Streetwise Professor

July 10, 2009

SWP on Speculation in FT Energy Source, and Another Reason Some Hedgers May Oppose Speculation

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Financial crisis,Politics — The Professor @ 5:01 pm

FT’s Energy Source blog kindly links to my piece on oil speculation.  Kate Mackenzie notes my argument on why commercial traders who perceive that they have an information advantage, and who speculate on that information, may support constraints on non-commercial speculators who compete with them.  (Ironically, we have houseguests named “Kate” and “Mackenzie” visiting this weekend.)

There’s another reason why some hedgers may want to crack down on speculation: some hedgers earn a risk premium rather than pay it, and competition from speculators reduces the profit that these hedgers earn.  When there is some segmentation between a particular commodity market (e.g., oil) and the broader financial markets, due for instance to a fixed participation cost like the cost of becoming informed, idiosyncratic risk affects risk premia.  This, in turn, can affect who benefits and loses from greater speculative participation.

The original Keynesian “normal backwardation” story assumes complete segmentation, in which case net hedging pressure–whether short hedging volumes exceed long hedging pressure at an unbiased price–determines the sign of the bias in the futures price (whether the future is above or below the expected spot price at expiration), and the amount of speculative risk bearing capacity determines the magnitude of the bias.  For instance, if short hedging pressure predominates (as Keynes believed) the futures price will be biased downwards (will be less than the expected spot price), meaning that short hedging is costly but long hedgers make a speculative profit; as the downward biased futures prices drift upwards on average to converge with the spot price at expiration, long hedgers profit on their long futures positions.  The bias is a profit for long hedgers, and a cost incurred by short hedgers.  This bias attracts speculators, who bid up the futures price until the expected profit arising from the bias balances the cost of the risk that they incur.  The greater the speculative risk bearing capacity, the lower the bias–and the lower the trading profit of the long hedgers.

This means that entry of speculators helps some hedgers–short hedgers–but HURTS others–long hedgers.  The bidding up of the futures price benefits hedgers who sell futures, and hurts hedgers that buy futures.  Thus, in a Keynesian world, long hedgers oppose speculators.  This means that hedgers will not uniformly support speculation.  Indeed, some market participants should actively support measures to constrain speculation.  

In a world where each commodity futures market is perfectly and frictionlessly integrated with the broader financial market, risk premia are determined solely by the systematic component of the commodity price’s risk.  

In a world between the frictionless world and the Keynesian one, both systematic and idiosyncratic risks affect risk premia, as was shown by Hirshleifer in the late-80s.  In this world, some hedgers will also prefer to crack down on speculation.  For instance, when short hedging predominates, long hedgers prefer to constrain speculation.  That’s because, like in the Keynesian world, they are effectively selling price insurance to the short hedgers, and receive a profit from doing so.  They don’t like the entry of speculators who compete away some of these profits.  

This can also explain why some hedgers would support measures that weaken the linkage between the broader financial market and a particular commodity market.  This weakening allows idiosyncratic risk to affect risk premia, and some hedgers in the market capture this risk premium as a profit even though those on the other side of the market pay it as a cost.  What’s more, the magnitude of this idiosyncratic risk premium depends on the ease of entry by speculators into the futures market.  

This analysis can explain some of the hostility to passive long index investors.  These investors are typically portfolio investors, and their participation in commodity markets helps to strengthen connections between commodity markets and the stock and bond markets.  Moreover, they compete with long hedgers in serving the risk management demands of short hedgers.  In so doing, they compete away some of the profit that long hedgers can earn in a market where short hedging predominates.  

Of course, this story implies that hedgers will not speak with one voice: based on these factors alone, one group of hedgers (e.g., short hedgers in the Keynesian story) will support speculation, while another group (long hedgers in the Keynesian theory) will oppose it.  (If long hedging predominates, the roles will be reversed.)  But combined with the other factors outlined in my earlier post–and perhaps others as well–this means that commercial traders who use futures markets as hedging tools can take very different views on the benefits of speculation.  

This is an old, old, old story in any analysis of regulation.  Although speculation improves the allocation of risk, and leads to overall improvements in welfare, it also has distributive effects.  Due to its effects on competition over information rents, or raising rivals costs considerations, or competition over risk premia, the entry of speculators can redistribute wealth at the same time that it increases (risk adjusted) wealth overall.  

This means that you should be very, very, very . . . skeptical about the protestations of some commercial firms about the evils of speculation.  They don’t necessarily have the interests of the market at large at heart.  Indeed, they almost certainly place their own interests foremost.  What’s more, it is inevitable that for some significant number of commercial firms these interests are contrary to market efficiency.  In derivatives markets, as in virtually every other, some firms can benefit from restrictions on entry or other impediments to competition.  Derivatives regulation, including regulation of speculation, is like other forms of regulation a rent seeking contest in which interested parties attempt to secure rents through the political process.  Sadly, it’s often those with the best lobbyists who win–not those with the strongest economic case.

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  1. I don’t have a problem with speculators or short sellers, they keep a market vibrant and honest. I do have a problem when a financial entity like Goldman Sachs dominates computer program trading and has an almost virtual monopoly on providing markey liquidity. That’s not an orderly and transparent market. Fundamentals don’t matter as it is now where Goldman wants the market that matters. I also don’t trust the unholy alliance that this administration has with finaciers and bankers. But, I’m digressing….

    Comment by penny — July 10, 2009 @ 8:51 pm

  2. Sorry, my comment is not on the subject.
    Here is the link.

    This web page can be translated with Google Translate.

    In a few words, in ’90s government of Moskow rented some real estate to MacDonalds for 49 years at very low price as an incentive to invest in Russia.
    Now the government of Moskow started a legal action to increase rent.

    It’s not that I want to defend MacDonalds. Not at all.
    Idiots who invest in Russia should be punished.

    This is to say that Putin’s Russia should not be allowed not only into WTO,
    but even into a club of cannibals. The only projects in Russia should be those where amount of capital needed to invest is low. Contract manufacturing, etc. Let them compete with China.

    Comment by Michael Vilkin — July 11, 2009 @ 1:58 pm

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