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Streetwise Professor

January 2, 2014

Riddle Me This: Speculation Vs. Hedger Edition

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 7:50 pm

To get back to the substance of the speculation debate, let me reprise something I’ve discussed for years to illustrate the vapidity of many of the arguments about speculation.  I’ve been making this point for more than 6 years: it was a focus of a presentation I made at a conference in Champuloc, Italy in January 2008.

It relates to the use of position data to attempt to identify the price impact of speculation.  You know the drill.  Speculators are huge net long, so they must be driving up prices, right?  We’ve seen that argument repeated over and over and over again.

But here’s the thing.  For every long, there’s a short.  So how do you know the net long speculators are driving prices up?  Why aren’t the net short hedgers driving down prices?

Here’s the example I keep coming back to that illustrates the stupidity of using net speculative positions to claim that prices are too high or too low.

Back in the 1990s and early 00s, gold prices were low.  Very low.  $300 and below.  Back then, the hue and cry was that prices were artificially low because . . . wait for it . . . producers were massively short because of hedging programs.

Well, if producers were massively short that means that speculators were massively long.  So if speculators drive prices, why weren’t gold prices stratospherically high in the late-90s early-00s?  After all, supposedly in 2008, and the last couple of years, the massive long speculative positions were inflating prices.  Why didn’t the massive long speculative gold positions a decade ago inflate gold prices?  Flipping things: If short commercial positions were depressing gold prices a decade ago, why didn’t they depress oil prices in 2007-2008, and over the last couple of years?

Hence the danger of superficially examining net positions and claiming that one side of the market is inflating (or depressing) prices: an equally legitimate argument is that the other side of the argument is depressing (or inflating) prices.

But the point is that neither argument is legitimate: both are equally illegitimate.  Derivatives positions net out to zero.  Derivatives are in zero net supply.  Looking at one side of the market, and ignoring the other, makes no sense.

Basic finance theory says that if anything, net positions should predict risk premia, and price trends.  In a simple Keynes-Kaldor model, if speculators are net long, prices should drift up.  Or not: if the price of the commodity in question is uncorrelated with the pricing kernel and markets are well-integrated, prices won’t drift at all even if speculators have a net position.

But the basic point is that in standard finance speculation and hedging affect risk premia, not price levels.  The relationship between positions and risk premia depends the integration between the commodity market of interest and the broader financial markets, and the covariation between the commodity price and the pricing kernel.  If the “financialization” of commodities means anything, it means that commodity markets have become more closely integrated with the broader financial markets, and that this has impacted risk premia.  The evidence of Hamilton and Wu (and UH PhD student Bingxin Li) points exactly in this direction: risk premia in oil plunged to near zero in the mid-2000s, when index trading increased dramatically.  Any impact on the level of prices overall is due to indirect effects of risk premia: risk premia affect the costs of hedging which affect output and storage and consumption, which affect prices.  But whatever those knock-on effects are, whether prices rise or fall, they are likely efficiency enhancing: they reflect the consequences of a more efficient allocation of risk.  (By the way, I explained this to Chilton years ago.  Talk about pearls before swine.)  (I say “likely” because of the usual caveats about the difficulty of making welfare comparisons in incomplete markets.)

So word to the wise.  If you want to make a persuasive argument about the impact of speculation (or hedging) on the level of spot prices (rather than on the difference between spot and futures prices), don’t say anything about net derivatives positions.  Because the market as a whole has no net position.

Comparing the gold and oil cases has reminded me of this Escher drawing.  Who is drawing whom?  Which hand is the long?  Which hand is the short?

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9 Comments »

  1. As a person that speculated for a long time, and had to report positions to the CFTC, I can assure you the analysis is correct. I might quibble with smaller markets that are more amenable to manipulation. Thinking of the pork belly market-where the players clearly manipulated it.

    Big liquid markets with lots of secondary and tertiary markets along with a cash spot market are virtually impossible to manipulate. They can be manipulated on the close for a settlement price; but that doesn’t impact the long term trend and only impacts nightly position margin money.

    However, as we saw, the bankers manipulated the LIBOR rate using the cash market in 2008. Futures traders knew something was up and reported the anamoly to the CFTC-to no avail.

    Day to day speculation doesn’t do anything to underlying price. The fact that 70% of the market speculates (high frequency trading) compared to 20% years ago is not relevant. Speculators have information and use that to project future prices. Different speculators have access to different information and price the market differently-even if they all are long or short. As you say, there is an opposing side and futures markets are a zero sum game.

    Speculators are necessary parts of well functioning markets. They provide the grease that make it easy to enter and exit, and narrow spreads to make the market cheaper to trade.

    Comment by Jeff — January 2, 2014 @ 9:25 pm

  2. Speculation which involves both buying and selling to assume risk from producers and consumers is exactly what commodity markets were designed for. The question for me is what happens when long term investing is introduced to commodity markets? When parties buy and only buy, does that not distort the price discovery mechanism?

    Comment by Andrew Stanton — January 3, 2014 @ 9:09 am

  3. I think of a speculator as an investor who takes on risk with a view to a transaction profit. In a futures market he may do that through buying first, and selling later; or through selling first and buying later. In doing so he fulfils a useful economic purpose by enabling end-user producers or consumers to hedge by off-loading risk with a view to avoiding a transaction loss.

    Now, when I started out in 1990 in the energy futures market as a Director of the International Petroleum Exchange (now part of ICE) the only Brent Crude Oil contract months in which there was any open interest were the spot Month 1, Month 2, and Month 3. It was rare for anyone in the market to buy forward beyond that.

    But over the years the market evolved and the key innovation was the introduction of the first long only or ‘passive’ fund – the Goldman Sachs Commodities Index fund. Goldman’s genius was to introduce the idea of ‘inflation hedging’ to investors whose aim was not – as with speculation – to make a transaction profit, but rather to avoid loss. This fund, and its successors and competitors were long only, and would roll contracts over from month to month.

    One of the IPE innovations I introduced – Exchange of Futures for Swaps – facilitated the funds and heir brokers in taking on long positions beyond Month Three,because the producers typically wanted to hedge as far out as they could.

    It wasn’t long before the funds’ presence in the market and the monthly roll-overs attracted the attention of ‘local’ traders and the phenomenon of ‘Date Rape’ later documented by John Dizard. I had come across the same phenomenon years earlier in 2000 after I left IPE when I became aware, during a disciplinary case, that routine manipulation of settlement prices was occurring with a view to making profits on OTC positions. I blew the whistle on this at an embarrassing time for IPE and I lost everything I had: income, home, family, the lot.

    But I digress.

    Since 2001 or so we began to see oil market players begin to take advantage of the use of the off-exchange prepay contracts with which Enron defrauded creditors and investors alike. The outcome of the use of prepay instruments is that producers lend oil to investors, who in turn lend dollars interest free to producers, and this form of monetisation of crude oil is achieved without going through the exchange casinos and paying a cut to the House.

    Over the period to 2008 we saw the IPE’s Brent Crude Oil complex become wholly owned/controlled by BP and Goldman, both through on and off-exchange trading, and the fact that BP’s Forties cargoes (BP maintained ownership of the pipeline and infrastructure even though they sold the field and Grangemouth refinery) essentially gave control of the BFOE physical market benchmark price.

    The Prof is quite right that speculation did not cause the 2008 spike: it was firstly caused by a long ramp in prices supported by inflation hedger investor funding, and the tight control and support of cargo prices, and secondly by a trading coup using proprietary money. When the price collapsed in 2008 the Saudis’ pain and cash-flow eventually became intolerable and JP Morgan sold them on the idea of prepay financing which was funded by the massive flood of ‘inflation hedging’ dollars which wanted anything but dollars as interest rates went to zero and the Fed turned on the printing press.

    The market was then marched back up the hill again, and the super contango at that time was a result of the sheer scale of the influx of dollars into physical markets via the creation of ‘dark inventory’ of monetised crude oil.

    It is my thesis that the oil market price has been financialised and supported by muppet money since then, plus a large chunk of Iran risk premium genuine speculation. If there is one thing certain about commodity markets it is that if producers can find the leverage to support prices then they will, and this ‘macro’ manipulation -quite reminiscent of Hamanaka’s 10 year escapade in the copper market has been going on ever since. The lunatic Brent/WTI spread and the disconnect between crude oil and natural gas prices are both evidence of this.

    What we are now seeing IMHO is what happens when the ‘dark inventory’ of pre-paid oil is liquidated. Financialisation of physical and futures exchange markets by investors whose motivation is to avoid loss, rather than to make transaction profit, in my view destroys the price formation of these markets wherever they have become dominant. For a time this accounted for the complete detachment of most markets from reality and the ‘risk on, risk off’ reactions which took place every time the yield curve twitched.

    So to come to a conclusion, I think that the Prof – who is more clued up about markets than anyone I know – has missed a trick in relation to the effects on price formation of participation of risk averse financial investors in markets.

    Comment by Chris Cook — January 3, 2014 @ 12:55 pm

  4. Thanks. I wouldn’t say though that the market is always net neutral. The market balance is the inventories. When they’re building, the market is going longer. When they’re depleting, the market is going shorter. You could imagine if you want that there is some theoretical “natural” inventory level below which the market is net short.

    So the best answer to speculator-driven overpricing of commodities is “where’s the inventory build”. The only way speculators can sustain a price over real supply-vs-demand is to remove supply – that is, to sustain overpricing one most continually build inventory.

    A short-term spike like the mid-2008 ramp from around $120 past $140 and right back again can surely be explained by speculation. Looked to me like a classic short squeeze 0 ie, long speculators briefly abusing the shorts in a weird little last long hurrah before the crash.

    A long-term price ramp like that from 2002 to mid-2008 can surely not be explained by speculators, as they would have had to have been building inventory continually the whole six years.

    Owning an ETF is no different from owning a future without intending to take delivery. Either way if you want to stay long you’ll have to pay a roll that more than covers the cost of storage. Although you’ll probably just be matched to a short or shorts. Yes, even if you own the supposedly long only GSCI.

    Comment by Tom — January 3, 2014 @ 9:13 pm

  5. Andrew Stanton, I think I know what you are getting at. When the big commodity funds just buy and roll, does it distort price? In the short run, maybe. In the long run, I don’t think so. If there is a price discrepancy between the expected future price, the spot and the current future price; a speculator should be able to arbitrage risk free between them to lock in a profit.

    Comment by Jeff — January 4, 2014 @ 9:17 am

  6. @Tom one quick question: why don’t we see in the data then hedgers selling and driving prices down though – that is temporary troughs in pricing.

    Comment by Mel — January 4, 2014 @ 6:51 pm

  7. The following doesn’t make sense to me – people engaging in high frequency trading are writing software to massively buy commodities to drive prices up and then selling them. But if I’m a clever programmer why cant I write software to detect this and then hedge it because I know prices will come down. I’m sure that speculating on prices going up went on in the early stages, but now with all these programmers? I think this is the Craig’s point that things are not getting away from the equilibrium point and if they do it is the require premium on their bet.

    Comment by Mel — January 4, 2014 @ 7:13 pm

  8. Buying a future and repeatedly rolling, or holding a commodity ETF and paying its built-in roll, is very much like owning physical commodity and then paying somebody to store it. (Okay, there are some minor differences re: future vs spot, but those don’t really matter except to market pros.) The more people own ETFs or roll futures, the higher inventories will climb. The other side of their trade will be the financial services sector, which will earn income from them by storing commodity, creating ETFs and/or futures, and collecting the roll. Storage is much cheaper than roll. That largely explains why the guys promoting commodity ETFs have been buying into storage.

    Surely building inventories must push up prices as it reduces real supply flows. But the impact of inventory build is a one-off: supply flows return to the production rate as soon as inventories stop building. Likewise, supply is above the production rate while inventories are liquidated, depressing the price.

    Prices meanwhile are set by speculators guessing future supply, demand and inventory trends. It’s surely possible for speculators to collectively guess wrong and push the price in the opposite direction from the underlying real supply and demand trends, until their Wile E Coyote moment.

    I see some room for intelligent debate over the question of how much speculation affects prices. We can intelligently debate what the inventory trends really were, as there is no definitive data. We can intelligently debate the elasticity of demand, ie, how much price movement do you get per x amount of inventory movement? But there’s no intelligent debate to be had on whether speculation caused the whole 2002-2008 commodity price ramp. That’s just ridiculous.

    Comment by Tom — January 4, 2014 @ 8:48 pm

  9. Tom

    The problem with prepay when carried out opaquely (Rosneft are busy doing prepay contracts transparently to repay debt taken on to finance the BP/TNK purchase) is that it creates a ‘dark’ inventory – with zero storage costs – of producer oil, in respect of which the economic interest has been monetised through an oil loan against a dollar loan.

    The existence of dark inventory also creates asymmetric information benefiting those who are aware of this inventory relative to those who are unaware, and a two tier physical market. BP/Goldman benefited massively from this asymmetry, and later on, so did JPM, who took on Goldman’s key trader, Jeff Frase.

    One sign that the commodity fund/passive investment game is over(there’s no point in hedging inflation that will never happen, is there?) we see Frase headed off to Noble: another is that JPM appears to have put its OTC forward leg of prepay positions on exchange as they are run off.

    Comment by Chris Cook — January 5, 2014 @ 1:11 pm

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