Streetwise Professor

All you clearing and market infrastructure aficionados must read Bill Hodgson’s piece on collateral transformation at DerivSource.  He points out quite accurately the new sources of fragility and vulnerability to stress that will arise from collateral transformation services that are being offered to finance CCP margins in the aftermath of clearing mandates.

The bitter irony here is that many derivatives end users (real money investment funds, industrial hedgers) did not pose any real systemic risk under bilateral structures.  But forcing them to clear drives them to utilize funding mechanisms that are systemically risky.  As one big corporate end user told me: clearing mandates have transformed credit risks into liquidity risks: I can manage the first, but the second scares me.

I continue to gape in amazement that the sorcerer’s apprentices that created these mandates did not think to step two.  They did not step back and ask: “Gee, we’re imposing a major change on the structure of financial markets.  How will market participants respond?”  This is especially unbelievable since a big component of the narrative of the financial crisis is that it was the result of excessive financial engineering.  What, did FrankenDodd, Timmy!, GiGi, the G-20, the EC, etc., think that the big changes that they imposed would not lead to a new burst of financial engineering?  Are they really that clueless?

I think I know the answer.  I think you do too.

Markets do not stand still.  Market participants will adjust contracts in response to regulations and laws motivated by beliefs that the existing system of contracts is flawed.  A useful first approximation is that these contractual adjustments will try to reproduce the economic substance of the banned or restricted contracts.  However, many of the work-arounds necessarily utilize less efficient–and often more fragile–ways to achieve that substance.  Which means that vulnerabilities have largely been relocated, rather than eliminated, and in many cases the new vulnerabilities are more dangerous than the old.

Read Bill’s piece to get an excellent illustration of this dynamic at work.  And then remember that the biggest systemic risk is government, and in particular, ill-considered government policies.  And that’s especially true when static-minded legislators and regulators attempt to impose their vision on a dynamic, strategic, reacting, self-ordering system.

Kinder Morgan’s Richard Kinder let it all hang out last week.   He laid into two of my favorite targets: the Obama administration’s unicorn-based energy policy and Gazprom.

On US energy policy:

Mr. Kinder didn’t stop there. He also regaled company employees, including many watching by webcast, with tales of his meetings with President Barack Obama and his energy secretary, Steven Chu.

He said he was “astounded” at how little consideration they gave to natural gas as a “game changer.” As time has gone on, he said, Mr. Obama and his aides have come to realize that “in the real world that the rest of us live in, you know, natural gas is really important.” But they “still like bicycles and wind,” Mr. Kinder said. And “you know, they loaned a lot of money for solar panels,” he said to laughs, in an apparent reference to the administration’s loan guarantees to Solyndra LLC.

That’s gonna leave a mark.  The White House’s response?  Pathetic:

“The President has made clear that natural gas has a central role to play in our energy economy,” a White House spokesman said in response.

Whatever.  Yes, gas will play a central role in the US’s and the world’s energy economy.  And Obama and Chu won’t have squat to do with it.  Private ingenuity and private capital are changing the game.  Public “ingenuity” and public “capital” generate waste, not power, pace the Solyndra debacle (which is only the first and most well-known of a slew of government-funded alternative energy snafus).

On Gazprom:

The bankers advising him, he said, had declared it to be the biggest pipeline company in the world. “And I said, ‘Wait a minute. What about that Russian company called Gazprom?'” he recounted at the company’s Houston headquarters. “We are not as big as [Russian Prime Minister Vladimir] Putin’s Gazprom, but then we don’t break people’s kneecaps either,” he said. “We just have to rely on ordinary persuasion, you know.”

Too true.  Too funny–in a kind of black way.  And as the previous post demonstrates, if Gazprom ever has to rely on ordinary persuasion, it is in deep trouble.

By the sounds of this speech by deputy chairman Alexander Medvedev, Gazprom is indeed feeling that its beloved oil-linked pricing mechanism is under siege.  Medvedev’s tone is very defensive, and his arguments risible.  How risible?  Let’s deconstruct.

Fail #1:

“Oil-indexed , long-term contracts that ensure the basic supply volumes from Russia, Qatar, Norway and Algeria… are exactly the mechanism that protects all the parties, since the gas market is not like, for example, the fish market, where you can catch, sell, and make a profit in one day,” Medvedev said.

Well.  Oil isn’t like fish: don’t catch, sell, and profit in a day on oil.  But there are vibrant spot and term markets for oil: oil prices aren’t linked to anything else, but fluctuate minute-to-minute with market forces.  And gas isn’t like fish either, but there is a vibrant spot and term gas market in North America.  So it’s obviously nothing inherent in gas as a commodity that precludes the development of a vigorous spot market, or necessitates oil-linked pricing.

Jeez, apparently Medvedev has been consulting with Gensler about inane market analogies.  Gensler: apples.  Medvedev: fish.  Both: lame.

Fail #2:

“Two-and-half years of abominably low spot prices in Europe have created the illusion that gas has lost its link to oil once and for all. This is not true.

So gas has decoupled from gas in the short run.  Even if they recouple in the future, gas is always coupled with gas.  A gas-based pricing mechanism can never become decoupled from gas, but gas and oil can become decoupled.  So the movement away from oil-linkages towards reliance on robust gas pricing mechanisms reduces the risk of decoupling and more efficient pricing.

Fail #3:

Spot-price trading is incapable of giving correct price signals to the market due to the small volumes and low liquidity.

Trading volume is endogenous.  Liquidity feeds liquidity.  As the US experience shows, liquid and deep cash and derivatives markets can develop very quickly given the right structural conditions: movement away from oil-linked mechanisms would accelerate this process dramatically.  What’s more, the Dutch gas hub is already pretty liquid, as is the UK’s National Balancing Point.  They certainly give better pricing signals than oil.  They will only give more accurate signals as market liquidity develops–which it will quite rapidly if oil-linked pricing and contracts fade away. Moreover, prices that don’t reflect fundamentals spur transactions that tend to eliminate inaccuracies.

Fail #4:

“US prices are so low they do not cover operating costs and in our opinion this situation will not last long. The situation there will return to normal and will make the US market attractive again.”

A lot of smart people are betting otherwise.

And here’s some whine to go with all that fail:

Medvedev also hit out at Europe’s efforts to reduce Gazprom’s dominance. “Natural gas has become a hostage of geopolitics in which there is an artificial demonisation of Gazprom,” he said. “Sometimes it seems that if even the export of bananas or coal were the largest source of budget revenues for Russia, it is in this area that political games would be played. We do not believe that there is an energy security problem in the EU.”

All at once now: awwwwwwwwww.  Boo-frickin’-hoo.  Poor, poor, persecuted Russia.  Poor, poor, misunderstood Gazprom.

Amazing.  Gazprom is a grotesquely inefficient state protected monopoly with a reputation for thuggishness, corruption, and opacity.  Gazprom isn’t demonized: it is justifiably reviled.  100 percent natural ingredients: nothing artificial about it.

Again, it warms the cockles of my heart to hear Gazprom attempt to defend an archaic pricing mechanism.  The defensiveness means they are feeling the heat: the silliness of their arguments makes it plain that the economics are inexorably consigning oil-linked contracts to oblivion.  The fundamentals of the gas market are changing as dramatically as the contracting practice: indeed, these fundamental changes will drive the move to new pricing mechanisms.

Medvedev knows that Gazprom is a Soviet relic that will face daunting difficulties in a more competitive environment in which gas fundamentals, not oil fundamentals, drive prices.  Gazprom is attempting to fight market forces, but in the end, market forces will win–with bleak consequences for Gazprom, and the parasitical class that feeds off it.

I’m in New York.  No, I’m not joining OWS down in Zuccotti Park.  Quite the opposite.  I was speaking at event sponsored by the object of their ire, at the JP Morgan Chase Commodity Forum.

I spoke about Dodd-Frank and commodity trading.  I did my shtick, and it went over pretty well: I was surprised that “Frank-n-Dodd” was something most hadn’t heard before.  The audience found the phrase amusing, and more than a few people remarked on the phrase afterwards.

Substantively, the most interesting thing I heard was said by Morgan’s head of commodities, Blythe Masters.  She noted that F-n-D imposed huge compliance and administrative burdens.  Huge.  Moreover, these are fixed costs.  So Frank-n-Dodd increases economies of scale in banking, which will favor the big over the small, and encourage the big to get bigger and the small to go away.

In other words, something ostensibly intended to address too big to fail will encourage big banks to get bigger through regulation-induced scale economies. The effect will be the exact opposite of the intent.

The road to hell is paved with good intentions.  Frank-n-Dodd just well may be the world’s largest paving company.

The CFTC voted out two rules today, one on position limits, the other on clearing.  I’ve beaten both issues to a bloody pulp over the last couple of years, so I don’t have too much to add.  Just a couple of high level comments.

Bottom line: Both rules are highly ill-advised.

Regarding position limits, some of the most inane provisions of the original proposal are gone, notably the “class” limits that constrained netting across the futures and OTC swaps.  This was a hidden constraint on market making by dealers, and made no economic sense.  Fortunately it is gone.  Also gone–for the most part–is the conditional spot month limit that treated cash-settled and delivery-settled contracts differently.  This made zero economic sense too, and it is also gone.  The one exception is that there are different limits for cash- and delivery-settled contracts for Henry Hub nat gas.  This makes zero economic sense too, and is a blatant political compromise by the Commission intended to throw a bone to ICE that lost on the conditional limit issue generally.  Laws, sausages–and CFTC rules.

My comment letter on position limits criticized both stricken provisions.  But other provisions I inveighed against, particularly those that constrain ETFs like USO and US Nat Gas funds, remain.

The partisan rancor on this issue came through loud and clear at the meeting, as this piece by Jeremy Grant makes clear.  Jill Sommers and Scott O’Malia were very outspoken:

“We went beyond the statute” by doing things like narrowing the bona fide hedge exemption, Sommers told Reuters. “Those are the things that people can use for a legal challenge.

O’Malia said: “over-reached in interpreting its statutory mandate to set position limits.”  O’Malia also emphasized the lack of empirical evidence of a need for limits, echoing my “No Theory? No Evidence? No Problem!” refrain.

As I was quoted saying in the Reuters piece, this statutory overreaching will be the basis for a legal challenge.  Not just on the hedge exemption issue, but on the more fundamental issue of whether it is necessary for the Commission to find that “excessive speculation” has indeed caused “unwarranted” fluctuations in prices, i.e., the “no evidence” point.  I would not be surprised if the cost-benefit analysis, such as it is, is not challenged as well.

The disappointing guy was Dunn, who blasted the idea of position limits, but voted for them anyways.  Not exactly a profile in courage or conviction by a retiring commissioner.

The other rule would require CCPs to admit firms with a minimum of $50 million in capital.  I think this is a terrible idea.  I understand that CCPs could potentially use excessively onerous admission requirements to reduce competition: hell, I’ve been making that point for well over a decade.  But I also understand that undercapitalized members, and members who cannot contribute constructively to the auctioning of a defaulter’s position, can undermine the effectiveness and even the safety of the clearinghouse.

There is a tension between encouraging competition, and making CCPs secure: Gensler and the majority focused on competition, and I think that is a major mistake, particularly given the fact that the clearing mandate in Dodd-Frank is intended to reduce systemic risk. Micromanaging CCP operations is a horrible, horrible idea.

Grounds for challenge?  Maybe.

No surprises here, really. Gensler is hell-bent on ramrodding through his agenda.  And that’s probably the best way to phrase it: the agenda is pretty bent, and will create some regulatory hell.

Two related stories.  The first: unofficial price controls on refined petroleum products in the runup to the Russian elections:

Russian authorities have unofficially reined in retail fuel prices, a sensitive issue for motorists before key elections, traders and sources in companies said Thursday.

The oil companies already had effectively put a lid on gasoline prices at pumping stations since mid-August, fearing a backlash from the government before the general elections in December and presidential poll in March.

Salesmen are now talking about direct verbal orders from the government not to increase prices.

“There won’t be any moves before the elections, although there are no written directives from Moscow,” said a worker at a TNK-BP retail station in Saratov, 880 kilometers southeast of Moscow.

“We were about to increase the price, but we were told to draw in our horns. ‘Are you crazy? There are elections coming!’ they told us,” said an official with LUKoil in Volgograd.

Retail prices have flatlined across the country despite skyrocketing wholesale prices for petroleum products.

After anti-monopoly regulators slapped companies with hundreds of millions of dollars of fines for expensive fuel over the past year, retail stations have been wary of raising prices, and their margins have been squeezed almost to nothing.

The second story: shortages of jet fuel:

Russian traders are alarmed at the sudden disappearance of aviation fuel from the market.

They say a hike in prices is imminent, with a fuel deficit likely before the end of October.

The main factor behind the deficit is thought to be the growing number of passengers using airlines in Russia, whereas the oil refineries around Moscow and Moscow regions ceased operating at full capacity. Additionally, in September, the Defense Ministry made a large order for aviation fuel.

Uhm, don’t believe the explanations given in the quoted bit, except to draw a direct line between the below-capacity operations of refiners, and the first story about unofficial price controls.  Although the price control article relates to motor fuel, it is highly likely that (a) there are also unofficial price controls on aviation fuel,  and/or (b) since gasoline and distillates are produced in relatively constant proportions, cutbacks in refining runs driven by the unprofitability of selling motor fuel at sub-competitive prices are also causing reductions in aviation fuel output.

This also adds credence to the earlier conjectures that the KHL air crash was the result of poor quality fuel, because reductions in quality are another predictably consequence of price controls.

Your favorite company and mine is under some stress.  Gazprom faced raids from EU officials pursuant to an antitrust investigation of the company against the background of Euro hemming and hawing (so what else is new?) over the creation of a unified energy market.  But perhaps more interestingly, Gazprom’s customers are rebelling against the anachronistic oil-based pricing, take-or-pay contracts under which the company has sold gas since the 1980s.  These contracts made economic sense then, when there was no liquid spot market.  They are not economically sensible now, given the development of such a market.  But given the divergence between oil prices and spot gas prices, they are quite lucrative for Gazprom, so the company is holding on to them with a death grip.

But cracks are appearing.  One long-standing contract (dating from 1986), with Turkey’s Botas, is about to expire.  Botas has terminated the contract citing a dispute over the pricing mechanism.  Perhaps this will give impetus to the efforts of other companies, such as Germany’s E.ON who are also pressing the Russian corruporation to move towards spot pricing.

The Turkey episode is actually quite entertaining, and should make anyone think N times before believing any Gazprom statement.  The initial threat to terminate the contract came from Turkey’s energy minister.  Gazprom then huffily said that the Energy inister was irrelevant, because it was negotiating with Botas not the Energy Ministry.  Uhm, 2 days later, Botas told Gazprom to hit the road, Jack.

I love it when that happens.  A twofer.  Gazprom loses a deal, and then looks foolish trying to deny it’s going to lose the deal.

The disputes over contracting are a short-to-medium term problem for the company.  Longer term, there is the threat from shale.  US shale is developing apace.  There was recently an announcement of a huge shale gas find in the UK (although there were soon naysaying reports–all of which is par for the course in this business).  Poland has also claimed that it has bright shale prospects (although a private correspondent who has investigated the issue closely argues these claims are overstated).

The company has ambitions to raise  its market share in Europe from about 25 percent to 30 percent.  It will not be able to achieve those ambitions and maintain its anachronistic pricing mechanism (which greatly overprices gas).  Moreover, it will face new competing suppliers.  Gazprom will no doubt continue to maintain its swagger, but as the Botas episode shows, cracks are appearing in its facade.  Look for those fissures to grow.

I look forward to hearing more music.

The most surprising development to follow the unsurprising (to me) Putin return is the revolt of Finance Minister Alexei Kudrin:

“I will definitely refuse,” Kudrin, 50, said when asked whether he would join Medvedev’s government. He spoke in Washington at a World Bank meeting.

“I have many disagreements with Medvedev on economic policy, first of all concerning the significant military spending,” said Kudrin, who is widely seen as the architect of Russia’s economic stability in the 2000s.

Spending on national defense will grow by 2.1 trillion rubles ($65 billion), or 3 percent of gross domestic product, from 2012 to 2014, Kudrin said, adding that this is how much the state is spending on education this year.

He did not comment on a declaration by Putin on Saturday that he would also push ahead with the army’s modernization.

Kudrin’s attack on Medvedev is facially farcical.  Putin has been Mr. Big Spender.  He has been the one who has been promising to spend huge quantities re-arming the Russian military (as suggested in the last quoted sentence).  Moreover, Putin has also been promising the sun and the moon domestically, from higher pensions to delaying increases in utility tariffs that would move prices closer to market levels.  The target of Kudrin’s ire–Medvedev–has done little more than his usual Sancho Panza impersonation.  Putin has led the way.

So what is Kudrin’s game?

Possibility 1: he really wants to be prime minister, and this is his way of knee-capping Medvedev.  Putin needs Kudrin way more than he needs Medvedev, and the threat to leave may be a sure fire way to get Putin to jettison Medvedev.

Possibility 2: Kudrin is truly alarmed at Putin’s profligacy, especially in the face of an impending financial crisis that could crater the price of oil and thereby completely undermine the Russian fisc.  Kudrin cannot call out Putin directly, so he slams the hapless Medvedev as a way of sending a message.

Possibility 3 (suggested by @ninaivanova on Twitter): Kudrin is having problems with his deputies, and wants the authority to choose them.  Threatening resignation could lead to Putin to agree to these demands.

Kudrin’s attack on Medvedev (and his silence on the truly culpable one, Putin) is so risible that I am leaning towards Possibility 2.  Kudrin has to know that Russia’s position is precarious (so is everybody’s, but as in 2008 Russia could suffer immense collateral damage that is actually more devastating than the harm suffered at the epicenter of the crisis).  He has to know that Russia has the thinnest margin for error, and that raining rubles on the defense establishment (where much of it will be skimmed, and disappear without a trace) and pensioners, etc., will make that margin disappear–and actually put the country in a hole.  Kudrin knows–and has said repeatedly–that the feasibility of the government’s budget depends crucially on the the price of oil, and that the price of oil is hostage to hair-raising developments abroad.  He further knows that he cannot publicly scold Putin–especially now.  Under these circumstances, sending a message to Putin by slamming Medvedev makes sense, in a perverse way.

It will be far more interesting to watch this play out than the scripted election.  Kudrin is Putin’s brain when it comes to anything economic, and Putin cannot function coherently in this sphere without him.  Hell, he can barely function coherently in this sphere with him.  This goes double in current circumstances, with the rumblings of disaster emanating from Europe.

Two other entertaining sidelights to this story.

One is this quote from the MT article:

Putin pledged to improve the investment climate and fight red tape by “consulting the entrepreneur community” on economic legislation.

Where would that community be, actually?  Putin probably imagines his judo buddies to be entrepreneurs.  As if.

The second is something that came across my Twitter feed.  It purported to be a quote from Kudrin: “Я бы предпочел работу в более гетеросексуальном коллективе”: “I would prefer to work in a heterosexual team.”  My inclination is to believe that this is a joke–in which case it is pretty funny.  But perhaps it isn’t–in which case it would be riotously funny.  Either way, I can see it being an accurate reflection of the way the manly men in the Putin circle view the elfin Medvedev and his group.  Can anybody cite a reliable source that quotes Kudrin saying this?

James Hamilton and Jing Wu have a new paper on speculation and oil futures pricing (h/t Brian Goff).  The paper is very carefully done and very impressive econometrically.  It presents some provocative results, but IMO the radical simplifying assumptions James and Jing used in order to come up with something that they could estimate cast serious doubts on the results.  I am also sure that the results will be overinterpreted and misinterpreted to advance political agendas, and regret that the authors provide the hook in a few careless statements that should have been heavily qualified, but weren’t.

Here are my initial detailed comments:

1. The paper focuses on risk premia.  Hallelujah!  The price of risk is what speculators are most likely to affect, because most speculative transactions involve a transfer of risk, rather than the commodity.  A very basic point, but one which is all too frequently overlooked.
2. The most provocative result in the paper is a huge discontinuity of their estimate of the risk premium in oil futures  between the pre-2005 period and 2005-2011 (see Fig. 5).  This discontinuity is an artifact of HW’s splitting of the sample.  They motivate the choice of splitting date by observing that the growth in crude oil futures open interest increased dramatically beginning in 2004.  It would be preferable to do some testing for structural breaks and estimate accordingly.
3. More generally, I am very suspicious of such a sharp discontinuity.  I think it is highly likely that it is symptomatic of other changes going on in the market, and the limitations of their model.  (More on the latter below).
4. The model is not complete, even on its own terms.  Although it discusses the role of speculators (“arbitrageurs” in HW) in absorbing risk from hedgers, hedgers are not formally modeled.  This is a huge hole.  Moreover, “investors”–such as those who trade via index funds–are modeled extremely mechanically.  Yes, once they are in the market, index traders tend to trade mechanically, but the allocation of speculative capital between index funds and other investment opportunities is not as mechanical a process as the paper assumes.  Indeed, in the model the index-fund investors’ trading does not depend at all on risk-return tradeoffs.  They are just automatons that flow in and out of the market based on some autoregressive process. This is extremely problematic: index investor capital allocation decisions are presumably the result of an optimization process that reflects their investment opportunity set and the pricing of risk across these opportunities.  (Again, more on this below).
5. Relatedly, since hedgers are not in the model, there is no effect of index investors shocks on hedger behavior.
6. The model of fundamentals is extremely cramped and limiting.  I am no big fan of affine models generally, but even overlooking that, it is definitely the case that more than one (latent) fundamental factor drives spot oil prices.  Thus, the model becomes a two-factor model, with one (fundamental) factor driving the spot price and the “risk neutral” forward curve and the other (index-investor buying) affecting the shape of the forward curve.
7. One cannot generate interesting forward curve dynamics using a one-factor fundamental model.  One cannot generate interesting and realistic inventory-price relations using a one factor model.  As I show in my forthcoming book, at least two fundamental factors are needed to generate reasonable dynamics.  Furthermore, as I also show in the book, the homoskedastic error structure for the fundamentals variable assumed in the HW paper cannot generate price and inventory behavior observed in the real world.
8. Thus, the fundamentals model is almost certainly seriously mis-specified.  I can understand the modeling choice, but it has consequences.  It is my sense that this mis-specification is so severe that it casts serious doubts on the results.
9. In a frictionless world, risk premia for a particular factor are determined by the covariation between that factor and the pricing kernel.  In markets with frictions (as in the Hirshleifer models of the late-80s, early-90s), idiosyncratic risk of the factor may impact risk premia, in addition to the effect of systematic risk (driven by the covariation).  HW is a single market model: the oil market is all there is, and only factors within the oil market affect risk premia.  This is in essence an old-school Keynesian model of the risk premium.  Again, this is highly problematic.  In particular, since the whole movement of financial investors into commodities strengthens the linkage between broader financial markets and commodity markets, ignoring systematic risk (and hence inter-market covariation) is a serious deficiency.
10. It is a stylized fact that correlations between commodity returns and returns on broad equity indices and FX have changed substantially in recent years.  Although some have asserted a connection between index trading and this change in correlation structures, you can tell fundamentals-based stories as well.  For instance, if supply shocks were dominant in pre-2005, but demand shocks (e.g., the growth of China, the financial crisis) were dominant since, one would tend to observe the oil-S&P correlation to change from negative to positive.  As long as you are not in a Keynesian world with each commodity and investment an island with risk borne only by those living on that island, this change in correlations would lead to a change in risk premia.  The change in sign in the risk premium at the end of the sample corresponds to the financial crisis and associated major recession.  During this time demand shocks were clearly driving oil prices, and the correlation between the S&P and crude prices was very high and positive.  Thus, there was more systematic risk 2007 and later, and this would be expected to affect risk premia, but the model precludes this.
11. The omission of systematic risk in a model of risk premia is a serious, and IMO disabling, limitation.  It is particularly odd to ignore this in a paper that examines “financialization” of a commodity market, since financialization involves financial investors adding commodities to broadly diversified portfolios in order to optimize some risk-return trade-off.
12. These issues all affect how one interprets the HW findings.  What if risk premia did in fact change?  This could well reflect more accurate risk pricing due to the integration of commodities into investor opportunity sets.  Risks are going to be priced differently–and more efficiently–if there is more trade between islands.  A reduction in frictions, and an increase in the connections between markets, should lead to better risk pricing.  So finding a change in risk pricing could represent a very salutary development.
13. Indeed, tying some of these threads together, doesn’t “financialization” reflect a normal economic process of equilibrating prices between segmented markets?  Here, the prices are the prices of risk, and the movement of resources (risk) is more abstract than the movement of physical oil between Cushing and the Gulf.  In the latter example, profit seeking traders will drive the difference in prices in the two markets to the cost of transportation between them.  In the case of risk premia, any innovations (which could well include index investing) that reduces the costs of moving resources (risk bearing capacity) between prices will affect the prices in those markets, and tend to equalize them.  Since in the broader financial markets, oil and other commodities are small relative to the broader capital markets, it should be expected that the risk prices of commodities should account for the bulk of the change toward equalization.  It should also be welcomed.
14. To summarize a bit, the crucial questions include: what risks are priced?  Who participates in the market that determines these prices?  and, What are the investment opportunities available to these participants?  I think on every question, the HW paper is on very, very shaky ground.  The one-dimension model of fundamentals is far too restrictive, and the dynamics are far too simplistic.  Crucial players–hedgers–are left out, and others are treated mechanically.  In a paper that attempts to determine the effect of the movement of well-diversified financial investors into commodities, the Keynesian islands approach is inadequate: these investors have extensive investment opportunities that affect their behavior–and the pricing of risk that is the whole subject of the paper.  Mechanical treatment of one group of agents can make sense in some models, as in noise trader microstructure models.  Mechanical treatment of investors actively and aggressively looking for superior risk-return performance is a serious shortcoming in a model of the pricing of this trade-off.
15. I sympathize with James and Jing.   The impressive empirical cleverness required to estimate even this radically simplified model demonstrates just how challenging is the task of understanding the pricing of commodity risk.  I could readily believe that it could be impossible to estimate a richer model that includes fundamentals subject multiple, potentially heteroskedastic shocks, and three classes of optimizing investors with diverse investment opportunities. But the very complexity of the problem should make people very reluctant to make strong statements about the effects of “financialization” on price behavior.
16. In summary, I believe Hamilton-Wu are eminently correct to focus on risk premia as the variable that could be affected by the entry of a new class of market participant, but the daunting nature of that task is evident.  The radical simplification (again, understandable as a practical matter) needed to permit estimation, which involves abstraction from virtually all of the important economic issues makes their conclusions and results highly dubious as a basis for policy.  But there are plenty of fools out there (and let’s be clear, I do not include the authors in that category) who will no doubt rush in where prudent and thoughtful angels fear to tread.
17. For this reason, I wish they would have abstained from statements likely the valediction in their paper: “We suggest that increased participation by financial investors in oil futures markets may have been a factor in changing the nature of risk premia in crude oil futures contracts.”  This kind of suggestion only encourages the fools.  Every link of the chain of reasoning supporting this suggestion is flimsy.  Most importantly, the suggestion rests on a structural break which corresponds roughly with a period of time during which more financial investors participated in commodity markets.  But many other things changed during the same period.  Indeed, Hamilton himself has repeatedly pointed out that this period was one in which there was a virtual cessation in the growth of oil output.  That’s a pretty important fundamental.  Moreover, this was a period in which emerging markets, notably China, began to impact commodity markets dramatically.  Furthermore, most of the period (say 2007-2011), was one of financial an economic upheaval not observed since the 1930s.  That’s a pretty big change too.  Why put all the focus on index investing?  The model certainly doesn’t support that, because (a) all of these other factors are omitted altogether, and (b) even the model of index investing is crude and mechanical.
18. That is, to attribute the change in risk premia estimated from a clearly mis-specified model to a single change among many that occurred during the period of change is highly, yes, speculative, and an extremely tenuous piece of post hoc ergo propter hoc reasoning.

I do not want to close on a negative note.  I admire that Hamilton and Wu have focused on the right issue and have brought impressive econometric skills to the problem.  Improving our understanding of these issues would best be achieved by following the direction James and Jing have pioneered, by incorporating some of the features discussed above.  It will be a hard road, but worth taking.  Hamilton-Wu is a helpful first step along that road, and I hope that people understand it is only that, and that much hard slogging remains.

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A few technical asides:

1. The use of NYMEX data in which time to expiration changes presents some complications to the estimation and interpretation.  It would be worthwhile to look at LME metals data (e.g., copper) because (a) it has also been claimed that financial investors have affected metals pricing, and (b) LME trades constant-maturity contracts that are easier to handle empirically.
2. If the focus is on index investors, who by definition trade in multiple commodities in a mechanical way, it seems that cross-sectional evidence would be quite informative.  For instance, did risk premia change in a way similar to that claimed for oil in other markets that are also part of commodity indices?

Javier Blas at FT was a standup guy about the sentence in his article on the Singleton that made it sound like I had criticized the CFTC for not inviting those taking contrary views to the August confab about speculation and the Singleton paper.  In response to my venting (who? me?), the sentence has been corrected in the online version to make it clear that I did not make any such claim, and the version online now contains this text:

“This article has been corrected since original publication to reflect that only Philip K.Verleger has criticised the CFTC’s move to invite academics, mainly with one point of view.”

I appreciate the rapid and gracious response.