Tuesday, July 08, 2008

In Defense of Oil Speculators

From Greg Mankiw:

The New Yorker.
The Economist.
Washington Post.

And one more from Greg Mankiw:

Foreign Students Flock to the US: Surge in Overseas Applicants Driven by Weak Dollar


At 7/08/2008 11:11 PM, Anonymous Anonymous said...

Professor, I'm not convinced yet. I reviewed the articles. Always these articles talk about the way traditional speculation/nymex works and I have no problem with that or volatility. But we can't just talk about how the nymex works and most importantly they never address what is going on on the intercontinental exchange(ICE), because it has been unregulated. As Professor Greenberger said: "As a result, capital zoomed to new unregulated exchanges like Atlanta-based ICE, an American firm operating under U.K. regulation, where trading volume tripled from 2005 to 2008, representing 47.8% of global oil futures trading. And participants in the new electronic markets didn't even have to file "large trade reports" with the CFTC, obscuring trading details across the fastest growing exchanges.the Enron loophole redefined who a speculator was, and more importantly, wasn't. If investment banks could claim they were "hedging" certain derivative trades, they could avoid speculation limits set by the exchanges altogether." This is an extremely complex issue and I don't profess to know the answer. But I know the "devil is in the details " and we need more details about ICE, not how nymex works. I just want to know why we needed the enron/london loophole and why it can't be closed immediately. What's wrong with transparency? The following is from the ft.com article you quoted: LAWMAKERS AND STAKEHOLDERS FAIL TO GRASP THE DETAILS OF THE DEBATE

In 2002, when the US Congress was debating whether to close the “Enron Loophole” – that is, to require that over-the-counter energy markets be brought under the full oversight of the US futures regulator – Republican Trent Lott rose to his feet in the Senate chamber.

Brandishing a dictionary, the senator looked up a definition of “a derivative”, a term referring to the complex futures contracts used in the energy markets to hedge the risks associated with holding physical supplies of commodities such as oil and natural gas. The dictionary told him that it was “the limit of the ratio of the change in a function to the corresponding change in its independent variable as the latter change approaches zero”.

Mr Lott turned to his colleagues with a warning: “We don’t know what we are doing here. I have serious doubts how many senators really understand [this] and it sounds pretty complicated to me.”

At 7/09/2008 7:56 AM, Blogger Unknown said...

Prof. Perry,

I don't understand using volatility levels in defense of speculators. This is a red herring.

First of all, nobody disputes that "normal" speculation is not only needed for the markets to be efficient but it is also necessary. Speculators are required so risk is transferred from hedgers and price discovery is efficient.

However, we must investigate the possibility whether in the case of oil there is some form of "speculation" that takes advantage of the complexity of price discovery dynamics to drive prices up.

I have explained numerous times how such mechanism might work and can add a significant premium to oil prices. Of course, the bulk of the rise is due to demand/supply consideration. But any form of speculation with the objective to exploit market dynamics to drive prices up should be investigated and limited.

I hope that you would agree, that is something like that is indeed happening it should be brought to a stop.

If you need a specific example of how such speculative expoitation can drive prices up, I can repeat it.

At 7/09/2008 4:03 PM, Anonymous Anonymous said...

The articles contain many valid points about the relationship between derivatives market and the physical commodity market, but some essential points have not been discussed.

Basically derivatives trading does affect the price of the physical market when a trade is executed between a hedging commercial participant and a speculative trader. If hedging related to this trade changes the behavior of the commercial participant in the physical market, it affects also the price in the physical market. For easily storable commodities like many metals it is possible to sell a future and hedge it with increased storage of the physical product. In the case of oil this is not practical in large volumes, but there is another mechanism that affects metals and oil as well as many other commodities. This mechanism goes through the producer and operates as follows.

An owner of an oil well available for immediate production may notice that the futures prices are higher than the present spot price. In such situation he may postpone the production and keep the oil underground selling the oil future instead of physical oil. He may even buy oil in the spot market in order to fulfill possible delivery contracts. Having the well available for production guarantees the owner the possibility hedge the futures position through own production if that turns out to be more profitable than closing the position in the market. As long as the prices stay high in the futures market he may repeatedly earn more through futures trading than own production. This effect is stronger if the oil well is running out as this situation makes it easier for the producer to search for the most profitable time for the remaining production.

More technically the owner of the oil well may calculate the opportunity cost of taking oil out of the well based on expected future prices of oil. He may use the prices in the futures market as proxy for the expected prices of physical oil and he can even hedge in the futures market to protect that income. If the result of this analysis tells him that it is more profitable to keep the oil in the well, this is the only natural choice for the owner. Through this mechanism high prices in the futures market may lead to reduced production and finally through reduced production raise the spot price to the level determined by speculative traders in the futures market.

From public data it is impossible to tell to what extent the actual production volumes are affected by the above mechanism. It is, however, completely natural and practically inevitable that at least part of the oil producers will be influenced by this mechanism.


At 7/09/2008 6:08 PM, Blogger Unknown said...


what you described indeed happens and carries risk. Yet, empirical evidence is against this happening because production has not decreased. On the contrary, production has increased. If the Arabs for example were in this type of game you mentioned, production would be much less. But they have increased production.

You do not need to provide mechanism for justifying that futures market prices do affct spot pirces. it is simple: rising futures prices raise expectation about future spot prices. When prices rise to fast, you get panic and a bubble. Poeple panic and try to buy as much they can to profit. These poeple are called speculators. Under normal conditions they are good for markets. But they can also create bubbles, we know that from history.

Oil should be at about $75 to reflect evels from globalized pressures on demand.

The rest, about $65 is the speculative premium. Speculators act to create a Ponzi scheme. The early ones to get in and get out profit. The late ones lose.

The sophist says that oil at this time next year will be around $80. This will be a good enough price to "save Alaska".

At 7/10/2008 9:19 AM, Anonymous Anonymous said...


Empirical evidence tells only that production has not increased enough to keep the spot price at a lower level. The evidence is not sufficient to tell, whether this is due to insufficient capacity and unavoidable delays in increasing the capacity or insufficient willingness to produce.

The standard critisism against your argumetation is that high prices in the futures market cannot prevent the competition from keeping the spot price at a much lower level. The point in my argument is that there is indeed a natural connection between these two markets and due to this connection high demand in the futures market spills over to the spot market leading to high prices in this market as well.

Furthermore this leads to the conclusion that speculators trading in futures market can indeed affect a fully competitive spot market and create a bubble in oil price. Possible and likely non-competitive behaviour of oil producers would naturally strenghten this effect.


At 7/10/2008 9:39 AM, Blogger Unknown said...

pp you said:

"The standard critisism against your argumetation is that high prices in the futures market cannot prevent the competition from keeping the spot price at a much lower level. "

Can you bee more specific?

Don't forget arbitragers that seel the contract and buy the spot to lock in the basis and that pushes the spot price up while futures keep rising due to speculation.

At 7/10/2008 10:42 AM, Anonymous Anonymous said...


Lack of storage facilities and cost of storage limit the possibilities of hedging sales of futures through bying in the spot market.

The only way of increasing oil storage in sufficient quantities and at low cost is to leave the oil in wells.

Similar behaviour is well known in certain electricity markets (at least in the Scandinavian market) where reservoirs for hydro power play a similar role of "storing electricity before it is produced". The hydro power producers use arbitrage between the physical market, power derivates market and their own power plants whenever an opportunity arises.


At 7/11/2008 8:32 AM, Blogger OBloodyHell said...

> I don't understand using volatility levels in defense of speculators. This is a red herring.

Jeez. The mind just boggles at the sheer, unadulteratd cluelessness:

"I don't understand. It must be irrelevant"?

Do you somehow NOT grasp how abysmally stupid that paragraph is?


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