John Kemp pixeled a rather lame response to my criticism of his earlier piece on “Broken Brent.” I say lame because he did not even attempt to address any of the analysis I laid out. Specifically, Kemp originally pointed to the dramatic drop in correlations between spot and forward prices and the different behavior of the curve in 2008 vs. 2012-2013 as evidence that fundamentals were somehow no longer driving oil prices. I pointed out that that a fundamentals-based model would predict exactly such a pattern due to the pronounced backwardation in Brent and the substantial decline in macro volatility; I further pointed out that I had presented theoretical models that made this prediction and empirical evidence supporting it going back to the early-to-mid-1990s. That’s what we call science.
Kemp’s response? <Crickets.>
The most plausible explanation for his failure to rebut my analysis is that he can’t. So instead he doubles down on “the hedge funds done it.” Although he does it in a much more circumspect, passive way the second time around:
In a recent column, I suggested most of the short-term movements in Brent (and WTI) prices since mid-2010 could be traced to changes in money managers’ positions rather than fundamentals.
Read his original piece, and you’ll see that he did more than “suggest.” Accuse is more like it.
Kemp’s evidence consists of a few graphs depicting managed money futures positions and prices. Point 1: eyeballs are not reliable evidence. Point 2: reliable evidence would involve some rigorous statistical analysis, which Kemp does not provide. Point 3: said statistical analysis should attempt to control for other relevant factors, notably fundamentals.
But Kemp breezily dismisses the possibility that fundamentals could explain price movements in recent months. After all, his original post is titled “static fundamentals”, and in that article and his response to me he asserts-and merely asserts-that fundamentals cannot explain price movements. Since he does not even attempt to control for any fundamentals-related variable, Kemp’s analysis is plagued by omitted variables bias. And that’s being charitable, because that phrase is usually employed to criticize statistical/econometric analyses, rather than gazes at graphs.
Sorry, John, but that doesn’t cut it. In a commodity characterized by extremely inelastic supply and demand, such as oil, small fluctuations in supply and demand fundamentals can cause appreciable price movements. Indeed, in a low macro volatility environment, fundamentals-based models imply that price movements are driven by highly technical, transient supply and demand shocks, and that moreover, these shocks cause substantial volatility in the shape of the forward curve. That is, they cause low correlations between spot and futures prices.
In such an environment, seemingly minor factors such as the shut down of a refinery or regulatory perversities (such as the impact of RIN credits) drive movements in prices and the slope of the curve. People who understand the fine structure of energy markets-people like Phil Verleger-realize this. Phil’s 18 February “Notes at the Margin” (which he kindly sent to me) provides a very detailed analysis of how low gasoline stocks and the closure of a Hess refinery are combining to increase gasoline cracks, which in turn are causing European refineries to buy and process Brent crude for sale to the US gasoline markets, which is in turn supporting Brent prices and backs. As Phil characterizes it, the tight US East Coast gasoline market tail is wagging the Brent crude dog. Fundamentals 101.
Phil analyzes these things carefully. John couldn’t be bothered. Instead, he squints at a few charts of COT data and prices, and declares fundamentals don’t matter. If he could show that after correcting for the kinds of factors Phil Verleger analyzes carefully week after week that managed money position movements were associated with price changes, he would have established that a necessary condition for speculative price impact would hold: merely a necessary condition, but not a sufficient condition, because it could well be the case that the fundamentals were driving the managed money trades. (To his credit, Kemp recognizes this possibility in his original article, though he dismisses it too readily.)
In brief, John Kemp’s attempt to show that hedge fund trading is causing movements in Brent crude prices and that fundamentals do not is plagued by numerous flaws. Methodologically, graph gazing is the start of an analysis, not the culmination. Furthermore, fundamentals-based models explain many of the phenomena Kemp finds anomalous. What’s more, a micro-level analysis of supply and demand factors in the oil and product markets can account for many of the price movements that mystify Kemp. When he confronts these issues head on, I’ll take him more seriously.
Climateer Investing weighs in on Kemp-Pirrong, and wonders why I felt obliged to go into smack down mode. The answer is simple. There are too many regulators and legislators and rabble-rousers (e.g., Oxfam) who are more than willing to seize upon any claim that evil speculators are distorting markets in order to justify interference, in the form of position limits or transaction taxes or just general harassment of those engaged in legitimate and beneficial activities: yes, speculation is a legitimate and beneficial activity. I have written and lectured extensively on the subject, and understand that speculation can, in exceptional circumstances, distort markets, but that such distortions leave distinctive tracks in quantities (e.g., inventories). If you believe speculation has distorted markets, provide evidence that those tracks indeed exist. Superficial examinations not grounded in well-established theoretical and empirical work don’t cut it, but feed prejudices that in turn too often lead to wrongheaded and destructive interventions into markets that cause real distortions (e.g., the rather cowardly decision of some European banks to exit the ag markets because of the propaganda campaigns waged by Oxfam and others). When people writing for reputable sources like Reuters lazily encourage these prejudices, I will respond. And being a Chicago guy, from a school where econ seminars are the academic equivalent of the MMA or UFC, my responses tend to be rather blunt and uncompromising. If you can’t take it, don’t get in the ring.
And as to Climateer’s claim that the fall in oil prices from the $140s in July 08 to the $30s in early ‘09 is some sort of “gotcha!” QED of the impact of speculation. Please. If you want me to take you seriously, you have to do a lot better than that. A major adverse macro shock that causes the most severe, protracted economic contraction in decades following a period of robust demand (and again I commend Phil Verleger’s analysis of the summer of 2008 as the go-to source to understand what drove prices in that period) will cause a precipitous drop in the price of an inelastically supplied commodity. Every time. It would be anomalous if they didn’t.