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.