Friday, July 11, 2008

Restricting Speculators Will Not Reduce Oil Prices

For the most part, speculators do not demand physical oil the way thirsty Chinese refiners do. There is no evidence that speculators are accumulating large and rising inventories of physical oil. But to cause prices to be above their competitive level, speculators would have to take physical oil off the market -- the way that governments have done in the past with agricultural products, amassing mountains of grain and cheese to prop up their prices.

What some speculators do instead is trade futures contracts that entitle them to take delivery of physical oil at a future date (say next August) at a price negotiated in the marketplace. But they almost never exercise the right to take delivery when the contract matures.

A speculator who anticipates rising prices buys a futures contract at the prevailing market price. If he is right, and the futures price rises, he can sell the contract at the higher price before contract maturity and pocket a profit; if he is wrong, and prices fall, he sells the contract at a loss. Buyers and sellers of these futures contracts almost never take delivery of the oil to implement their trading strategies.

Restricting these speculators won't reduce the price of oil -- but they are likely to make consumers and investors worse off. Futures and swap markets facilitate the efficient management of price risks, and speculators are an important part of that process. For instance, a producer of oil may want to lock in the price at which he sells his oil in the coming months in order to hedge against fluctuations in its price. He can do so by selling a futures contract at the prevailing market price. Similarly, an airline can protect itself against price increases next summer by buying today a futures contract that locks in a purchase price for next July.

The unprecedented run-up in oil prices is painful for consumers around the world. But the focus on speculation is misguided, and represents a convenient distraction from an understanding of the real, underlying causes of high oil prices -- most notably continuing demand growth in the face of stagnant production, supply disruptions and the weakening dollar.

More restrictions and regulations of energy markets, in the vain belief that such actions will bring price relief, are counterproductive. They will make the energy markets less efficient, rather than more so.

Univ. of Houston Finance Professor Craig Pirrong, in today's WSJ

9 Comments:

At 7/11/2008 4:52 PM, Blogger Sophist said...

Prof Pirrong fails to justify his position. The fact that "Buyers and sellers of these futures contracts almost never take delivery of the oil to implement their trading strategies." provides no information as to whether there is either ogranized price manipulation by some groups or a bubble market effect in oil prices due to hedge fund investments.

The main assumption of those in support of speculation is that there is no price manipulation taking place. The main argument is based on making an analogy with horse racing bets. When you bet on a horse to win, you do not get the horse if you win, they claim.

Well, the basic flaw in the argumentation of those who a priori assume that there can be no manipulation of oil prices through the futures markets is that the spot price and the futures price are inextricably related.

Unlike in horse racing, in the oil market there are hedgers who hold physical and also engage in futures markets. Thus, speculative activity in the futures market afafcts pricing of spot market.

I wonder whether all these professors in favor of speculators have ever put down margin to buy a single oil futures contract. Theory is not always clear how it relates to the real world.

I have explained many times how orchestrated futures buying by accepting continuously high offers can raise oil prices while affecting other markets.

Nobody disputes that normal speculation is good for the markets. But we must differentiate normal speculation from price manipulation through the exploitation of price discovery mechanisms such as the futures markets.

In my opinion this price manipulation takes place for benefits in cross-asset trading, like manipulating oil prices and shorting stocks and the dollar.

I have no evidence but given the records of the exchanges and a couple of good programmers I could probably determine in a few weeks whether such manipulation is or ever was present. Exchanges should do it and come up with a final verdict so that this issue is settled.

The situation is not as simple as some professors think.

 
At 7/11/2008 4:55 PM, Blogger juandos said...

"But the focus on speculation is misguided, and represents a convenient distraction from an understanding of the real, underlying causes of high oil prices -- most notably continuing demand growth in the face of stagnant production, supply disruptions and the weakening dollar"...

Ahhh yes...

The problem is that Congress and apparently most of the constituents don't know what speculators really do...

Jon Birger of Fortune writes (June 27, 2008): "They're not buying oil, they're buying futures, and this is a crucial distinction. A futures contract is an agreement between a buyer and a seller to deliver a set amount of oil - typically 1,000 barrels - at a specific price on a specific date. The value of that contract rises and falls, depending upon market conditions, right up until the date of delivery"

Maybe these Congress critters should have one of their staff read them Dr. William's commentary: Stop The Scapegoating Of Oil Speculators And Give Them Good Reason To Go Short (h/t to Professor Mark)...

 
At 7/11/2008 5:39 PM, Anonymous Machiavelli999 said...

sophist,

Seriously, how on earth would you even begin to orchestrate a rise in oil prices, let alone profit from it.

Major international central banks with literally trillions of dollars at times attempt to orchestrate a rise in certain currencies and even they have limited success. How would some speculators do that?

And even if you do get a large amount of money, I am not sure if that really helps.

Large mutual funds actually find that their large size hurts them because of the amount of money they are dealing with actually changes the price of the investments they try to trade in. Thats why large funds often close themselves off to new investments.

So, sophist, please explain to me a theoretical way that you would orchestrate a price rise in oil AND profit from it.

 
At 7/11/2008 10:06 PM, Anonymous sam said...

again Prof Pirrong only talks about traditional regulated speculation no mention of ICE.""To date nobody has brought any credible evidence that these distortions exist," Craig Pirrong, a finance professor at the University of Houston and an expert on market manipulation, told the committee.

Critics warned that the lack of regulatory oversight for most oil trading makes it impossible to say anything with certainty, and meanwhile airlines, truckers and many consumers are struggling to stay afloat amid sky-high energy prices.

"I don't think the burden should be on them (consumers) to prove there's no speculation," said Michael Greenberger, who was the head of the Commodity Futures Trading Commission's trading division during the late 1990s.

The sudden inflow of big money into oil markets has come largely through "index investing." That's when state pension funds, university endowments and other big institutional investors place long-term bets on an index of commodities, expecting prices to rise over time.

Some of these investments take place in regulated markets where the Commodity Futures Trading Commission can determine whether a particular investor or group is cornering the market and pushing up prices.

But a much larger portion of index investment happens through unregulated over-the-counter swaps, which usually are arranged by large investment banks such as Goldman Sachs & Co. or Morgan Stanley.

Swaps are complex deals between two parties, usually an investment bank and a big investor. The investor agrees to plunk down a fixed amount of money on a specified quantity — say $135 for a barrel of oil — over a fixed period. The investor is seeking to limit the risk of being exposed to prices going above that point.

Big consumers of oil, such as airlines, complain that the money washing through the swaps market is pushing up the prices of regulated futures contracts. To hedge against the risks they've assumed in private swaps deals, investment banks are deeply involved in the regulated futures market. They also are the dominant players in overseas markets in London and elsewhere, where U.S. oil contracts are traded under weaker supervision.

The market for swaps is estimated to be about 18 times larger than the more transparent and regulated futures market. That means a huge amount of trading in oil-related products is happening away from any sort of regulatory scrutiny. Regulators don't even know who's on the other end of a swap. It could be California's pension fund or it could be Osama bin Laden.It's significant that regulators don't appear to know the answer to this question, and it's why the commission has come under criticism and promises to report on the swaps market and index investment by Sept. 15." please read artcle:http://www.mcclatchydc.com/251/story/43876.html

 
At 7/12/2008 3:36 AM, Blogger Sophist said...

machiavelli asked (not in the Principe):

"Seriously, how on earth would you even begin to orchestrate a rise in oil prices, let alone profit from it."

I'm just tired to repeat it one more time. The mechanism is very simple and straight forward.

Sam quoted:

"Regulators don't even know who's on the other end of a swap."

Don't matter. You only need to detect their involvement in the futures market and identify patterns of manipulation.

A good Data MIning program can do the job and identify the patterns of manipulation from exchange records.

The problem is that it has become a political issue rather than a regular exchange related routine operation.

 
At 7/13/2008 5:17 AM, Blogger juandos said...

Well with his usual panache sophist gets it wrong again...

How bizzare and nonsensical is the following? "Don't matter. You only need to detect their involvement in the futures market and identify patterns of manipulation"...

Dude even NPR gets it...

Here you go sophist, maybe a simple video will explain it to you...

 
At 7/13/2008 9:44 AM, Blogger OBloodyHell said...

> How would some speculators do that?

MAGIC!!!

They wave their evil sorceror's wands, and POOF!! prices skyrocket!!

Never fear, thanks to newly developed technology created by The Left's Economic WHIZards, the Democrat's newly trained sorceror's apprentices will cast a counterspell which will stuff an ecopotato up the Economic Engine's Tailpipe. Once successfully cast, this ecopotato will successfully destroy all economic activity in the West, massively reducing oil consumption, thus lowering prices down to where They Ought To Be... upon which time the Democrats will attach special consumption taxes to all oil usage, which will fund further ecopotato planting, which will ensure that This Problem Will Never Happen Again.

So, remember this in November: Your salvation lies with The Wonderful WHIZard of Obama, the Wonderful WHIZard of Change.

Trust us: If anyone ever needed a Whiz, he is the most wonderful Whiz there was.

 
At 7/13/2008 9:46 AM, Blogger OBloodyHell said...

> Well with his usual panache sophist gets it wrong again...

juandos, "panache" suggests intent. Need I say more?

 
At 7/13/2008 9:55 AM, Blogger OBloodyHell said...

> A good Data MIning program can do the job and identify the patterns of manipulation from exchange records.

If it was that friggin' easy you clothead then there wouldn't be an argument about it, would there? Dozens, if not hundreds, of people would have set up the analysis and published the results.

Q.E.D.

And the fact that you can't even detect it using those techniques (which ARE at least capable of actually detecting it) means it probably doesn't exist in the first place, since NO ONE (and there ARE people with the resources and the will to do it) has published any results to that end.

Q.E.D., too.

In summary, it's not easy, despite sophist's casual dismissal that it is, and yet, it hasn't been published: if it were true, since it would be published, it must not be true.

So sophist manages to produce yet another paragraph with two conceptual errors in it, for the second time in a couple days... He's on a roll!

Thank you, sophist, for demonstrating to all and sundry how bad reasoning can demonstrate... bad argumentation techniques.

 

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