Streetwise Professor

Any time that commodity prices reach highs or lows, speculators are invariably the culprits. Today’s energy market is no exception. Many commodity market commentators have been quite upfront in their assertions that current high energy prices (and metals prices too) are due to speculative excess, rather than supply and demand conditions. Now the Senate Permanent Subcommittee on Investigations has endorsed these views (and given them substantial credibility) in a just released a report claiming that fundamental supply and demand conditions cannot explain current high oil prices, and asserting that speculative activity is to blame instead. The report breathlessly repeats claims that speculation in energy markets has inflated oil prices by as much as $25 per barrel.

Where to begin? The report is a farrago of facts, factoids, and falsehoods stitched together to arrive at a conclusion that is miles beyond what the evidence actually supports. Moreover, although I concur that manipulation is a potential problem in energy markets–as it is in all commodity and even financial markets–the report does not even make the effort to show that current price levels are the effect of manipulation. Nonetheless, it sternly recommends a variety of new regulatory initiatives to combat manipulation, suggesting (by implication) that manipulation is the cause of high oil prices. This is a flagrant example of bait-and-switch of a variety that I imagine that the Subcommittee members would vigorously condemn if committed by your local used car salesman.

The report (and most of the other criticisms of speculation) fails on only two points: logic and evidence. Other than these shortcomings, it’s great.

With respect to logic, the report documents (to the extent available–reliable evidence being hard to come by) the growth of speculative activity in energy markets. It draws particular attention to “long only” speculators such as pension funds and other traditional investment vehicles that historically have not participated in the commodity markets to any great extent, but which have increased their exposure to commodity prices in recent years as a way of diversifying their portfolios. These funds typically invest in the commodity market through investment vehicles tied to commodity indices, such as the Goldman Sachs Commodity Index (“GSCI”), which parenthetically have a very high exposure to the energy market. Moreover, the report alleges that these funds typically are index buyers rather than sellers. (NB. This is itself something curious, as the diversification benefits could be obtained by shorting the index too.)

According to the report:

As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the futures contract by a refiner or other user of petroleum (p. 16).

The large purchases of crude oil futures by speculators, have, in effect, created an additional demand for oil, driving up the price of oil for future delivery in the same manner that additional demand for contracts for the delivery of a physical barrel of oil today drives up the price for oil on the spot market.

Well, not exactly. Note that most speculators–and most particularly the long commodity indexed investors–offset their positions prior to delivery. For instance, the GSCI is rolled according to a fixed schedule, meaning that to replicate the index, the nearby futures contract is purchased sometime prior to the expiration month and then sold some days before that contract moves to delivery. Thus, the “rolling” speculator, even if continuously long, does not contribute any additional demand for physical oil. The supply and demand for spot oil determines the spot price, and the long speculator–and indeed, virtually all speculators–do not participate in this physical market.

If anything, the entry of speculators affects the price of energy price risk. That is, it impacts the “drift” in a futures price to an expected future spot price that is based on expectations regarding supply and demand conditions at contract expiration, rather than affecting the price of physical oil. Put differently, derivatives markets are primarily for buying and selling price risks rather than for buying and selling the commodities themselves. The delivery process ensures that futures prices converge to physical spot prices, but the amount of activity in contracts with payoffs tied to a commodity price need bear no relationship to the amount of the physical commodity available, and if speculators (and others) act competitively, the physical spot price will be driven by supply and demand fundamentals regardless of the magnitude of the “side bets” on commodity price risk.

I wish that this was an original analysis that I could take credit for, but it’s actually quite old. That’s because the arguments against speculation like those contained in the Senate report are themselves quite old, and spurred cogent refutations long ago. For instance, back in the day when the concern was about short speculators driving down farm prices rather than long speculators driving up energy prices, a 1901 report from the United States Industrial Commission on “The Distribution of Food Products” stated:

As we have attempted to show, it is a mistake to represent speculation in futures as an organized attempt to depress prices to the producers.

First. Because every short seller must become a buyer before he carries out his contract.

Second. Because, so far as spot prices are concerned, the short seller appears as a buyer not a seller, and therefore, against his own will is instrumental in raising prices. (p. 233).

These arguments apply with equal force to analyses of long speculation, as to the short speculation that was the concern of the report.

Insofar as evidence is concerned, the report points to the the current contango in the energy market and the co-existence of historically high prices and high inventories as a smoking gun that proves that energy prices have become unmoored from fundamentals, and are instead driven by speculation. (NB. “Contango” means that prices for more distant delivery–such as for delivery in a year–exceed the spot price. The opposite situation is “backwardation.”)

It is indeed true that historically, high levels of inventory are associated with low prices, and since contango is associated with high inventories, contango is also typically found in energy markets when prices are low. Current conditions are therefore anomalous (by historical standards) and require some explanation.

In this regard, it is important to understand just what inventories are for. Commodity stocks are a buffer against future adverse supply and demand shocks. Typically it is desirable to accumulate inventories when demand is low (or supply is high) relative to future expected supply and demand. Thus, during a recession, demand is low, and is expected to rise at some future date. Therefore, it is often economically rational to accumulate inventories during a recession. Conversely, during a demand boom, it is typically economically rational to draw down on stocks in anticipation of a fall in demand, or perhaps more likely, the entry of new production capacity. The market often moves to backwardation under these circumstances. Thus, all else equal, inventories are typically high when prices are low, but it is important to remember that the price and quantity are determined simultaneously.

It is also possible to identify circumstances in which inventories may be high during periods when prices are at historically high levels. In particular, this can occur if: demand is already high relative to productive capacity, demand is not expected to dampen soon, entry of new productive capacity takes a considerable period of time and no new large sources of supply are in prospect, and there major risks of future supply disruptions. The current high demand causes current prices to be high. The dim prospect for demand declines or augmentation of supply means that if current inventories are consumed they will not be available to meet expected future demand or offset future production disruptions, nor will they be readily replaced through the entry of new production capacity. Moreover, the possibility of major supply disruption in the future means that even though things are tight today, they could get even tighter in the future–which in turn means that consuming a unit from inventory today may be very costly in the future when that unit is not available in the event of a supply disruption.

In my opinion, these conditions are present in the current energy market. The current demand-supply balance is tight. There are no major supply enhancements on the horizon. Indeed, some major investments in new capacity, most notably Canadian oil sands, will come on line much later than originally anticipated due to bottlenecks in getting labor and materials in place. The world is rife with unrest in major oil producing regions–the Middle East, Venezuela, Nigeria, even Indonesia and Russia. Rightly or wrongly, in light of the devastating effects of Rita and Katrina (and Ivan the year before), concerns about increased frequency and intensity of hurricanes in the major US production region has raised sensitivity about the vulnerability of US output to future weather-related disruption.

In brief, as tight as things are today, there is a very real prospect that they could get significantly tighter in the future. Under these circumstances, holding inventories in the face of high prices makes sense, and certainly these conditions make it very difficult to have a high degree of confidence that market participants are holding too much inventory.

The evidence–most notably comparisons across markets–also casts serious doubt on the validity of the hypothesis that speculation is causing excessive inventory accumulation and high prices in energy.

First note that most indexed money (e.g., funds that are tracking the GSCI) have positions concentrated in the nearby contracts. The GSCI tracks front month contracts. Therefore, per the speculative excess theory, the presence of new speculative longs should lead to less contango, not more.

Furthermore, note that speculators are active in many commodity markets, not just oil. Many participants in industrial metals markets have also argued that speculation, including speculation from funds, has distorted those markets. Prices are indeed high in these markets (notably copper and nickel), but the inventory and term structure patterns are very different. Base metal stocks (again esp. copper and nickel) are at very low levels and these markets are backwardated. This either suggests that speculators are behaving very differently in energy and metals markets (which would be peculiar, as many of the speculators, especially indexed money are in both markets and trade the same way in both) or that there are different fundamentals driving prices in these markets and that speculation is not the overriding determinant of price and inventory action.

(As an aside, I read a brokerage study which claimed that speculators were driving all the price action in metals, and the producers were notably absent. This begs the question: if speculators had driven prices to unreasonably high levels, why haven’t producers sold into the rally in a big way? )

There are other markets that also attract significant speculative action, including participation by indexed money that trades almost exactly the same way in all markets, that are at relatively low price levels. For instance, wheat, corn and soybean prices are currently at relatively low levels. If mindless long speculation driven by commodity-indexed money is the main driver of commodity prices, why are grain prices low when energy prices are high?

Of course these comparisons cannot by themselves rule out the possibility that speculation has some impact on prices. However, they do speak to the broad claims that speculation is the 800 pound gorilla that is moving commodity prices far away from their fundamental values. The Senate report argues that oil prices are perhaps 30 percent too high as a result of speculation. That’s a huge impact. Given that the “story” in the Senate report holds true for industrial metals and grains (and other commodities too) such a huge impact should be manifest in prices and inventories for other commodities. Most importantly, since especially indexed money trades all markets in the indices the same way, we should see high prices, contangos, and high inventories in all these markets if this type of speculation is exerting such a decisive influence on commodity prices.

All these markets exhibit very different patterns, however. Therefore, the burden should be on the advocates of the speculative distortion theory to provide an explanation for this diverse behavior in response to an activity–speculation, especially by indexed money–that is common to all markets.

The arguments over the impact of speculation have gone on for a very long time–in Wealth of Nations Adam Smith wrote about laws against “engrossing” passed in the late-Middle Ages. These arguments have cropped up periodically in the years since, and are made with particular force when commodity prices are low or high by historical standards. These arguments are so durable because they are so superficially appealing, and because they are hard to disprove. After all, nobody knows what the “right” price should be given supply and demand fundamentals, because these fundamentals are unobserved. That is, no direct test of the speculative-excess hypothesis is feasible. However, if it is widely apparent that commodity prices are substantially different from fundamentals, other speculators would see a profit opportunity and tend to act in a way that would mitigate, and perhaps eliminate, the observed deviation. This mechanism is not perfect (for reasons set out by DeLong-Schelifer-Summers-Waldman, among others) but in a world where hedge funds and others can go long or short at will, and where these vast pools of speculative capital have a strong economic incentive to take advantage of price distortions, one must posit very strange behavior on speculators’ parts in order to rationalize long, speculatively-driven departures of prices from fundamentals.

Long as it is (no pun intended), this post only scratches the surface of the economic issues related to speculation. The “real” impact of speculation–on investment, production, and inventory decisions–is of crucial importance, but altogether neglected here. I look to remedy this in future posts. Specifically, I am working on some dynamic programming models that will make predictions about the impact of speculation on price levels, stock levels, and price volatility in a storage economy. This should be directly relevant to the current debate over the stock-price relationship that is the source of so much controversy in the energy market.

Reduced IT/systems costs is one of the major economies that has been advanced to motivate/explain/rationalize exchange mergers. It is quite risky to bet the farm on realizing these economies, however. Integrating IT systems is always a tricky endeavor given their complexity and idiosyncracies. Much of the information regarding systems lives in the heads of individuals who can leave the merging firm (and since cutting IT headcount is one of the sources of “savings” many are indeed destined to leave). Moreover, fixes of past problems, or implementations of various systems, are imperfectly remembered even by those that remain.

Case in point–LCH.Clearnet. The whole “story” behind the merger was that the merger would allow the creation of a single, efficient clearing IT system to replace the legacy systems of the merger partners, LCH and Clearnet. Three years and many millions of pounds sterling later, the merged entity has not realized these benefits. LCH.Clearnet’s chairman resigned in May, and just recently the CEO David Hardy resigned. His resignation was directly attributable to the difficulties in the IT implementation. A ComputerWeekly article provides a detailed account of the problems, delays, and cost overruns.

To me, this suggests that an exchange merger makes sense if the products of one exchange can be migrated to the existing system of the other partner to the merger. For instance, moving NYMEX products to CME’s Globex, or NYBOT products to CBT’s electronic system (or ICE, as rumor now has it) would not face the type s of challenges that have heretofore stymied LCH.Clearnet. Conversely, mergers involving major systems integration (which seems to be the case for NYSE-Euronext) are much riskier. Indeed, as it is rare (unprecedented?) to read of systems integrations that went more smoothly than anticipated, all of the risk seems to be on the downside.

So a word to the wise would-be empire building exchange CEO. Building empires can be fun–if it doesn’t cost you your head. If the economic case for a merger is predicated on realizing IT savings, that is a very real risk indeed.

Growing up in the Midwest during the Cold War, the word “silo” evoked images of blue A.O. Smith grain silos, or Minuteman missile facilities. Now the word has come to mean “vertical integration” in MBA-speak.

The “vertical silo” issue is front and center in debates over the structure of European financial markets. Deutsche Borse owns both a trading platform and a clearing system. Trading is pretty well understood, but clearing is part of the essential “plumbing” of the financial system that most don’t understand. Clearing is the process of confirming and matching transactions, establishing obligations to complete trades, and in some cases, putting a central counterparty in between ultimate buyer and seller in order to reduce performance risk.

The DB silo has been criticized as an impediment to competition in the trading for German stocks. It has been alleged that by denying other exchanges to its clearing platform, DB protects its market dominance in trading. The recent merger discussions between DB and EuroNext stalled in part over DB’s refusal to shed its clearing operation. The proposed EuroNext-NYSE combination will supposedly eschew the silo model.

So who’s right? As a dyed-in-the-wool Chicago School guy, I look askance at anti-competitive explanations of vertical restrictions and vertical integration–it’s in my DNA. Nonetheless, I do recognize that there are circumstances in which vertical restraints can be used to impede competition. (Note that quintessential Chicago guy Les Telser’s famous article on resale price maintenance considered both pro- and anti-competitive explanations of this vertical restriction.) Hence, rather than respond reflexively, I think I should provide some analysis of the issue.

This analysis must be predicated on a recognition of the importance of network effects in both trading and clearing. It is well known that the nature of liquidity creates a network effect in trading of financial instruments; see my 2002 JLEO paper, or an earlier paper by Pagano for a formal analysis. This network effect exerts a centripetal force that tends to induce all trading to tip to a single venue. In my JLEO piece, I show that alternative trading venues (e.g., the block market, the third market) can survive only by limiting participation to the verifiably uninformed. The predictions of these models are largely supported by the data. Most trading does tend to concentrate on a single market, and off-exchange trading tends to have much less information content than on-exchange trading. Attempts of entrants to compete with incumbents, e.g., LSE’s attempt to wrest the Dutch equities trade from EuroNext, Eurex v. CBOT in Treasuries, or EuroNext.Liffe v. CME in Eurodollars, almost always end in failure.

Although it has not been analyzed as extensively, there are strong sources of network economies in clearing too. The number of matches between buyers and sellers is maximized when all trades are submitted to one clearer. If there are several clearers, and the buyer and seller direct orders to different ones, no match occurs, or the clearers must take the additional step of contacting each other to complete the trade. This is duplicative, and increases the possibility for costly errors or delays in trade processing.

The use of netting to economize on the flows of cash and securities also creates network effects. Netting economizes on liquidity needs; traders who both buy and sell in a given settlement cycle need only the cash necessary to pay for their net transactions. Netting possibilities are maximized when all orders are directed to a single clearer. [N.B. The term “liquidity” used in this context is somewhat different than its use in the trading context. In the clearing/settlement context it refers to to the amount of liquid assets (cash, readily marketable securities) needed to support/finance the clearing and settlement process.]

Network effects create a centripetal force which induces tipping to a single venue. Therefore, if clearing and trading in a particular instrument are separate, one would expect tipping to lead to the survival of a single trading platform and a single clearer. This creates the real possibility of a bilateral monopoly problem. This has two potentially adverse consequences. First, it leads to double marginalization. An exchange that possesses market power due to the network effect in trading will markup the above marginal cost clearing cost that a clearer that also possesses market power due to the network effect in clearing. Second, it raises the possibility of holdup and opportunism as the monopoly exchange and the monopoly clearer attempt to capture the quasi rents that arise due to specialized investments in clearing and trading infrastructures. (There will be an additional source of inefficiency if clearing services and trading services are not consumed in fixed proportions, i.e., they are not perfect complements. In this case, production may be inefficient due to distortions in the mix of clearing and trading inputs. However, it seems that fixed proportions is a reasonable assumption so I focus on double marginalization and opportunism.)

Integration is a well-known–and usually efficient–way to mitigate both double marginalization and holdup. Therefore, one expects to observe integration between trading and clearing. This is typically, though not always the case. Most US futures exchanges own their clearing arms. The US stock exchanges jointly own their clearing entity, the NSCC, just as US options exchanges own the Options Clearing Corporation. As already noted, DB is integrated into clearing. EuroNext is something of a hybrid. It owns a 25 percent stake in its clearing provider, LCH.Clearnet.

There are exceptions, of course. The LSE secures its clearing services in an arms length transaction with LCH.Clearnet. The LCH has long provided clearing services for numerous (and relatively small) UK futures exchanges. Nonetheless, there is considerable integration between clearing and trading functions, which is not surprising given the bilateral monopoly issues.

So what are the efficiency implications of integration, and how would mandatory dis-integration of clearing and trading affect efficiency? I am putting the finishing touches on some models that address these issues. In the basic model, there are network effects in both trading and clearing. Moreover, neither stage is contestible. These effects lead to tipping at each level. That is, competition between clearers leads to the market tipping to a single clearer, and competition between exchanges leads the market to tip to a single trading platform. If clearing and trading are separate, double marginalization impairs efficiency, and creates an incentive to integrate clearing and trading. Similarly, any holdup costs also reduce efficiency. Therefore, integration is the efficient outcome in this case even though it is not first best because there is market power due to network effects.

Therefore, when the realities of network effects are considered, the case for dis-integration, well, disintegrates. Since network effects lead to considerable market power–and arguably natural monopoly in certain segments of the market for trading–dis-integration can create serious double marginalization inefficiencies since it is highly unlikely that an independent clearer–which will likely be a monopoly or at the very least a firm with considerable market power due to network induced tipping–will sell its services at marginal cost. Moreover, dis-integration will likely raise holdup costs. If there is considerable market power in trading as one would expect due to tipping (though regulations such as RegNMS can mitigate this power), dis-integration will not appreciably reduce exchange market power, but will raise double marginalization and holdup inefficiencies. This is a lose-lose proposition.

Therefore, any case for dis-integration must be based on the presumption that trading in and of itself is reasonably competitive. I am working on other models which attempt to derive conditions in which dis-integration can enhance efficiency. In these models, there is tipping in clearing due to network effects (so the clearer is a natural monopoly) but Cournot competition among N>1 exchanges at the trading level. If (a) the monopoly clearer in independent, and for some reason sells at marginal cost, and (b) there are sufficiently high fixed costs of operating a clearinghouse (which obviously makes assumption (a) problematic unless there is some two part pricing scheme), then foreclosure and a loss of efficiency can occur. One of the Cournot competitors can buy the clearer, and the other Cournot competitor(s) find it better to go out of business rather than incur the fixed costs of establishing their own (inefficiently small) clearing operation. In this case, output and welfare go down. Welfare is higher if the clearer is separate–and is constrained in its ability to exercise market power.

Back here on earth, we should doubt that a monopoly clearer will provide services at cost (more on this below). If the monopoly clearer charges a super-marginal cost price, double marginalization arises with Cournot competition at the trading level. In this case, integration of clearing and trading into a single monopoly firm actually results in larger output and welfare, even though deadweight monopoly losses persist; integration doesn’t increase the amount of monopoly power, which the clearer possessed in any event, but does reduce the double marginalization inefficiency.

This “foreclosure” outcome can be an equilibrium if the fixed cost of operating a clearing function is sufficiently high. If fixed costs are sufficiently high, one exchange and the clearer merge, and the other exchange loses money if it creates its own integrated clearing operations (because of the fixed costs and the fact that these integrated operations are inefficiently small since they cannot exploit all the network effects). If fixed costs are sufficiently small, the model predicts that one may observe competing integrated exchanges, each with its own suboptimally small clearing operation. I have not yet pinned down the welfare comparison here, as there are offsetting effects–redundant fixed costs and suboptimally small clearing networks on the one hand and greater competition on the other. My intuition is that there is no unambiguous welfare ranking in this model.

Regardless, I don’t find this model very plausible. The Cournot model banishes network effects from trading, which is unrealistic. Moreover, it’s hard to have a great deal of confidence that a separate, monopoly clearer will charge marginal cost prices. In this case, double marginalization inefficiencies likely overwhelm the competitive implications of foreclosure; barring integration doesn’t reduce market power (because the monopoly power arises at the clearing level) but it does raise double marginalization costs. Moreover, the multiple-integrated-exchange outcome that is possible in the model is not widely observed. Indeed, it is hardly if ever observed. Thus, although there are conditions in which dis-integration is welfare enhancing, it is highly doubtful that one would observe these conditions in practice.

Standing back and reviewing the argument makes it clear that a necessary–but not sufficient–condition for forced dis-integration to make sense is that the natural monopoly clearer sell its services at marginal cost. Is this realistic? Color me skeptical.

In essence, this requires either (a) contestibility in clearing or (b) regulation of clearing prices. Don’t even get me started on the latter possibility, so let’s focus on contestibility. On a priori grounds, there is some reason to be skeptical about the complete contestibility of the clearing market. There are likely large costs to switching clearers, especially inasmuch as system users must invest in an IT infrastructure specific to a given clearer in order to connect to it. Switching clearers requires investment in a whole new infrastructure. Given the sums of money involved in the clearing process, and therefore the high costs associated with errors, technical problems, lack of connectivity, etc., this investment is not likely to be small. This clearly creates switching costs, and thereby impedes contestibility.

That said, it must be noted that there are exceptions to vertical integration that suggest some degree of contestibility at the contract renewal stage. Recall that LSE is not integrated with its clearinghouse. Moreover, when its clearing contract with LCH neared expiration, LSE let the contract out for tender. There was competition for the business, which LCH retained, but at a 25 percent savings according to LSE officials. The interesting–and unanswered question–is how the contract price compared to cost. As George Stigler said, data is not the plural of anecdote, but this episode does suggest the possibility that there is a degree of contestibility in the clearing business. On the other side of the ledger, this may be the exception that proves the rule–integration or exclusive contract is the norm, and the LSE episode is the exception.

LSE is also attempting to encourage competition between LCH.Clearnet and a Swiss clearing firm x-clear. Specifically, LSE has signed an agreement whereby x-clear can provide member firms with the ability to choose where to clear. x-clear has a “sub-CCP” account with LCH.Clearnet. If the buyer and seller in a trade both choose x-clear to clear the trade, that entity serves as the CCP. Conversely if one chooses x-clear and the other LCH.Clearnet, x-clear serves as the equivalent of a clearing member of LCH.

It is evident that there are trade-offs in this arrangement. On the one hand, it may increase competition–at least for awhile. On the other, it almost certainly will result in cost duplication and failure to exploit all netting economies. This trade-0ff raises questions. If the arrangement does not result in a relatively seamless merger of the two clearing pools, does the increase in competition more than outweigh the inefficiency that results from the simultaneous existence of two suboptimally scaled clearers that do not exploit all network effects? Will the two actually survive, or will the market tip? That is, will the increase in competition endure, or will it prove evanescent? Do customers need links with both clearing houses? How much additional cost does this involve? The experiment is new, and deserves watching.

In sum, dis-integration is not a magic spell that will make European securities markets more efficient. Indeed, it is plausible that it would make these markets even less efficient. In essence, it is necessary to acknowledge the implications of network effects in trading and clearing. These are the sources of market power and inefficiency, and dis-integration will not fix them. In my view, it is plausible that not only will dis-integration not fix these inefficiencies, it will introduce other inefficiencies (double marginalization and holdup). Therefore, dis-integration in and of itself is not equivalent to cutting some Gordian knot that constrains competition in securities markets.

Instead, improving efficiency will require separate responses to facilitate competition in both clearing and trading. Measures like RegNMS in the US–which effectively weakens the order flow/liquidity externality by opening access to the total liquidity pool–can improve competition in trading. Clearing seems to be a bit more nettlesome.

In brief, don’t expect any easy solutions. Network industries always pose competitive challenges, and virtually every conceivable regulatory scheme to address these challenges is problematic, at best.

Interestingly, integration has attracted little regulatory or legislative attention in the US futures industry. It will be interesting to see whether US futures bourses will be able to fly under the radar on this issue forever. Even if US regulators don’t express concern, the growing internationalization of the futures business might spark foreign (esp. European) regulatory/anti-trust scrutiny. Note that the EU is engaged in a long raging anti-trust battle against Microsoft. Note too that there is considerable opposition to the vertically integrated clearing model in the EU. Putting two-and-two together, this suggests that EU regulators might put CME or CBT or NYMEX in their crosshairs as the globalization of the futures business proceeds apace. This may be particularly true if a US exchange attempts an acquisition in the EU. Just speculatin’, but it should be an issue that US futures exchange executives give some thought to.