Streetwise Professor

January 13, 2014

Scott Irwin Answers Kocieniewski

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 9:04 pm

Scott Irwin has provided his responses to David Kocieniewski.  Read the whole thing.

It’s My Turn

The responses to the recent NYT article by David Kocieniewksi certainly make interesting reading.   I don’t want to belabor points already made so well by others in response to the numerous problems with the article (especially Craig).  Instead, I want to offer some additional points that I think merit further consideration or elaboration:

  1. To start, it is important to clarify that the heart of the controversy is the trading activities of a new type of participant in commodity futures markets—financial index investors—during the 2007-2008 commodity price spikes.  The concern was that unprecedented buying pressure from index investors created massive bubbles in commodity futures prices, and these bubbles were transmitted to spot prices through arbitrage linkages between futures and spot prices.  The end result was that commodity prices far exceeded fundamental values during the spikes.  Dwight Sanders and I labeled this the “Masters Hypothesis” in honor (dishonor?) of the central role that hedge fund manager Michael W. Masters played in pushing this line of thinking.   It is crucial to understand the key features of the Masters Hypothesis.  First, it implies that index buying in commodity futures markets created massive price bubbles—20, 30, 50% overvaluations (take your pick).  Second, it implies the price bubbles were long-lived, measured in months if not years.  These features have driven the acrimonious debate about “speculation” in commodity markets that first erupted in 2008.  Without the charge of massive and long-lasting bubbles the intense public policy debate about speculation limits would not have taken place.
  2. My position on the validity of the Masters Hypothesis has been consistent from the earliest days of the controversy.   In fact, in an ironic twist, one of my earliest publications on the controversy was an op-ed that Dwight Sanders and I jointly authored—drum roll please—yes, in the NYT in July 2008.   A few quotes:  “Over all, there is limited evidence that anything other than economic fundamentals is driving the recent run-up in commodity prices…The complex interplay of these factors and how they affect commodity prices is often difficult to grasp immediately, and speculators are a convenient scapegoat for the public’s frustration with rising prices. That’s unfortunate because curbing speculation — and hobbling the ability of businesses that rely on futures markets to reduce their risk — is counterproductive.{
  3. If my work was somehow tainted by associations with “Wall Street,” then why the editorial endorsement by the Paper of Record in 2008?   It also seems convenient that this little fact was omitted in Mr. Kocieniewksi’s recent article.   I made sure he was aware of my previous NYT op-ed article when he interviewed me. I suspect he was already aware of it given his exhaustive background research on the two of us.
  4. The academic research pertaining to the Masters Hypothesis since 2008 has been overwhelmingly negative.  I submit that there is very little credible academic research that is consistent with the basic tenets of the Masters Hypothesis.  That is, index buying is not associated with massive and long-lasting price bubbles in commodity futures markets.  There are no “accidental Hunt Brothers.”   Some unnamed persons (one has the initials GG) like to characterize academic research on the subject as being roughly equally divided between studies that find a positive impact of index positions on prices and studies that fail to find an impact.  This characterization is misleading.  Yes, some studies find evidence of a positive impact but the impacts are invariably small and fleeting or do not line up with the spikes of 2007-2008.  This type of evidence does not support the Masters Hypothesis.  So, when properly interpreted the evidence to date is not divided equally, but instead overwhelmingly rejects the Masters Hypothesis.  And this is what is important from a public policy perspective—small impacts do not provide much justification for costly new regulation of commodity futures markets.
  5. My approach to research on the market impact of index investment has always been to go where the data lead.  My co-authors and I have sliced and diced the available data many different ways and we cannot find a smoking gun (a full list can be found here).  As I like to put it, if the Masters Hypothesis is true then the relationship between index positions and commodity futures prices should literally jump off the page.  It does not.  Importantly, there is also limited evidence of bubbles in commodity futures markets independent of whether or not they are associated with index investment.   My co-authors and I could not find evidence that bubbles have become larger or longer-lasting since index investment came on the scene.  If anything they have become smaller and less frequent.
  6. If my research on speculation is slanted/biased/tainted then it sure has fooled a whole bunch of academics who serve as journal editors and reviewers.  I have published 13 papers since 2009 dealing directly with the speculation controversy in 9 different academic journals.  And several more are currently under review.  Yes, under review.  This means the articles don’t get published unless they first pass muster with reviewers and then a journal editor.  I don’t know exactly how many editors and reviewers I have dealt with on these papers (several were invited submissions but still subject to peer-review), but it is safe to say that it must be at least 20-30 people.  So, we are to believe that my biased research ran this gauntlet of editors and reviewers and the bias managed to go undetected the entire time?  Give me a break.
  7. Just for the record, I want to state in public that I did not even know about the Chicago Mercantile Exchange (CME) donations to the business school here at the University of Illinois when the donations were made.  I only became aware of them in the last year or so through conversations with our development staff.   (OK, I should actually be a little embarrassed by that last statement given my work on commodity futures markets.)   In any event, to draw an inference between the gifts to the business school from the CME and my research really is ridiculous.  I made this clear in my interviews with Mr. Kocieniewksi.
  8. I do have a long working relationship with the CME, and before that, with the Chicago Board of Trade (CBOT).  This after all is my research area.   The CME has not funded any of my research since 2007.  However, I did work on a commissioned white paper for the CME in 2005 when the grain contract convergence problems first erupted.  My co-authors (Phil Garcia and Darrel Good) and I were paid a total of $15,000 for the work, which we split equally.   I did accept a position on a new Agricultural Advisory Council that the CME started in late 2013.  The council will meet three times a year at various locations around the country and serve as a sounding board for various issues that come up with regard to agricultural futures markets.  I will receive the same $10,000 annual stipend for this position as the other members of the council.   That is the sum total of my financial ties to the CME.
  9. I have had numerous interactions with CME staff in recent years on a host of issues related to commodity futures markets, including, of course speculation.  Sometimes I have reached out to them and sometimes they reach out to me.  Most of the time it is the former and involves pretty obscure questions about things like how the grain delivery process works or help in getting some data.  My research would be far less interesting and useful without this help.  I have the utmost respect for the professionalism of the CME staff and I have never been asked for any type of quid pro quo.  Never.  When I have agreed to participate in presentations, write blogs, etc. I have done so because I believed my research and analysis contributed to better understanding of the issues.
  10. My other research on commodity market speculation has been funded from three main sources.  First, the Laurence J. Norton Chair that I hold here at the University of Illinois provides earnings each year that go to support my research program (thank you U of I!).  Second, I have had two grants from the Economic Research Service of the USDA on commodity speculation related topics since 2008.  The first one included work directly on speculation while the second focused on convergence in grain futures contracts. Both have been completed.  Third, Dwight Sanders and I did a commissioned study for the OECD in 2010.  I lost track of the emails with the exact amount we were paid but I know it was only a few thousand dollars.
  11. Yieldcast is a product of T-Storm Weather that I helped develop with a former graduate student, Mike Tannura, and Darrel Good.  Yieldcast provides “real-time” U.S. corn and soybean yield forecasts for subscribers.  My main role is to build the statistical models that form the basis of the forecasts and to prepare the weekly forecasts during the growing season.  As indicated in the NYT article I do not have direct contact with Yieldcast subscribers.  I am fortunate that side of the business is ably handled by Mike Tannura through T-Storm.  It is really laughable to think that I have somehow been rewarded through this channel by Wall Street as a payoff for my speculation research.  I know how hard Mike has worked to build the base of subscribers for this product, and if it only were that easy!  I have never seen one email, one voice mail, or absolutely anything that connects my research on speculation to taking out a subscription for Yieldcast.
  12. As the NYT article indicated, Dwight Sanders and I did conduct a study in 2012 for Gresham Investment LLC on the market impact of index investment.   Given the political sensitivities surrounding the speculation issue, I gave considerable thought as to whether I ought to pursue the consulting project.  I knew some would see taking any funding from a commodity firm as being a conflict of interest.  But, the project provided access to detailed firm level position data that has previously been unavailable to researchers and this made it worthwhile in my mind.  Sure, I didn’t mind getting paid as well.  The NYT article got it wrong when it said I was paid the full $50,000.  Dwight and I split that equally so I was actually only paid $25,000.  We are working on several interesting papers based on this new dataset.
  13. If the charges (really, innuendoes) in the NYT article are baseless, then readers might reasonably ask what does motivate my “defense of Wall Street”?  Good question.   I am indeed a “freshwater” economist that became convinced early in my career that commodity futures markets were an invaluable market institution that improved the discovery of prices and the ability of market participants to shift risks.  While these markets are by no means perfect (as Craig’s work on manipulation highlights), on balance, the good vastly outweighs the bad.  So, when the current speculation controversy erupted in 2008 I was struck by the similarity of the present controversy and those that have buffeted the industry in the past.  Change only the names and dates and not all that much is different.  This has been a reoccurring theme in my own writings since 2008 (including the July 2008 NYT article…could not resist).  And I admit that I made an intentional decision early on to play a more public role in the present controversy.  Three of my professional heroes are Holbrook Working, Tom Hieronymus, and Roger Gray, who spent much of their illustrious academic careers defending futures markets.  All the motivation I needed.

Scott Irwin

University of Illinois

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  1. Masters is right in principle.

    Buying by index fund and ETF investors hose aim is to avoid loss, rather than make transaction profit (aka speculation) subverts the price formation of markets, and where this investment becomes dominant, it literally kills the market in relation to the purpose for which it was designed.

    But Masters wrong in practice: the futures markets were the tail, not the dog.

    It is supply and demand in the physical market which affects the market price, and which is then reflected by derivative markets.

    This is where opaque prepay contracts have enabled producers to lend commodities etc to investors in exchange for a loan of dollars. It was Enron who kicked off prepay – which enabled them to defraud creditors and investors alike via a couple of compliant investment banks. It was BP and Goldman Sachs between them – based upon iron control of the Brent complex of contracts and BP’s complete control of the Forties market – which saw the long ramp, followed by a manipulated spike/market coup in 2008.

    Post 2009, it has been the Saudi use of prepay contracts – courtesy of JPM – which first reflated the bubble and has since seen them act subsequently as de facto global oil bank. The deal was that the oil price didn’t sink below a level which keeps the Saudis in goodies; while the product price didn’t go above the level at which POTUS could get re-elected.

    The prima facie evidence of this financialisation by fund money has been the ludicrous Brent/WTI spread, and the detachment of natural gas prices from crude oil prices – to the great discomfiture of Gazprom. This sort of financialisation/macro manipulation can go on for years. Hamanaka managed it for ten years, and five of those were AFTER David Threlkeld blew the whistle.

    Prepay is now coming out of the closet. It’s the only way that Rosneft can finance their repurchase of oil production equity.

    Comment by Chris Cook — January 14, 2014 @ 5:16 am

  2. Great response. If I can, I will illuminate what I saw in futures markets in 2007=08. I was an active trader in the hog market at CME (traded my own money as a local). My positions weren’t huge, but not small either. I would carry 100-500 spreads, and trade between 10-100 outright contracts naked at a crack. There were many other traders in the pit that were far larger than I.

    If people recall, in 2007 the Chinese were buying all kinds of commodities. Their economy was expanding, and they were getting ready for the Olympics. As a nation, they were not going to lose face by having a ruined Olympics and one facet of that was having enough food on hand. That provided upward pressure on prices, because it takes a while for supply in commodity markets to adjust to new demand. Hog and cattle gestation periods and fattening periods are what they are-and we can only grow grain in the summer (dependent on the weather for yield)

    The index buy only funds entered the hog market when the contract changed from delivery to cash settled. I don’t remember the exact day, but it was back around 2000. No one was bitching about price pressure back then.

    I never saw manipulation of price, and the market took on every buy order that was placed. As has been cited on this blog ad infinitum, futures is a zero sum game. For every long there is a short. Additionally, index funds had to roll their positions, so at expiration they had to buy one market and sell another. Spreads often would move quite a bit, but the overall price of the market tracked the cash price. I believe academic research has proven that.

    In July or August of 2007, I remember looking at the oil price and thinking it was too high. I shorted crude oil at $135/bbl when it was on the way to $140. After swallowing a lot of bile, I scratched the trade on the way down. (for people that don’t know futures, you can only take so much pain and capital requirements constrain you) I believe the price tanked to around $40/bbl. I thought this price action had a lot to do with world events and the discovery that the banks were insolvent than price manipulation.

    It is vitally important not to lump commodity markets together. The crude market isn’t like the soybean market isn’t like the hog market even though a bank index buy only fund acts the same in each. By the way, money is flowing out of these funds at a rapid clip now. Hot money in the market is headed toward currencies-so no doubt in the next two years we will see charges of currency manipulation by the banks. As if federal banks aren’t doing anything……but I digress.

    I am typing this post purely from memory so others might look at charts and see if my price points track actual ones. This article was extremely offensive to me as a market participant, as a former member of the CME board, as a member of CME, as an alumnus who has donated money to the University of Illinois.

    Comment by Jeff — January 14, 2014 @ 7:11 am

  3. @ Chris Cook

    “It was BP and Goldman Sachs between them – based upon iron control of the Brent complex of contracts and BP’s complete control of the Forties market – which saw the long ramp, followed by a manipulated spike/market coup in 2008.”

    Chris, is it your view / expectation then that an investment bank and an oil company would have positions facing the same way? I.e. both long or both short?

    Comment by Green as Grass — January 14, 2014 @ 7:43 am

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  7. Getting to this very late, but thanks for putting it up.

    I can only restate what I said before: if the “Masters Theory” were true, there would have been a sustained inventory build in 2007-2008. The flaw of the “Masters Theory” was that it assumed commodity index investors lived in a separate universe from the rest of the market where they could not be matched with shorts and so were equivalent to real inventory build.

    Comment by Tom — January 27, 2014 @ 7:25 am

  8. There is a significant difference between the current time period and the time period of your “heroes”: when they wrote, there were strict position limits on “financial” interests; those don’t apply today. Today, it’s a lot easier for the tail to wag the dog…

    Comment by TiPs — February 28, 2014 @ 10:03 am

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