Streetwise Professor

March 8, 2013

Thanks for Playing, John, But Your Effort Doesn’t Even Warrant a Parting Gift

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics — The Professor @ 7:44 pm

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.

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9 Comments »

  1. Prof, I know you have a public duty to expose the lack of understanding and intellectual heft of these “pundits.” But, as you and others have observed elsewhere, most of these folks do not understand markets or appreciate their function. These are folks who have to fill news holes or have a ready “explanation” for what’s going on in the markets, so, rather than devoting any effort to actual understanding, they reach behind their desks and pull out the ever-ready “hedge funds,” traders, and all manner of nefarious deal-makers as the “cause” for what’s observed in prices and price changes.

    You must be exhausted — as we all are whenever a new round of market-bashing arises — but thank you for calling out the obvious misrepresentations.

    fwiw, I’d pay to watch an econ slam at Univ of Chi. That must have been a lot of fun! Maybe you should get ‘em to televise the seminars … :)

    Comment by markets.aurelius — March 9, 2013 @ 7:36 am

  2. Separate issue, here, Prof: When are you going to dig into Holder’s complete ineptitude?

    http://www.youtube.com/watch?v=cNhujFZM_P0

    How about this from Holder’s former No.1 on the prosecutorial front — the outgoing head of the Justice Department’s criminal division, Lanny “Do Nothing” Breuer:

    http://www.pbs.org/wgbh/pages/frontline/untouchables/

    http://www.pbs.org/wgbh/pages/frontline/business-economy-financial-crisis/untouchables/lanny-breuer-financial-fraud-has-not-gone-unpunished/

    http://www.pbs.org/wgbh/pages/frontline/business-economy-financial-crisis/untouchables/report-doj-criminal-chief-lanny-breuer-stepping-down/

    Don’t just focus on DoJ, tho. When are you going to take to task the geniuses at the OCC (CalTech on the Potomac) re JP’s whale trade?

    I’ve seen very little re how JP could run a massive London book on an excel spreadsheet — with inputs cut and pasted by a low-level associate — with a wrong calc, no less!!!!! A divide instead of a multiply! (Or some such similar error, which had the effect of reducing V@R as risk was being added!!!!!!!!!.) A spreadsheet!!!! JP loses $6+ BILLION on a spreadsheet input and calc error. This position wasn’t even in the bank’s V@R model. It was a free-standing black hole outside the bank’s daily V@R that the other desks at JP were feeling the gravity of in the market and forced to hedge against. It was run on an excel spreadsheet!!!!

    Oh, did I mention it was run on a spreadsheet??????????!!!!!!!!!!!! The biggest f*cking position in JP is on a spreadsheet outside the bank’s V@R model!!!!!!!! These guys were being sucked into a black hole unaware its center of gravity was within its own building! All that BS Jamie was spouting (pun intended … again) re how V@R models are vetted and tested … my head’s spinning … It’s like they’re all toking on a huge hookah like there’s no tomorrow and free-associating and riffing on sh*t they learned in business school … I’ve gotta sign off. This is the pivot the international financial markets are balanced on!!!!! God help us …. Not kidding.

    Comment by markets.aurelius — March 9, 2013 @ 9:06 am

  3. Dammit markets, I’m just a doctor (of economics) not a miracle worker :-P In all seriousness, I hope to have time to get to Holder soon, but will probably get to the JPM debacle first.

    I was just as incredulous as you when I read about the spreadsheet debacle. I discussed it in class two weeks ago when I was lecturing about risk measurement and V@R.

    Hell, I do as little of my research and consulting work as possible in spreadsheets precisely because who the hell knows what error is hiding in this cell or that. I use them for data input and output, and little else. They are totally lacking in transparency, and the ability to audit/check your work is highly limited. The idea of running any position, let alone a position of that magnitude, off a spreadsheet deserves even more “!” and expletives than you used.

    And yes. God help us.

    The ProfessorComment by The Professor — March 9, 2013 @ 12:08 pm

  4. Agreed re what’s lurking in those cells, Prof. I use excel to export raw data to real software that’s been properly vetted, tested then tested again. Ideally, your code — or the code you’re using — is in constant beta-test mode. That way you’re always improving. With MS, you never know. Ever.

    Comment by markets.aurelius — March 9, 2013 @ 12:59 pm

  5. @markets . . . I work primarily in Matlab. Yes, constantly checking and improving the code. Commenting the sh*t out of it, and keeping a diary for each project describing each program I use and the changes I make in them. xlsread and xlswrite are very helpful and permit the import of raw data from and the writing of output to Excel files, but that’s the extent to which I rely on Excel for anything but the most trivial work. There are times I have to revisit analysis years later. Looking back over code years later is bad enough. Trying to figure out what they hell you did in a spreadsheet . . . fuggedaboutit.

    I would wager spreadsheets vie with rogue traders as the biggest operational risk of any trading operation.

    The ProfessorComment by The Professor — March 9, 2013 @ 2:31 pm

  6. Here’s Sunday’s laugh riot: http://www.occ.gov/publications/publications-by-type/comptrollers-handbook/banksupervisionprocess.pdf

    I’ve gotta stop looking for this stuff — too much coffee gets sprayed on my computer screen when I’m reading it and laughing hysterically.

    Comment by markets.aurelius — March 10, 2013 @ 8:15 am

  7. What I find baffling about John Kemp’s article is his assertion that “which (sic) is remarkable about the positioning data for Brent and WTI is their similarity….hedge fund and other money managers’ positions in the two markets are notable for their similarities rather than differences.”

    CME WTI commercial long / short: 17% / 16%
    ICE BRT commercial long / short: 38% / 48%

    CME WTI Managed Money long / short: 31% / 23%
    ICE BRT Managed Money long / short: 20% / 12%

    (most recent week)

    Don’t look very similar to me.

    Comment by Green as Grass — March 11, 2013 @ 9:46 am

  8. [...] See full story on streetwiseprofessor.com [...]

    Pingback by Thanks for Playing, John, But Your Effort Doesn’t Even Warrant a Parting Gift | Fifth Estate — March 12, 2013 @ 7:40 am

  9. Dear MA and Perfesser,

    Granted that crappy code is a real problem, and that the debugging process is less than clear (or carried out by third parties), The BIGGEST problem with spread sheets, particularly in a trading or operations environment is that they are not a good way to store data. The update facilities are appalling and there are many, many cases where outdated data is used in these so called analytic systems. The terms relational integrity and normalization are paid lip service, at best.

    As MA states that it VB and MatLab needs to be run in “real” software. This means that there is version control, existence of a development and testing environments, and release procedures – almost none of which exists in many shops (from personal experience upwards of ^mmm under management).

    This is compounded by the cultural problems of techies vs. traders. Traders have no patience and work from large picture down, while systems start at output and then go to detail (DRL’s and procedures) with the middle filled out later. Techies are notorious for not understanding what their customers need (as opposed to what they say they need), and are terrible at communicating to their audience – assuming they want to hear it. One example includes a major name software that in an intermediate screen displays a price of 101-13+ as 1.01 – the data is (maybe) there and correct, but there is no way to see without running a debugger, as it is generated in a stored procedure or view. What financially literate person is going to volunteer for that?

    The systems people and traders also have a tendency to increment themselves to death. consider the following scenario: a rude, rabid demanding jerk(trader or Head of desk) comes bellowing down to systems where everyone has either been working on their minesweeper skills or discussing arcana such as table and key access speeds, queuing, etc. It demands that abc must be done immediately or there will be hell to pay. The natural tendency is to whip out something and get it out of the office. Do this thirty or forty times, give some personal turnover, and the best systems can and will develop into a hairball.

    Dear MA as regards the OCC, 22 years ago I was hired as the mortgage guy by the then NY Region Div. of Liquidations when the first FDIC (not FSLIC) thrifts had to be closed down. Watching the controlled chaos of a closing with the Local DOL Chief, he turned to me and said “What is scary is not that we are incompetent, which we probably are, but that we are the best – wait till you deal with the morons at the OCC! A friend of mine once got the criticized that his problem was he saw the big picture( I am not making this up). Whatever they write, the goal is to check the box on the appropriate form. Expect more than that (a la FrankenDodd), and trouble will follow.

    Comment by Sotos — March 12, 2013 @ 9:42 am

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