10:54 am

Martin,

No, the supplier is not speculating on storage, etc. Anybody speculation is about future price. Both participants in the example are hedging against price moves. Implicitly, of course, the buyer of the future is betting that the price of the commodity goes up and the the seller is betting that it goes down. But the main purpose is to hedge against price volatility.

A pure speculator will sell a contract if he thinks the price is going down and buy one if he thinks it's going up. Arbitrageurs ensure that contracts trade at the no arbitrage price by buying underpriced contracts and selling overpriced ones. Obviously, the more liquid the market, the more arbs and the less mispricing.

Steve Plunk July 25, 2008 at 12:10 pm

Late to the conversation as usual but I gotta ask, with more money being put into commodities can't we assume that will drive up futures prices? I understand it is not the only driver of commodity prices but it makes sense that an influx of money will drive prices higher. Right? Wrong?

Martin Brock July 25, 2008 at 12:10 pm

Martin, your flawed logic is that "threating" to bomb Iran causes the price to go up.

I observe that "threatening" to bomb Iran drives up the price, and this observation is consistent with a completely reasonable theory of price formation. If I need oil in the future and expect it to be less available in the future, I'll pay more to have it delivered in the future.

In as much that bombing Iran's potential bomb making facilities does not affect their oil pumps, Iran doesn't export a drop of oil to the US, 2nd, it is "heavy oil", not the light sweet crude used to refine gasoline, 3rd, Iraq's production actually ceased, and we didn't get the spike in the oil price we are getting today.

There are no threats to bomb "potential bomb making facilities". There are threats to bomb uranium enrichment facilities. It makes no difference who buys Iran's exports, because 1) oil is fungible and 2) war with Iran does not only threaten Iranian oil. Iran threatens to retaliate by mining the Strait of Hormuz and is well positioned to do it. I'm not suggesting that threatened acts of war against Iran are the only reason that the price has risen. These threats are among the reasons that the price has risen.

Do factions within Iran's state contemplate nuclear weapons development? Of course, they do, precisely because your partisans want to "take them out" and credibly threaten to do it. Is the state actively pursuing this develoment presently? According to the consensus of U.S. intelligence agencies in their National Intelligence Estimate last year, they aren't. According to the International Atomic Energy Agency, which routinely inspects the facilties threatened with bombing, they aren't.

You can't blame this on Cheney or Bush.

Sure I can.

The best thing for world oil production would be to take out Iran's mad politico and replace it like we did with Iraq.

This assertion is incredible. We've replaced the Baathists with a state much friendlier toward Iran's Islamic Republic, and we're in no position to "take them out" and replace them. If you want to sign up for this Quixotic, megalomanical campaign of global dominance, you go right ahead. I'm not interested, and I thank you not to point your guns in my direction when you go looking for backers. My children will already spend decades repaying the fascistic, pseudo-capitalist "investors" providing the trillions neocons have already squandered.

The threat to bomb Iran should be soothing to oil prices.

Well, it isn't. The world doesn't yield gently to your assertions of how it should be.

If there is any blame to be laid, it is to be laid at the feet of the Dems, in as much as they have always cheered higher prices and done every single thing in their power to stamp out US production. Republicans are only guilty in as much as they have not fought the Dems on this.

Your Dems vs. Reps dichotomy is simpleminded. I couldn't care less about McCain's party affiliation. I'm not affiliated with either party.

The market is experiencing a bubble. We had the exact oposite in the early 90's when oil dropped to $10.00 per barrel. Way below the cost to find and produce it at the level of demand. It's just what markets do from time to time. You can't irrationally blame the people you don't like for it.

The notion that oil markets would not respond to credible threats of war in this region is irrational, and the threats exist as a matter of fact.

Martin Brock July 25, 2008 at 12:53 pm

No, the supplier is not speculating on storage, etc. Anybody speculation is about future price. Both participants in the example are hedging against price moves.

Again, if I can take delivery now of oil I need in six months for X dollars and if I can store the oil, for delivery to where I need it in six months, for Y dollars (including finance, insurance, delivery and other costs), I will not pay more than X + Y dollars for a futures contract promising delivery of the oil to where I need it in six months. Right?

Y dollars is what you call "the carrying cost" and I've called "storage cost", and it includes an insurance premium. This insurance must cover the expected (but uncertain) cost of obtaining the oil somewhere else if my stored oil cannot be delivered as expected. The stored oil could be stolen or destroyed or confiscated by a state at war with my state for example. This insurance premium (which I include in "storage cost") includes the "speculation" we're discussing.

I'm not trying to tell you your business here. I'm happy to use "carrying cost", but whatever we call it, this cost includes insurance against the risk that a supplier cannot deliver oil purchased today and stored until the delivery date, so it includes speculation upon the future price. Furthermore, a supplier may speculate that no storage is necessary to deliver oil to me in six months at a particular price, so he may offer to deliver the oil a price that doesn't include the cost of this storage.

Implicitly, of course, the buyer of the future is betting that the price of the commodity goes up and the the seller is betting that it goes down. But the main purpose is to hedge against price volatility.

Right. These bets are "speculation".

A pure speculator will sell a contract if he thinks the price is going down and buy one if he thinks it's going up.

Right. I can be a pure speculator buying a contract only to resell it later, with no other interest in producing or consuming oil at any time, but buyer and sellers with an interest in producing or consuming are also speculating.

Arbitrageurs ensure that contracts trade at the no arbitrage price by buying underpriced contracts and selling overpriced ones. Obviously, the more liquid the market, the more arbs and the less mispricing.

"Underpriced" and "overpriced" are uncertain terms. An arbitrageur looks for opportunities to profit when prices in different markets are not in equilibrium. For example, gas across town in a sparsely populated area might sell for $3.00 a gallon while gas in my more heavily populated neighborhood sells for $4.00. If you can profitably drive my car across town and fill it up for $3.50 a gallon, and if paying you for this service is more valuable to me than the time I'll spend driving across town myself, you're essentially an arbitrageur.

You have no assurance that you'll find enough people like me willing to be without their cars while you drive across town, so you have no assurance, day to day, that you'll profit. Even if you profit at $3.50/gallon, the gasoline dealer across town may respond to increased demand for his gas by raising the price from $3.00 to $3.25, making your venture less profitable. You're always speculating. We're all always speculating.

Michael Miller July 25, 2008 at 12:53 pm

Martin,

The middle east is a politically volatile region that supplies a very significant portion of the world's economies with oil.

I know that you do not agree with the Bush/Cheney approach to the region.

Negotiations and diplomacy have been tried on and off over a period of 40 years have not yielded any tangible benefits. This approach has failed.

Do you agree that this region needs to become politically stable? If so, what proactive approach would you choose in order to achieve that goal?

Methinks July 25, 2008 at 1:30 pm

Underpriced" and "overpriced" are uncertain terms.

"underpriced" and "overpriced" refers to futures contract pricing. If there is an arbitrage, the contract is mispriced and it is absolutely not uncertain. It is, in fact, one of the most certain things in trading – and the reason that there is very little edge in arbing futures.

If you have a storage facility, you can buy spot fore immediate delivery and store the commodity yourself. But storage facilities are expensive, so few users of commodities have them. Incidentally, insurance portion of the carry is generally against stuff like fire in storage facility, vandalism, flooding, etc.

Again, I think with your math background it's easier for you to just pick up a math of derivatives securities book (Kolb and Hull are my favourites) and just have a look at the math. It's always simpler than a verbal explanation.

On very rare occasions, a commodities future trader will forget to close out a futures contract and ends up having to take delivery of the commodity! That always pretty funny.

Martin Brock July 25, 2008 at 1:45 pm

I know that you do not agree with the Bush/Cheney approach to the region.

I don't. They will sell us the oil. What else would they do? Drink it? bin Laden is a madman, but he is right on this score, and he is not remotely comparable to Hitler in the 1930s. He is the leader of a rag-tag bunch of medieval religious zealots, not the head of a powerful state. Ahmadinejad is not comparable to Hitler either. Saddam Hussein was closer to Hitler, ideologically, than either of these men, but his state was hardly a great military power, particularly in 2003.

Negotiations and diplomacy have been tried on and off over a period of 40 years have not yielded any tangible benefits. This approach has failed.

Negotiation has "failed" only if I assume that Iran must necessarily yield to our demand that it cease all uranium enrichment for any purpose. Iran is a signatory to a Nonproliferation Treaty that explicitly entitles it to the civilian use of nuclear energy including uranium enrichment with IAEA safeguards. I have no interest in forcing Iran to stop uranium enrichment. We may buy oil from them and mind our own business otherwise. I don't like many things about the state and won't be immigrating there anytime soon, but that's beside the point.

Do you agree that this region needs to become politically stable? If so, what proactive approach would you choose in order to achieve that goal?

I don't make regions politically stable, and the U.S. government isn't making this region stable either. It didn't make the region stable when it deposed Mossadegh and installed the Shah in Iran. It didn't make the region stable when it supported the Baathists in wars against Iran. The U.S.S.R. didn't make the region stable when it invaded Afghanistan. Britain didn't stabilize Iraq or Afghanistan earlier.

A proactive approach? Free trade. Open travel. Negotiation to settle disputes. Staying on our side of the line unless our side of the line is actually, substantially threatened, not only "potentially" threatened in the imagination of statesmen who are always, necessarily self-serving. Realizing that we aren't the good guys on our side of the line. We're must more guys.

Martin Brock July 25, 2008 at 1:49 pm

Just more guys.

Methinks July 25, 2008 at 1:59 pm

Steve Plunk,

If there are more buyers of commodities, it's because they think commodities prices will increase. They think this by looking at factors that impact supply and demand. Obviously, projections of the future can never be completely accurate. Market participants are quick to adjust their expectations to new information. Because these markets are very liquid, the are quick to adjust to new information and the price will adjusts quickly as well as participants act on new information.

Persistent bubbles – like the one in the illiquid and fragmented housing market, where shorting was not feasible – are far less likely in these liquid markets with many participants trading an undifferentiated commodity and where shorting is basically unrestricted. While expectations can temporarily drive prices higher or lower, changes in expectations are very quickly reflected.

Sam Grove July 25, 2008 at 3:15 pm

Due to the fungible nature of oil, I wouldn't think that buying a futures contract on oil would entail much in the way of storage. The contract is likely for future production.

What a buyer is hedging against is price increases and the seller, against price decreases…on future output.

Sam Grove July 25, 2008 at 3:16 pm

Additionally, one of the things being hedged against is variations in the value of the dollar…how many will be printed in the time between contract and delivery.

Steve Plunk July 25, 2008 at 3:53 pm

Thanks Martin. If I could follow up please indulge me.

There are claims that a great deal of money left the stock market and real estate because of their recent declines and investors "parked" that money in commodities or commodity funds. Could that have created a short lived (6 months) speculative bubble based upon the excess money flowing in rather than market conditions or rational expectations? Could the rapid increase in the number of futures contracts be evidence of that speculative money flowing into the system? And finally, while I agree that speculators have a place in the market would it do much harm to increase margin requirements for futures speculators (those not actually taking deliveries)?

Again, thank you. I own a small trucking company so these questions are very sincere.

Martin Brock July 25, 2008 at 4:07 pm

Due to the fungible nature of oil, I wouldn't think that buying a futures contract on oil would entail much in the way of storage. The contract is likely for future production.

I agree. I suggested "storage" initially only because the idea occurred to me. The price of a contract for future delivery can't be arbitrarily higher than the current price, because I can buy at the current price and store the oil. My ability to store the oil at a cost puts some limit on what I'll pay now for future delivery. Methinks extended this idea to "carrying cost", which certainly involves more than literal storage. If carrying cost includes an insurance premium, then it essentially encompasses all speculation.

If buyers generally expect the price of oil to rise precipitously in the future, they'll bid up the current price trying to hoard oil, so the ability to store oil does place a limit on the difference between the current price and the price of a contract for future delivery. If a commodity cannot be stored this way, the relationship between current and future price could be more elastic.

Methinks July 25, 2008 at 4:19 pm

Sam,

I don't trade commodity futures and can't answer precisely what mix of components baked into the carry. However, oil is stored because while oil production is a 24/7 process, demand fluctuates throughout the year. The DOE releases weekly oil inventory number at 10:30 am every Wednesday (natural gas at 10:30 am on Tuesdays, btw). So, storage is a component of carry – as it is for all commodities that I know of.

Here's a copy of the DOE's oil inventory report released last Wednesday. It also talks about the percentage of capacity at which refineries are running and lots of other good stuff.

Methinks July 25, 2008 at 4:21 pm

People, whether storage is a component of carry is not a theoretical debate. Find a website that tells you how commodity futures are priced, if you don't believe me, and be done with it.

Michael Miller July 25, 2008 at 4:43 pm

Martin, thank you for responding to my my two questions.

At this point Iran is not in compliance with the Nonproliferation Treaty, as they are not allowing inspectors full access to their facilities. If Iran is using uranium enrichment to build nuclear weapons, then Iran would be in obvious violation of the treaty.

Then, the process of sanctions would then begin and in the meanwhile they could build all the weapons they want.

Many people believe that the Iranians have had an active nuclear weapons program in progress for a while.

The Israelis, who are not signatories to the treaty, are expected through military force, to take out the Iranian enrichment program. The Israelis do have a right to protect themselves and have been threatened with annihilation by the Iranians. You wrote:

"I have no interest in forcing Iran to stop uranium enrichment. We may buy oil from them and mind our own business otherwise."

I cannot believe that you are really this naive about Iran's intentions. At this point in time I do not think that many people of voting age really believe that the Iranians are telling us the truth. But obviously, you seem to be completely unconcerned about that possibility.

I then asked you, do you agree that this region needs to become politically stable?

You evaded answering the question, when you replied:

"I don't make regions politically stable, and the U.S. government isn't making this region stable either."

I did not ask if the U.S. should be shouldering the responsibility of assisting the region in becoming politically stable. You answered as if I did. Personally, I believe that the ultimate responsibility for political stability in this region lies with the peoples of the middle east and not with the peoples of North America. But the peoples of North America are closely tied to the region through their need for oil supplies and through oaths and treaties signed with the State of Israel, and therefore the U.S. has strong and vital national interests in this region.

I then asked if you had a preferred a proactive approach and you said:

"A proactive approach? Free trade. Open travel. Negotiation to settle disputes. Staying on our side of the line unless our side of the line is actually, substantially threatened, not only "potentially" threatened in the imagination of statesmen who are always, necessarily self-serving. Realizing that we aren't the good guys on our side of the line. We're must more guys."

This is a clear answer. And I agree. Laissez-faire should be the ground rule until a line has been crossed that substantially threatens security or vital national interests. I have no problem with this.

But is Iran not threatening Israel's national security and does Israel not have a right to defend itself?

Methinks July 25, 2008 at 4:57 pm

Steve Plunk,

It was Methinks who answered your post, not Martin.

Could that have created a short lived (6 months) speculative bubble based upon the excess money flowing in rather than market conditions or rational expectations?

The short answer is "no". Market participants continuously (and by continuously, I mean literally "continuously) monitor information that effects supply and demand and react to new information instantly. Since the market is very liquid, it also adjusts instantly. So, market participants may be "off" (if you want to call it that) in their expectations only until previously unknown information becomes known. I find that for some reason, "expectations" is what people have the hardest time wrapping their minds around when thinking about markets. I don't know why that is.

Could the rapid increase in the number of futures contracts be evidence of that speculative money flowing into the system?

Yes. Let's phrase this another way: more people are expressing their opinions about that market. More opinions, means more information is available to the market. The more information you have, the more sure you are of the price.

And finally, while I agree that speculators have a place in the market would it do much harm to increase margin requirements for futures speculators (those not actually taking deliveries)?

Yes, it would harm the market. It'll drive out oil traders, reducing liquidity and taking those people's opinion out of the market. The effect of those two things will be to make the market MORE not less prone to mispricing. if margins are not raised much and only a few participants are driven out, there may not be much of an effect (which begs the question: why do it at all?) and if enough are driven out, the effect will be wider price swings and less confidence in the market price. Raising margin requirements by enough to drive out arbitrageurs and speculators will increase volatility in oil prices and make futures contracts more prone to mispricing.

limiting speculators and arbitrageurs in any way will do absolutely nothing to change the drivers of oil price: supply and demand expectations. It'll only serve to make the market less efficient.

I sincerely appreciate the difficult position you're in as an owner of a small trucking company. In my past life as an analyst in the mid-1990's, I covered tiny American oil producers. Around 1998, the oil and gas prices dropped so low that they could just barely eek out enough to meet their capex requirements. Some went bankrupt, of course. Now, If I may ask you a question: is it your practice to buy gasoline futures contracts or options to hedge some of your projected gasoline demand? I'm curious how different companies are handling this issue.

Martin Brock July 25, 2008 at 5:02 pm

Could that have created a short lived (6 months) speculative bubble based upon the excess money flowing in rather than market conditions or rational expectations?

These bubbles presumably exist, but investors liquidating other positions have options other than oil. It's not a simple question, obviously. Gold shot up recently too. Demand for oil in China and elsewhere really has risen. The dollar has fallen. There is no single explanation for the increased dollar price of oil, but I don't see how with prospects of war with Iran could not drive up the price. The issue we're discussing here is short-term speculation, and saber rattling tops the list of these signals. I certainly don't see how it could be off shore oil exploration, not with a six month time horizon. That's what McCain is saying.

Could the rapid increase in the number of futures contracts be evidence of that speculative money flowing into the system?

I also worry about the quantity of credit lately. The warfare state absorbs credit too, but we're also entering a period, demographically, in which relatively more people expect to consume the yield of capital other than their own labor. I expect more dollars chasing the yields, and it's not obvious to me that real yields just automatically materialize to satisfy the nominal demand.

So this unprecedented proportion of people have money they didn't spend in the past. "Saving money" in the past doesn't imply any real capital. Treasury notes financing wars are not real capital for example. Did we really produce a lot more capital with real yields for the boomers to consume? Even if we did, are they really entitled to consume the yields? I'm not sure.

Younger workers now are more productive, because they work with capital owned by retirees. That's the theory. Is it really true? Maybe, the young workers (in China) can freely organize themselves productively without owing the booming capitalists (in the U.S.) so much. Maybe, mortgages at low interest rates were more plentiful just because more people wanted to lend someone money, not because the number of credit worthy borrowers actually rose proportionately. These questions concern me too.

And finally, while I agree that speculators have a place in the market would it do much harm to increase margin requirements for futures speculators (those not actually taking deliveries)?

I don't know how much oil is bought speculatively on margin in the futures market, but I doubt that the figure is very high. It's a great way to go broke fast. If creditors are pouring out cash all over the place, that's definitely a problem, but it's a problem for all capital markets, not for oil specifically. Regardless, McCain's attribution of recent price volatility to speculation over offshore oil exploration is both dubious and disingenuous. He needs to focus on the mote in his own eye.

Methinks July 25, 2008 at 5:26 pm

For the record, Martin..

I agree with you with regard to the effect on the oil market of changing probabilities of war with Iran. Even if we don't buy oil directly from Iran because of sanctions, war anywhere in that region can cause supply disruptions and the market factors that in. However, I think you're overstating the effect of saber rattling.

Steve Plunk July 25, 2008 at 6:05 pm

Thanks to both Methinks and Martin.

To answer Methink's question, small companies such as mine do not have enough cash reserves to purchase futures and I doubt my local fuel distributor would even entertain the idea.

Fuel surcharges have helped us weather these price increases but they seldom react quick enough to fully cover the costs. If prices do fall we hope to recoup some of those losses.

What really surprises me is how strong freight shipments have remained in the face of higher shipping costs. There is some evidence of a slowing economy but not anything drastic. Now I'm only west coast so I cannot speak about national trends or other regions.

I thank both of you for your insights.

Sam Grove July 25, 2008 at 8:34 pm

Obviously storage costs figure in the price of petro products, even gas stations have to spend money to store gasoline underground. I would suppose that that storage cost are figured as part of production overhead, but producers can't arbitrarily charge more for oil that has entailed the cost of storage compared to product that is delivered straight away to retail consumption.

My supposition is that if you buy a futures contract for 100 month delivery of oil, they aren't going to put that amount in a storage facility marked as 'yours'.

Martin Brock July 26, 2008 at 8:39 am

My supposition is that if you buy a futures contract for 100 month delivery of oil, they aren't going to put that amount in a storage facility marked as 'yours'.

Maybe they won't, but you could, so you won't pay more than the current price plus the cost of storing the oil for 100 months (including insurance against lost of the stored oil and financing the cost of the oil and storage for the period). That's the point.

Suppliers selling me a futures contract may not have a storage container with my name on it, but they have lots of storage containers, and they know how full they are and how fast their supply of stored oil is rising or falling when they sell me the contract.

Of course, I needn't produce or store any oil to sell a futures contract. I can sell oil short nakedly. I expect the price to fall over six months, and you expect the price to rise, so I sell you a contract for delivery in six months at the current price. In six months, I buy the oil and deliver it. If I'm right, I profit. If not, I lose.

Naked short selling may be what people imagine as "pure speculation", but any futures contract involves some speculation, and storage costs still affect purely a speculative transaction, because you still won't pay more than current price plus the cost of storing oil for six months.

Methinks July 26, 2008 at 11:24 am

Martin,

You realize that not buying or selling a futures contract is also speculating, by your definition. If you buy a futures contract, you're "speculating" that the commodity will increase in price. If you don't, you're speculating that it will decline in price.

You should also know that the definition of "speculation" and "hedging" is clearly defined in finance. "Hedging" is what I described in my example. A person who is buying or selling a contract not to hedge a specific output or input but to purely bet on price moves is a "speculator".

Methinks July 26, 2008 at 11:31 am

Steve Plunk,

Thanks for sharing that. Very interesting. I'm under the impression that the state controls fuel surcharges. Am I correct?

I'm not saying you should run out and implement a hedging strategy, but if you did, you would not buy a futures contract (or options) for gasoline directly from your distributer. The are very liquid and trade on exchanges – like stocks. An option is the right but not an obligation to purchase a certain amount of fuel for a certain price by a certain day.

From your response, I gather most small trucking companies don't hedge. I wonder if big companies like Swift do.

Methinks July 26, 2008 at 11:49 am

I would suppose that that storage cost are figured as part of production overhead, but producers can't arbitrarily charge more for oil that has entailed the cost of storage compared to product that is delivered straight away to retail consumption.

You're thinking of this from the wrong perspective. For an undifferentiated commodity product like oil, the producer can only charge what the next guy is willing to pay right now. Otherwise, he won't sell his oil. But, if the buyer want delivery in six months, he has to pay the costs associated with carrying today's oil forward six months. Production overhead never has anything to do with it. In 1998, when oil touched $9+/bbl, U.S. producers were selling oil at below production costs in some cases. They were forced to take a loss or shut in wells. Since shutting in wells can reduce productions once they're put back online (making things worse in the long run), some companies continued to sell oil below production cost. You're always selling oil at today's price and today's price always has expectations of future supply and demand baked in.

Here's the arbitrage: If futures were selling at above spot + carry, then an arbitrageur would sell the contract at that price, buy the oil, store it until delivery, and pocket the difference between the cost + carry and the price of the future. And, yes, there are storage facilities for arbs to do just that. The barrels don't have "your name on them" but the number of barrels which the arb has to deliver have to be there, otherwise he's not hedged (and not an arbitrage) and he risks failing to deliver. that'll be the end of his days as an oil futures trader.

Martin Brock July 26, 2008 at 2:51 pm

You realize that not buying or selling a futures contract is also speculating, by your definition.

Getting up in the morning is speculative, but it's not the speculation we're discussing.

If you buy a futures contract, you're "speculating" that the commodity will increase in price. If you don't, you're speculating that it will decline in price.

Right. Whether or not you actually supply the oil or will actually consume it, you're still speculating. You may not be a "pure speculator", but you are speculating.

You should also know that the definition of "speculation" and "hedging" is clearly defined in finance.

Thanks for clarifying the precise usage of these terms in academic finance. I try to use language precisely when I understand a precise usage, but I have no academic training in finance.

We're discussing how McCain and other politicians use the term. That's the issue Don raises above. McCain apparently has limited training as well. If he's elected, let's hope he's trainable.

"Hedging" is what I described in my example. A person who is buying or selling a contract not to hedge a specific output or input but to purely bet on price moves is a "speculator".

Whatever we're calling these people, I suppose they aren't stupid enough to bet on a large move in the next few months based on new exploration for offshore oil that Congress hasn't even authorized yet, based on a facile act by McCain's partisan. I suppose the recent moves are more likely related to speculation over saber rattling as well as reports of lowered consumption and building inventories. The saber rattling and inventories are consequential over the term of contracts being traded.

Sam Grove July 26, 2008 at 4:01 pm

Maybe they won't, but you could, so you won't pay more than the current price plus the cost of storing the oil for 100 months (including insurance against lost of the stored oil and financing the cost of the oil and storage for the period). That's the point.

So if you are storing oil based upon expected future price increases, isn't the cost of storage the same whether you've sold contracts for it or just plan to sell on the market at that time?

IOW, whether you buy oil now, buy a futures contract, or buy it when you need it, the cost of storage is included in the price.

Even if you buy it from the well, likely you will be storing it…which also is part of your cost.

I expect that there are very few people who buy oil in bulk for immediate use.

There must be a buffer supply in storage at all times, the situation would be pretty scary otherwise.

Back to my original point, which perhaps wasn't clearly made, I wouldn't think that storage plays an inordinate role in speculation, but is always a factor in the oil market.

Martin Brock July 27, 2008 at 1:14 am

So if you are storing oil based upon expected future price increases, isn't the cost of storage the same whether you've sold contracts for it or just plan to sell on the market at that time?

The issue is not what the price will be in the future. No one knows that. The issue is how much I'm willing to pay for a contract for future delivery today to hedge against an expected rise in the price. I will pay more than the current price, but I won't pay arbitrarily more, even though the price could rise arbitrarily.

Even if I expect the price to rise from $125/barrel to $1250/barrel in the next six months, with complete certainty based on information that only I possess, I still won't buy a six month futures contract for $1000/barrel. I won't even pay $126/barrel if I can store oil for six months for less than $1/barrel. I'll instead buy oil at $125/barrel and store it for six months, then resell the oil for $1250. The most I'll pay for a six month contract is the current price plus the cost of storing the oil for six months, regardless of my expectation of the future price. Right?

Even if you buy it from the well, likely you will be storing it…which also is part of your cost.

Again, "storage" is my unconventional description of what Methinks more conventionally calls "carry". It's more than a literal storage cost. It's also the opportunity cost of sinking my money into the purchase of oil now when I won't have the oil for six months, and it's the cost of insuring the oil I've secured with the contract against any loss over the six months. This insurance could literally protect me against oil stolen from a storage tank, or it could protect me against a short seller who can't cover his position in six months. I don't necessarily pay the supplier of the oil for these services (storage, finance, insurnance), so they aren't accounted as part of the cost of the oil.

Sam Grove July 27, 2008 at 10:27 am

Sellers are always hoping that the sale price will cover all their costs of delivering product, + some profit, in any scenario.

Selling a future in oil requires insurance whether that amount is put in storage now, or whether it is planned to be purchased later.

I don't necessarily pay the supplier of the oil for these services (storage, finance, insurnance)so they aren't accounted as part of the cost of the oil.

Unless the supplier screwed up and is taking a loss, these costs are always included in the price.

Methinks July 27, 2008 at 11:04 am

I officially give up.

Sam Grove July 27, 2008 at 2:04 pm

Methinks, I don't believe I disagree with you anywhere.

If I may ask a question: What portion of the oil market is not subject to speculation?

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