Streetwise Professor

I gave testimony on the role of speculation in energy markets before the House Agriculture Committee on Friday, 10 July. Here’s my written testimony. I will post a link to the transcript as soon as it appears.

It was an interesting experience. I doubt I changed any Congressional minds, but I think I did provide a framework that may help policymakers sort through the issues. The key lesson I tried to hammer home was that it is imperative to distinguish between the derivative markets and the physical markets. These markets perform different functions. Derivatives markets are markets for risk, and speculative and hedging activities in these markets will affect the price of risk. Absent any use of the derivatives markets to distort the physical market–as during a squeeze, for instance–even very large scale speculation in the derivatives market is unlikely to have an impact on the prices in the physical market (except insofar as that speculation is informed, and therefore influences expectations about future spot prices.)

The other point I tried to emphasize–and this is what I think made the biggest impression, at least on some–is that if “excessive” speculation truly screws up prices, these price distortions necessarily manifest themselves in the form of distortions in quantities; in inventories, in output, in consumption. The reason prices are important is that they direct the flow of resources. If prices are distorted, resource flows will be distorted too. Heretofore, there is no credible evidence of distortions in quantities. Hence, in my view, there is no credible evidence that speculation has been “excessive” in any meaningful (economic) sense of the word.

My OpEd on oil speculation ran in Friday’s (7/11) Wall Street Journal.

Index funds and pension funds are the most recent bêtes noir in the commodity speculation debate. These participants are primarily long, are supposedly relatively insensitive to price (which is an assertion, rather than something for which reliable evidence has been produced), and hence according to critics are driving up prices of oil and grain. And by “prices,” critics mean the prices of physical commodities that consumers buy.

These arguments fail to grasp important aspects of the operation of derivative and commodity markets, and ignore the benefits these market participants can reap from trading in the commodity markets.

The main error in the argument is that it does not recognize that there are multiple markets for commodities, some of which are markets for the physical commodity proper, and some of which are for commodity price risks. Derivatives markets serve the latter purpose, and fund investors almost exclusively restrict their activities to those markets, and hence affect only the prices for commodity price risks rather than the prices of commodities themselves.

Virtually all index investors and pension funds do not participate in any way in the physical market. If they are in futures, they roll their positions prior to delivery. If they gain commodity exposure through swaps, they are pure price takers, and even if their counterparties hedge some of the index exposure through the futures markets, these firms also roll prior to delivery and hence do not contribute any demand for physical commodities. Hence, they cannot affect—or in particular, elevate—the price of any physical commodity.

But, the critics reply, since these funds are buying, they HAVE TO make prices higher than they would otherwise be. In addressing this criticism, it is necessary to be precise and ask: what price? Clearly, all else equal, with more buying interest, the futures price will be higher than it would be without it (unless the supply of offsetting positions is perfectly elastic, as may be the case). But it is important to recognize that this buying raises the futures price relative to the expected spot price. Since index traders and index funds are likely uninformed, their buying does not systematically convey bullish information to the market, and hence does not affect the expected spot price; and if these trades have any information content, they should have an impact on prices, and this impact is beneficial.

By moving the futures price relative to the expected spot price, index/fund trading (a) does not elevate the prices consumers pay for physical commodities; and (b) affects the RISK PREMIUM embedded in futures prices, and hence the trend in the futures price for a particular contract up to the expiration date. In other words, the price that fund traders affect is the price of risk, not the spot price of oil or gas or corn.

In a Keynesian “normal backwardation” type model, in which speculators are not diversified and hence idiosyncratic risk affects futures prices, and hedgers are net short, the addition of new long speculators causes the futures price to rise relative to the expected spot price, reducing the discount in the futures price and the upward trend in the price. Their entry also displaces some other long speculators who find that the greater competition from the index/fund investors reduces the profits they earn from their trading. In this model, these other longs only participate if the futures price is below the expected spot price. Hence, as long as any of these traders remain, the futures price must remain below the expected spot price, but by a smaller amount. All that the entry of index funds does is replace one set of long speculators with another that bears the commodity price risk at lower cost, reduces the risk adjustment in futures prices, and therefore makes the net short hedgers better off. This is not Pareto improving—the displaced long speculators and some long hedgers are made worse off—but overall surplus rises because risk is borne at a lower cost. So, what’s the problem? None that I can see.

It is theoretically possible that that long index/fund participation can be so great that it completely displaces other long speculators. That is, fund trading causes the futures price to rise above the expected spot price, meaning that all other long speculators leave the market. Again, though—so what? This hurts those speculators and some long hedgers, but benefits short hedgers even more. (I should also add there is no evidence that this has in fact happened. There are still long speculators in the markets other than the index funds, so evidently they have not all been displaced.)

The theoretical possibility that participation of index/fund investors causes the sign of the risk premium to flip also points out that it is dubious to call these folks “speculators” in any event. They are really hedgers, in the very real sense that they are buying futures to reduce risk exposure. They are buying futures for diversification reasons—that is a risk reducing trade, and hence it is legitimately referred to as a hedge. They are not traditional hedgers, to be sure, but again—so what? Investors are people too. Why should they be denied the opportunity to use the commodity markets to reduce their risks? Why should they be considered inferior to other long hedgers who just happen to participate in the physical markets? Suspicion of these non-physical long hedgers seems to be an example of what Thomas Sowell once termed “the physical fallacy” in his excellent book Knowledge and Decisions.

Indeed, the presence of index/fund investors in the commodity markets serves to integrate the financial and commodity markets. This integration ensures that risks are priced consistently across the two markets. Indeed, the flow of funds from portfolio investors (who may include hedge funds too) from traditional equity and fixed income investments to commodity markets is likely a reflection of a mispricing of risks across these markets. In essence, this flow is serving to arbitrage away a differential in risk prices across previously segmented markets. Again—this is a feature, not a bug.

My work (with Martin Jermakyan) on electricity prices shows that incomplete integration can impose very large costs on hedgers. Electricity is probably an extreme case, but due to incomplete integration forward prices are substantially above expected spot prices. This is a symptom of inefficient risk pricing and risk allocation.

If all the markets are completely integrated, risk premia in commodity prices will be driven purely by the covariation between those prices and the market pricing kernel. The composition of market participants would be completely irrelevant. Barring one group from participating in the market would just open up a profit opportunity for somebody else without having the slightest effect on risk prices.

However, restricting the participation of portfolio investors may impede integration of the commodity, stock, and bond markets. In this case, risks will be priced inefficiently and risks and capital will be allocated inefficiently. Why is that considered desirable?

The main things to remember in this debate are: (a) since fund investors do not participate in the delivery market, they cannot be influencing physical market prices, except to the extent that by improving risk allocation they are making hedging more efficient and thereby beneficially affecting investment and stockholding decisions, and (b) the main effect of index/fund participation is to affect risk premia in futures prices (i.e., the relation between futures and expected spot prices), and in a way that improves the efficiency of risk allocation. Index/fund participation facilitates the integration of commodity and financial markets. This helps rationalize the pricing of risk. Again—a good thing.

The entire debate over speculation in commodity markets, at least the political side of that debate, is largely devoid of good economic reasoning. This goes in spades for the debate over the role of index funds and pension funds in the market. The “they buy therefore they drive up prices therefore they should be banned” syllogism is completely bogus. It is bogus because fund buying does not in the first instance drive up physical prices, and hence does not affect the price that we all pay at the pump. It is bogus because fund participation affects risk premia—the relation between futures prices and expected spot prices rather than spot prices or expected spot prices. It is bogus because it affects risk premia in a good way. It ensures consistent pricing of risk across markets and the efficient allocation of risks across markets.

Some people may be hurt by this flow of capital—but it is not the people that politicians are allegedly defending, such as individual consumers. Traditional speculators who earned rents in less-integrated markets are hurt. Long hedgers in markets dominated by short hedgers may be hurt, but their losses are more than offset by the gains of short hedgers and the fund investors themselves.

More generally, I have yet to hear anyone—anyone—present a credible case that there is a true (rather than pecuniary) externality that results from the entry of a new class of participants into the commodity markets. Absent such an externality, the free flow of capital across markets will have a beneficial effect, rather than a baleful one. Index and pension fund investors participate in the commodity markets because it improves their risk-return tradeoffs. This is a bad thing? Competition and the free flow of capital facilitates the efficient pricing of risk. This is a bad thing? These flows do not affect, let alone distort, the physical markets except insofar as improving the allocation of risk improves the efficiency of investment and inventory decisions. So this is a bad thing?

When one understands the very basic finance of index/fund participation in commodity derivatives, it is evident that restrictions on their participation in the market, either through position limits or (in the extreme) banning them altogether are extremely misguided. Extremely. Their participation should be encouraged, not limited. Derivatives markets are first and foremost markets for risk, and index/fund investors in commodities are just using those markets for the very purpose of managing risk. By doing so, they are improving the allocation of risk and its pricing across all markets—stocks, bonds, real estate, and commodities. They bear commodity price risk at a lower cost than others. This is unambiguously a good. Unambiguously. Will Congress understand this? Sadly, there is considerable room for doubt.

Over my extended European sojourn, the Antitrust Division of the USDOJ gave its approval to the CME’s acquisition of NYMEX. During the height of the kerfuffle over the Antitrust Division’s letter on exchange ownership of clearing, it was widely conjectured that this signaled that the Division would fight the deal. I disagreed, arguing that the Division would have to approve it if it wanted to maintain even a shred of dignity. There is no way it could approve the CME-CBT tie up in June ’07 and turn around in June ’08 and disapprove CME-NYMEX. And approve it did. One curious thing. There is no announcement of the decision on the Anti Trust Division website, even though there was such an announcement when it approved the CBT deal. Now, that’s interesting.

Russians can indeed be proud of their recent sports accomplishments, with their victory in the World Hockey Championship and their stellar performance in Euro 2008; a friend tells me that the latter was a unifying experience, with the nation cheering in unison–literally–during and after the early-morning victory over Holland.

The achievements on the ice and the football field are feeding an already burgeoning sense of national accomplishment; a sense that the humiliations of the past are over, and that the future is Russia’s for the taking. This sentiment manifests itself in myriad ways, most notably in geopolitics. Russia is putting extreme pressure on some neighbors, notably the Baltic states and Georgia, and more subtle (but intense nonetheless) pressure on others, notably Ukraine, the Central Asian states, and even Mongolia. Medvedev and Lavrov are also pronouncing on the need for a new international political and economic architecture that will raise Russia’s profile and diminish that of the US, and to a lesser degree, the EU. (This can be seen as just another Russian divide-and-conquer/disaggregation play.) Russia is also taking a bold line with the Europeans, who are never very solid in the best of times, and who are distracted and perhaps even teetering on the brink of chaos in the aftermath of the Irish vote on the Madrid Treaty. The US is constrained by the disarray of its European allies, the continuing (though dramatically improving) situation in Iraq; economic woes; divisive partisanship; and the upcoming elections. As a result, Russian aggressiveness and revanchism are facing only feeble opposition. No wonder that Putin and the siloviki feel emboldened.

But it is necessary to take the longer view. When one does so, it is evident that Russia’s current advances are powered by high energy prices and built on a foundation of quicksand, and hence are unlikely to persist long into the future. Russia suffers from several debilitating structural weaknesses, some of which I have touched on in SWP before, but which are worth remembering.

Three such weaknesses are readily apparent: institutions, demographics, and infrastructure.

Russia’s weak institutions are well known. Headline events, such as Yukos, or Sakhalin, or as of late, BP-TNK provide spectacular illustrations of the precarious state of property rights. It is widely acknowledged–by Russians and outsiders both–that corruption is worse today than even during the 90s–perhaps by an order of magnitude. Even President Medvedev acknowledges the “legal nihilism” of his country.

But this article describing a Levada Center poll shows how deep the institutional rot is in Russia, and how it affects not just foreigners or out-of-favor oligarchs, but every Russian. According to the poll, about half of the Russian middle class contemplates emigration, primarily because of their palpable sense of vulnerability to the predations of the state:

Only 13 percent of those polled by Levada Center agreed with the statement that Russia had entered a period of protracted stability, while 59 percent said the situation could change for the worse at any moment. Around 76 percent of those polled said that they could not protect themselves from the arbitrary actions of the authorities, in particular the police, and around 65 percent said they were not sure that they could protect their rights and interests in court.

“Despite the fact that Russians are not delighted by this situation, it appears that they have resigned themselves to it,” wrote Nezavisimaya gazeta. “Many of the respondents believe that they cannot influence the political processes in the country and are prepared to use dishonest and unlawful means for the resolution of conflicts and problems. The readiness to give bribes and to use personal contacts is very high within the Russian middle class.” Indeed, around half of the respondents in Levada Center polls have said that if they were falsely accused of not paying taxes, it would be better to use bribes to resolve the problem than to take it to court. The respondents indicated that they were prepared to act similarly in more “neutral” situations. For example,
59 percent said that they would pay for medical services, which in theory are provided at no cost. . . .

Asked why they were considering leaving Russia, 86 percent cited the desire to get a greater guarantee for a stable and safe future; 79 percent cited a desire to live under conditions in which the rule of law, rights and freedom prevailed;
69 percent cited the desire to avoid governmental lawlessness; and 83 percent cited the desire to enjoy better and more comfortable living conditions.
According to Nezavisimaya gazeta, the Levada Center’s researchers believe that the high level of desire to leave Russia is evidence of serious social malaise.

“The central feature of the consciousness of the middle class is a feeling of the in-betweenness [sic] of its own existence and a radical collision of the way of life with the way of thinking,” Dubin told Nezavisimaya gazeta. He added that without radical changes in society, the prospects for Russia’s middle class to grow and transform into a wide and stable social stratum seem doubtful (Nezavisimaya gazeta, June 27).

By design, the poll focused on those most likely to have thrived as a result of Russia’s economic rebound. Even among this restricted sample, the effects of institutional weakness are manifest. This is hardly conducive to the formation of trust and social capital that facilitates exchange and investment in human or physical capital. This bodes ill for Russian growth.

The fears expressed in the poll are anything but groundless. This article from the Guardian details the practice of corporate raiding a la Russe, which puts a whole new meaning on the phrase “hostile takeover.” Through a combination of force and fraud, often abetted by–or committed by–corrupt state organs, the raiders confiscate the assets of successful firms that attract their attention, often leaving the firm’s owner in jail. This is a tax on success and capital (accumulate no capital–no risk of expropriation!), and it is well known that capital taxes are extremely detrimental to growth. Now, this tax is not paid with certainty; not all successful entrepreneurs are subjected to the tender mercies of these latter-day Mongol hordes. Instead, it is, well, a Russian Roulette tax; you lose everything with some non-trivial probability. Again, hardly conducive to encouraging small business growth. (Another reason, perhaps, that small business formation in Russia is notoriously low.)

Need more evidence? Consider this Business Week piece describing the results of a poll conducted by my friend Sergei Guriev and Igor Fayukin, his colleague at the New Economic School:

The study’s participants believe “the lack of political competition and restrictions on political, economic and personal freedoms” are “a serious problem for the country.” The vast majority are concerned about Russia’s declining population, but also see corruption, the lack of an independent and effective judiciary and a disregard for citizens’ rights by the authorities as the leading challenges in the near future.”

Executives think the solution to corruption and state inefficiency can be found through “broader political change in the country.” One respondent said that the situationrequires the “liberalization of civil society, a reduction of barriers for business, and the modernization of government institutions in accordance with the aspirations and business and civil society.”

“In the eyes of many, the current problems are connected with the low level of competition in the country,” the study’s authors write. Another of their respondents thought what is needed is “more competition, a fight against the fusion of government and business and against monopolization.”

One might argue that other nations–notably China–have weak institutions as compared to the US and Europe, but have prospered in recent years. There appears to me to be a significant difference between China and Russia, however. China is ruled by what Mancur Olson called “stationary bandits.” Yeah, the Chinese bureaucrats and party elite steal, but they are sufficiently confident in the security of their positions that they take a relatively long view, and discipline their short run rapacity to increase their long run take; due to the security of their tenure, China’s new mandarins have an incentive to encourage growth. Russia in the 90s was beset by roving bandits, who knew that their long run prospects were dim, so they took everything they could, the future be damned. Things are a little better now (this is one of the wages of Putinesque “stability”), but as the raiding and confiscations and widespread sense of personal insecurity before the agents of the state demonstrate, roving banditry and short termism are still rife in Russia. (An example: it has been mooted that one source of conflict between BP and the Russian partners in TNK is that the latter want to maximize the short term revenues from the company’s properties, whereas the former wants to use techniques to conserve the oil reservoirs in order to maximize their long run potential.) Another potential difference is that Chinese businessmen have been more successful at organizing to advance their interests, whereas the atomization of Russian society has prevented the coalescence of any corporate resistance to the state’s predations.

With regards to demographics, although the government has crowed about increased birth rates, the overall picture is still grim. According to a recent report by the Russian State Statistical Service as reported in ITAR-TASS, Russia’s permanent population fell .07 percent in the first 4 months of 2008, corresponding to a .21 percent annual decrease. Although this figure is lower than the .5 percent decrease experienced throughout the 1990s and early-2000s, it is still hardly a sign of a healthy country. Indeed, immigration has cushioned the effect of continuing low birth rates and high death rates: “In the first four months of the year, the statistics service reported 547,100 births and 725,200 deaths, Prime Tass said.” Although the birth rate is up slightly, so is the death rate. And, as is widely understood, a good portion of the increased birthrate is a demographic fluke as the last large generation of Russian women is reaching childbearing age. Although the statistics do not say this explicitly, it should also be recognized that the educational and skill level of most of the immigrants and a disproportionate number of the childbearing families is below that of those dying–because immigrants and those having children are disproportionately from the more backward regions of the former-USSR and the more backward regions of Russia. Some baby boom. Some demographic rebound; more like a dead cat bounce.

Russia’s infrastructure woes are also widely acknowledged. I can’t find the cite (probably JRL), but I remember reading that the mileage (kilometerage?) of paved roads in Russia has actually declined in recent years. It is widely recognized that the railroad system is in desperate need of maintenance and expansion. In a country as large as Russia, infrastructure is crucial.

Of course, the government has announced grandiose plans to improve Russian infrastructure. The challenge is translating those airy promises into economically productive investment. The institutional deficit is one obstacle to achieving anything substantive; large infrastructure projects are especially vulnerable to corruption that inflates costs, not just in Russia, but in Russia the problem will be especially daunting. Moreover, the Edifice Complex and political considerations tend to divert too many resources to “prestige” projects and megadevelopments; the Sochi Olympics and the fantastical plans for a tunnel between Siberia and Alaska being conspicuous examples. Russian tendencies towards giganticism and the above-noted Russian desire to proclaim Russia’s resurgence in blingy ways will only exacerbate these problems. My prediction?: Infrastructure spending will indeed expand, but the social return on this investment will be very low. The private return–to those feeding at the trough–will be high indeed.

Other problems abound, but many fit comfortably in the categories just defined. Health care and public health are appalling in Russia, for instance, but this is really one of the sources of the demographic meltdown described above, and the intransigence of the problem reflects Russia’s institutional deficit.

So, to repeat old themes: Russia is never as strong as she looks, and her current strengths and successes are likely to be transitory as the institutional, demographic, and economic foundations for long run success are decrepit; the bleak long run prospects arguably contribute to the short term focus that characterizes Russian business and government; Russian aggressiveness is fueled by remarkable events in the commodities markets, the volatility of which make a very tenuous basis for long term success; and, in the end, no amount of chest thumping or prestige projects today will defer indefinitely a very painful future crash.

Russia would be much better served by a focus inwards on its pressing structural problems rather than by its current attempts to achieve some simulacrum of great power status. Not going to happen, unfortunately. And given that, Europe in particular should recognize Russia’s debilitating and deep seated weaknesses, and abandon its cringing and pusillanimous posture towards its eastern neighbor. This only feeds Russia’s presumptions and enables its dysfunctional political and economic culture.

James Hamilton is a world-class econometrician who has done pathbreaking work on the relations between oil prices and the real economy. Recently, he has blogged extensively about the potential contribution of speculation to the price of oil. Although he argues that most of the runup is fundamentals-driven, he is open to the suggestion that the increase in price since January is not primarily the result of fundamentals, but is instead speculative in origin. He is sensitive to the objection that a speculative distortion in prices should also manifest itself in increases in stocks. He attempts to counter this criticism with an example:

A much more important way in which the spot price of crude would affect the refiner’s demand for the product is through an intertemporal calculation. Given my customers’ demand, I’m going to need to buy the product sooner or later. If you charge me a lower price today than you’re going to charge me next month, I’d choose to buy more today to put it into inventory. If you charge me a higher price today, I’d rather run down my inventory and buy the oil next month, and of course the futures market allows me an opportunity to lock in a price for doing just that. Thus by far the most important factor in refiner’s demand for July oil will be the August futures price. If my production plans left me willing to buy July oil for $124.25/barrel when August oil was selling for $124/barrel, I’ll probably want to buy July oil for $126.25/barrel now that I’m forced to pay $126/barrel for August oil. Thus to a first approximation, the spot price would move by exactly the same amount as the near-term futures price. A $1 increase in the August futures price would shift the demand curve for July spot oil up by $1. In this fashion, an ever-increasing volume of speculative purchases of the near-term futures contracts would drive the spot price up with them.

There are two fundamental problems with this example, one logical the other empirical.

With regards to the logical problem. The premise of the hypothetical reminds me of the old Steve Martin routine “How to make a million dollars without paying taxes! First, make a million dollars.” That is, James pulls the $1 increase in the August price out of a hat, like a magician producing a rabbit. But why would an increase in speculative futures purchases lead to a dollar increase in the price of the August contract? Setting aside that the speculators might be informed–in which case, the price response is likely rational and efficient–why would other market participants believe that an (uninformed) speculator’s purchase should lead to an increase in the price of oil in August? Perhaps they anticipate that the August contract will be offset, but the speculator will buy even more for September delivery. This just kicks the can down the road a bit. Due to the ultimate connection between the futures price and the price of physical oil (that results from the delivery mechanism) the only way an uninformed speculative purchase will lead to a price increase is if market participants anticipate that some portion of the speculator’s purchase will not be offset. That instead, the speculator will take delivery of oil, and USE THAT OIL INEFFICIENTLY.

Inefficient use can occur as a result of a corner or squeeze. The speculators could squeeze some future contract, causing distortions in the production and transportation of oil. (A squeezer demands excessive deliveries, and essentially forces the delivery market up the supply curve to outputs beyond the competitive equilibrium point.) The problem here is that many speculators are unlikely to execute a squeeze, although A Speculator might do so. Multiple speculators may collectively have the ability to squeeze the contract, but they also face a collective action problem. Each one reasons: if everybody else is going to take to many deliveries to drive up prices, why should I go along? Why don’t I just liquidate my entire position at the artificially high price, and let everybody else bury the corpse (i.e., dispose of the excessive deliveries at a depressed post-squeeze price.) Individual rationality of the speculators results in a non-cooperative equilibrium where no squeeze takes place. Thus, given that myriad hedge funds, pension funds, investment banks, etc., make up the speculative crowd, unless one or two of them possess market power it is highly unlikely that anticipation of a squeeze could cause the price to rise in response to an increase in speculative purchases.

Another story is that somewhere along the line, speculators will take excessive deliveries, and just hoard the oil, keeping it off the market to enhance the price. This scenario also faces the prisoners’ dilemma issue, and another problem as well. Even for an individual speculator, it is difficult–and arguably impossible–to make a credible commitment to carry out this inefficient action. This is analogous to the Coase durable goods monopoly problem. (My 1993 Journal of Business paper discusses this issue in detail in the section titled “Pure Monopoly Manipulation.”)

That is, once he takes delivery and liquidates his futures position (at a high price), why should he just hold onto the commodity he received via delivery, reducing consumption below its efficient level and elevating price going forward? He would rationally sell the good, driving down its price to the efficient competitive level. But, forward looking counterparties, recognizing the speculator’s inability to precommit to the inefficient policy, would conjecture that he will not carry through on his threat, and hence are willing to sell the future at the competitive price today. The long would like to precommit to holding supplies off the market, but this is problematic, not to say impossible.

In a nutshell: distortion in the futures price today via the mechanism of speculative purchases requires an anticipation that the speculators will somehow take actions (a corner or hoarding) that reduce consumption below its efficient level in the future. There is no credible reason to believe that a large number of speculators can do this. Index funds that roll all their positions deterministically definitely cannot do this–they are effectively precommited NOT to take delivery. Ditto for those rading cash settled instruments, such as ICE WTI futures, or swaps (although the holders of such instruments could have an incentive to distort the physical market to enhance the value of their derivatives position.)

James’s example also poses other difficulties. The expectation that speculators will somehow take actions in the physical market that reduce supplies in the future (and such an expectation is a necessary condition for the price to move today, per the hypothetical) will induce immediate real responses. An anticipated increase in the demand for oil in the future will induce, at the margin, a decline in current consumption and an increase in current output, and an increase in stocks, in order to meet the anticipated future demand. That is, it is unrealistic to argue, as James’s example suggests, that an increase in future demand for the physical product will not lead to an increase in current inventories.

The empirical difficulty relates to the prediction inherent in the example: that there is a one-for-one relationship between the change in the spot and futures prices, especially when the market is in backwardation (as James deliberately specifies in the example, as he explains in his responses to comments). I have produced empirical evidence for industrial metals (J. of Bus., 1994) and oil (J. Futures Markets, 1996) that shows that when the market is in backwardation: (a) the correlation between spot and futures is well below one, and (b) the spot volatility is higher than the futures volatility. This implies that if one regresses the futures price change against the spot price change, the coefficient on the latter will be less than one–and often substantially so (e.g., on the order of .75 or .8). (Of course, if the regression is run the other way, the coefficient could be bigger or less than one, but in practice the coefficient is still less than one because the correlation effect dominates.)

Futures and spot move one-for-one when the market is in full carry (or nearly so)–but only because inventories (which are large when the market is in a carry) provides an intertemporal connection between spot and futures prices. This link is attenuated when the market is in backwardation. (I’ve also demonstrated this theoretically/numerically in solving dynamic storage models.) But when the market is in backwardation, the one-to-one relationship between spot and futures moves is unlikely to be observed in practice. Thus, if one treats the example seriously, as a source of empirical predictions about comovements of spot and futures prices, it is refuted by the data.

While musing about contango and backwardation, it is interesting to note that back in 2005-2006 those blaming speculation for distorting prices pointed to the strong contango as evidence that funds trading progressively more in the back end of the curve were distorting prices. These voices were notably silent when the market returned to backwardation last July. If anything, it appears that more activity is moving to the back end of the curve–so why did the contango go away? Moreover, although the price runup post-Katrina was accompanied by an increase in inventories–which is it at least superficially consistent with the price distortion story–the recent price runup was not accompanied by a jump in stocks. (And, as I said in my “Dance the Contango” post that is so loved by spam commentors, and in my recent working paper formalizing that intuition, in a world with stochastic fundamental volatility a positive co-movement in stocks and prices can occur in a rational expectations equilibrium, and hence is not necessarily a smoking gun of speculative distortion.)

In conclusion, I find James’s example unpersuasive. Although an increase in stocks that accompanies an increase in prices does not necessarily indicate speculative distortion, it is hard to imagine how the speculators could force prices above the competitive level without having to get their wingtips dirty with holdings of the gooey black stuff.

Edward Lucas and Bob Amsterdam both offer recent comments on the potential for an OPEC-like cartel for natural gas.

In a book review in the WSJ, Edward writes:

[Marshall Goldman] also sees no danger of an international natural-gas cartel forming along the lines of the Organization of Petroleum Exporting Countries, one that would presumably include Turkmenistan, Venezuela and Trinidad.

Russia would never let its decision-making be affected by others, Mr. Goldman says. That may be true in the case of price-setting (where the economics are quite different from the oil market, because oil is traded on the spot market, whereas the international gas business is mainly based on long-term contracts). But a possible Organization of Gas Exporting Countries could still help bolster Russia’s position by consolidating producer power in exploration, pipeline routes and the market for liquefied natural gas.

Yes, oil is currently traded on a spot market–but it wasn’t always so. The spot oil market began during the second oil shock of 1979, with the abrogation of equity agreements between Mideast producers and the “seven sisters” oil companies. Contracts are made to be broken, and something similar could well occur in LNG if producing nations found it to be in their interest.

Moreover, contracting choices are endogenous. Long term contracting makes sense when there are relatively few potential consumers and producers of LNG. Under these circumstances, individual buyers and sellers are locked into bilateral relationships characterized by huge investments in specific assets. As more LNG production facilities and ports are created, however, the lock in problem is mitigated. Put differently, the market is “thicker”–and thick markets can support spot contracting.

Indeed, the spot market for LNG is developing apace, and the flexibility of spot market contracting is increasingly recognized as an important source of value for producers. Thus, although it is correct to say as a historical observation that LNG is bought and sold under long term contracts, this is unlikely to be an accurate forecast of how the market will look even 5 years hence. A cartel could effectively control such a spot market for LNG, and affect pricing for all natural gas, even that delivered by traditional pipelines.

Robert writes:

Such a cartel would not function in the same manner as OPEC – and this is the most frequent sticking point for critics who say there is nothing to worry about. Given the regional nature of natural gas (LNG is still not produced in high enough quantities to generate a spot market), it is unlikely that cooperating exporters could ever achieve production quotas in order to put supply pressures on price.

As I just noted, this statement is becoming increasingly obsolete. Natural gas is becoming less and less a regional market. And what’s important to remember is that prices are set on the margin–and for most major consuming regions LNG is, or will soon become, the marginal fuel. Even if a particular market receives the bulk of its gas from a traditional pipeline, its marginal source, and the only alternative source for major supply increases, is or will soon be LNG. The price of this marginal/alternative source will limit the price that the traditional supplier–Gazprom, say–can charge.

Hence, even if LNG volumes are smaller than volumes delivered through traditional pipes, it is becoming sufficiently important to be a major determinant of the profitability of traditional operators like Gazprom. That firm’s market power will depend in large part on the potential competition from LNG. Hence, the firm has a tremendous incentive to take actions–most importantly, the formation of a gas cartel–that would reduce competition from this source.

Britain is a case in point. At the UH-GEMI energy trading conference in March, Davis Thames from Cheniere (which ran into some financial problems in May) noted that Britain is building LNG capacity that is (if memory serves) about 9 times what its LNG imports are likely to be in the near to medium term. Why would this possibly make sense? If the LNG market is competitive, this excess capacity would sharply constrain the ability of a traditional pipeline supplier to hold up Britain for a higher price. In other words, the capacity would greatly increase British negotiating leverage–if the LNG market is sufficiently competitive and liquid.

But if it is not . . . the traditional suppliers–most notably Gazprom–would have tremendous market power despite the consumer investment in LNG ports. Hence, throttling competition in LNG is essential to Gazprom as a means of maintaining its market dominance.

When appraising the prospects for a gas cartel, I therefore take very little solace in differences between the market for oil and the market for LNG. The oil market once looked not too different from the LNG market; the oil spot market only blossomed during the second oil shock, and with the increasing diversity of LNG supply sources and demand sinks, the LNG spot market is developing and will continue to mature and grow. Since LNG is becoming, and will almost certainly be, the marginal, price setting source of gas for most consumers, it is the most important competitor for traditional pipe-in-the-ground (or under-the-sea) operators, most notably Gazprom. Gazprom therefore has a tremendous incentive to facilitate formation of a gas cartel, and exporters of LNG could profit from its formation. Hence, in my view, such a cartel is a matter of serious concern. Unfortunately, as seen too often in Central Asia, major consumers in Europe and the US don’t seem to be taking the threat seriously, and are running the risk that OGEC will do to the gas market what OPEC did for oil.

The words are, of course, Mark Twain’s. And almost a century after rumors of his death were no longer exaggerations, Congress daily works assiduously to bring his joke to life. Especially with regards to energy policy. Case in point: Rep. Maurice Hinchey (D for do you even need to ask, NY) has called for nationalization of US oil refineries. Methinks that even that ultimate cynic Twain would be amazed at such gobsmacking stupidity.

Another case in point; the mindless blather about energy speculation, and the various vacuous proposals to curb it. I’ve blogged on this subject many times, and will return to it again soon, but here I will limit myself to repeating a point I’ve made before: these assertions are based on bad economics and no evidence–always a great basis for effective policy.

From Econbrowser, I learned that Paul Krugman (oy) made a point that I was going to blog about, but my procrastination gene kicked in. Specifically, Krugman opined that if speculation were really driving up prices above the equilibrium level, we should also observe an increase in inventories. In energy, and in some other commodity markets, inventories have actually been decreasing. So Krugman concludes–reasonably–that this is inconsistent with the ceaselessly repeated mantra that speculation is causing prices to diverge widely from the equilibrium fundamentals-driven value.

There are historical examples of this phenomenon. The International Tin Council attempted to prop up the price of this metal. The ITC had to buy increasing quantities of tin, as the high price discouraged consumption and encouraged production. Eventually, inventories became so large that the ITC could no longer afford its scheme; tin was dumped on the market; and the price plunged. The accumulation of stocks of grains by governments (including the US government) as the result of price support programs are also good examples.

James Hamilton at Econbrowser is skeptical, noting that in the short run supply and demand for most commodities is so inelastic that prices can diverge substantially from the equilibrium value without leading to a detectable increase in stocks.

If forced to choose, I would go with Krugman on this. The speculation-is-driving-the-market (nuts) mantra has been heard for nigh onto three years, which is more than enough time to see an accumulation of stocks in the hands of speculators (and it would be speculators that hold the stocks as they are the ones allegedly willing to pay the inflated price). Yet this has not happened. Hamilton argues that yes, the last three years have been fundamentals-driven, but the January-February spike may not be. In such a short time frame, he notes, given the inelasticities in supply and demand it may be very difficult to detect any speculative distortion in stocks given their natural volatility. That’s a fair point, but I am reluctant to conclude, based on this absence of evidence that speculators did not cause a distortion, that prices were irrationally high in two months after being fundamentally driven for years during which speculative activity was also intense.

I do have one quibble with Krugman (about this issue–about politics, quibble doesn’t come close to covering it.) Krugman’s analysis is a static, supply-demand one. Any analysis of inventories must incorporate dynamic effects.

Moreover, a dynamic analysis implies that it is possible that stocks and prices can rise simultaneously even if all speculation is rational, i.e., in a rational expectations equilibrium. I sketched the argument in the 2006 post “Care to Dance the Contango?” There I conjectured that increases in uncertainty could cause the simultaneous increase in inventories, prices, and contango in the oil market. I’ve recently completed a stochastic dynamic programming model that formalizes the intuition from that post. (A working paper is in progress, but its completion will have to await my return from Europe in June.)

Commodity storage dynamic programming models posit that equilibrium speculative storage decisions maximize welfare. Given current inventories, the state of the economy, and the stochastic processes governing the evolution of this state, speculative storage decisions maximize the expected present value of net surplus (consumer surplus plus consumer surplus). Equilibrium prices adjust to provide maximizing individual agents the incentive to implement the optimal plan.

One proceeds by conjecturing a function that relates forward prices to the current state of the economy and carry-in. One then solves for the amount of carry out such that the current spot price equals the present value of the forward price; if the spot price with zero carry-out (i.e., complete consumption of inventory) exceeds the forward price, it is optimal to store nothing, and to have a “stock out.” The possibility of stockouts (which will occur with positive probability in equilibrium) leads to backwardations.

Conventional storage models typically restrict attention to a single, mean reverting (i.e., stationary), homoskedastic net demand shock. Other models I have worked on posit two mean reverting homoskedastic shocks, with different speeds of mean reversion.

In this most current work, I have two state variables: a mean reverting net demand shock, and a mean reverting stochastic volatility shock. That is, I don’t assume that net demand is homoskedastic; the second state variable in the economy is the volatility (or variance) of the demand shock.

This framework formalizes the intuition in “Dance the Contango.” And the results of the model are exactly as conjectured in that post. When there is a positive volatility shock, agents respond by increasing storage, and thereby reducing consumption. This leads to a simultaneous increase in inventory and price–a phenomenon that has mystified many commentators on the energy markets in recent years.

I presented the results of the analysis at a conference in Italy in January. Here are the slides, complete with some graphs illustrating the results of the model.

In sum, although a simultaneous increase in stocks and prices could be a consequence of speculative distortion–but this is not necessarily the case. I would surmise that the absence of inventory accumulation is strong evidence against the excess speculation hypothesis, but that the existence of inventory accumulation when prices are rising does not imply that speculation is distorting prices.

I understand that this is not an especially satisfactory conclusion, but it illustrates that it is very difficult to identify implications that definitively distinguish the competing hypotheses. Methinks, however, that it is necessary to go beyond the crude correlation=causation argumentation that dominates the current debate about the impact of speculation: “There is a lot of speculation. Prices are high. Therefore the speculation caused the high prices.” The exact mechanism by which this works is seldom specified. Krugman is on the right track to point out that the excess speculation hypothesis should have implications for quantities as well as prices. His Micro 101 analysis is a good place to start, but when considering storable commodities, it is necessary to model the dynamics. When one does so, one finds that his test may generate false positives. That is, in a world where the amount of fundamental uncertainty is itself random, a simultaneous increase in stocks need not be definitive proof that speculation is distorting prices. It may instead show that speculation is in fact ensuring that resources are being allocated efficiently.

It is this very difficulty of coming up with empirical tests that cleanly distinguish between the rational speculation hypothesis and its irrational speculation alternative that make it so difficult to resolve this debate. Which is why it has raged for centuries, and will continue to rage into the foreseeable future.

Churchill once said “The Germans are either at your throat or at your feet.” (He actually said “The Hun is either at your throat or at your feet,” but (a) some folks might not know “Hun” was a common epithet for “German”, and (b) no need to use old insults, even though this post will hardly be kind to the current German leadership.) At present, Germany is firmly planted at Russia’s feet, doing its bidding at the NATO meetings by opposing Ukraine’s and Georgia’s Membership Action Plans (MAPs). The German arguments are disingenuous at best. Moreover, as this article by Klaus-Helge Donath (translated on Robert Amsterdam’s blog) says, Gemany’s prokynesis will earn it nothing but scorn from the Kremlin:

Behind the Kremlin walls officials are smirking over German Foreign Minister Frank-Walter Steinmeier’s appeasement. That’s why Moscow also does not take the European Union and Berlin seriously. The way Russians understand things making concessions, approaching the rival is a sign of weakness and European softness. . . Even if Russia talks about a “multi-polar world order and “respect” in the international arena that applies exclusively to the respect of others for Russia, not the other way around.

Why does Germany grovel? Gas, gas, and gas. Did I mention gas? But is appeasement on NATO enlargement an effective way of obtaining future Russian forebearance on gas pricing, access, or shutoffs? Will its carrying Putin’s water ensure Russia’s future goodwill and the steady, reliable flow of gas at reasonably competitive prices? Not bloody likely. Russia will take Germany’s gift today, and do exactly what is in its economic and political interest tomorrow. So Germany has sold out NATO, stiffed Ukraine and Georgia, and handed Russia a victory, and will be lucky to get a mess of pottage–or borscht–in return. And the Kremlin will figure it rolled Germany once, so it might as well try it again. And again. And again.

Donath also makes a point I’ve emphasized at SWP; Russia’s fears about NATO’s military threat are fantastical. (Stephen Blank has made a similar point.) (One can debate whether they are the result of paranoid delusions, or whether the expressed fears are merely intended to manipulate Russian public opinion.) So why does Russia protest so much?

If NATO expansion does not threaten Russian territory in the slightest, it does sharply constrain Russian freedom of action in Ukraine and Georgia. That is, Russia does not oppose NATO expansion because it legitimately fears that this would threaten the territorial integrity or political independence of Russia; instead it fears NATO expansion because that jeopardizes Russia’s ability to threaten the territorial integrity and political independence of the countries in the near abroad, Ukraine prominent among them.

Russia portrays NATO as aggressively absorbing new states. Its characterization of NATO is analogous to Sparta’s description of the Athenian empire. But NATO does not collect tribute from its members under the threat of force. Georgia, and to a lesser degree Ukraine want to join. Earlier joiners from the old East Bloc–such as the Baltic states, the Czech Republic, Bulgaria, and Romania–also wanted to join. They volunteered–and in some cases clamored–to join NATO. NATO did not force them to join.

This should raise the question in Russian minds: why are our former satellites so eager to join what we consider an aggressive alliance? Perhaps the answer lay in centuries of history and very long memories of suffering–and at times, suffering quite cruelly–under Russian domination.

The irony of the situation is that current Russian behavior only reinforces the desire of Eastern European states to deepen their NATO ties, and for Ukraine and Georgia to enter the alliance. The Russians have apparently not learned that (as my grandfather used to say) you catch more flies with sugar than gall. Blustering, bullying, manipulating, supporting breakway provinces, using gas as a political weapon, poisoning presidential candidates etc., is no way to win friends and influence people. But that’s the kind of things the Russians have done consistently in the near abroad, and continue to do today. Like an abusive husband driven to rage by his wife’s attempt to leave home, the chekists’ thuggery only further alienates those it wants to control.

This reflects an attitude that noted American scholar of Russia, James Billington, describes in his book Russia in Search of Itself:

Seeking to preserve unity and maintain control over a vast and exposed territory, the Russian empire was frequently at war with its neighbors. The Russian’s basic understanding of all this recurrent conflict has been diametrically opposite to that of their principal neighbors. Russians have generally seen themselves as perpetual victims of foreign predators, building on the fact that rival empires have invaded their lands from the Mongols and Teutonic Knights to Napoleon and Hitler. Most of Russia’s immediate neighbors however have seen themselves as victims threatened with conquest by the relentless expansion of a much larger power armed with unlimited ideological justification for extending its empire.

The eagerness of former satellites to join NATO provides ample evidence that Russia is still perceived as an aggressive power. Russia’s actions only justify this perception.

To turn around Putin’s insult of the US, the Russian wolf is just doing what wolves do. Its behavior is of a piece with its actions over centuries. The sad thing is that Germany enables this behavior, and like most codependents, will gain nothing for its current humiliation but more humiliation in the future.