Streetwise Professor

August 3, 2008

Another History Lesson

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics — The Professor @ 8:40 am

During his testimony before the House Ag Committee on 9 July, 2008, Rep. Bart Stupak (D-MI) asserted that current speculation in the oil markets is just like the Hunts in silver in 1980. The next day, a Republican representative (Bob Goodlatte, R-VA of Virginia, if memory serves) asked me whether the analogy was correct. (Unfortunately, hearing transcripts are not yet available.)

I responded no, they were not, and that indeed the contrast between the Hunt episode and the current oil market provides an excellent illustration of (a) why there is no evidence that speculation is distortion the energy markets, and (b) what kind of evidence you would see when such distortion occurs.

In stark contrast to oil speculators today, the Hunts accumulated huge–and I mean huge–quantities of physical silver. In September, 1979 the Hunts owned about 40mm ounces of silver in deliverable stocks, and COMEX and CBT deliverable stocks were approximately 105mm ounces. By March the Hunts owned approximately 100mm ounces of deliverable stocks, and total COMEX stocks had risen to about 130mm ounces. In addition, I have read that the Hunts also owned about 90mm ounces in Switzerland. In a nutshell, during their silver escapades, as prices were rising dramatically, the Hunts held large and rising amounts of physical silver, and deliverable silver stocks rose substantially (approximately 20 percent).

Moreover, there were manifest signs of distortions in the physical market. Massive amounts of silver coins were melted into bullion. So many coins were melted that the capacity to convert them was strained. As a result, the differential between the price of bullion and the price of coins swelled to unprecedented levels. (This differential represents the shadow price, and the marginal cost, of the conversion. The marginal cost increases with the amount of coins converted.) Large amounts of silver flowed out of India–and into the hands of the Hunts.

The prices of silver were clearly distorted in 1979-1980. These price distortions were reflected in (a) the flow of large stocks of silver into the Hunts’ hands, and (b) distortions in the physical market. This illustrates that if speculators drive up prices–if they are willing to pay more than anybody else for the commodity–they must end up holding the commodity, and that distortions in prices inevitably lead to distortions in the physical market.

None of these signs are present in today’s energy market, or other commodity markets, for that matter. Prices are indeed high, but speculators are not sitting atop large and growing stocks of the physical commodity. If they were, one could say, with Rep. Stupak, that we are seeing the second coming of the Hunts. Since they aren’t, we can’t. Indeed, as I testified in Congress, the differences between silver 1979-1980, and energy in 2007-2008 are very revealing. And what they reveal is that today one should look for other causes of high energy/commodity prices than excessive speculation.

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