Wednesday, June 25, 2008
paul krugman and the oil bubble that isn't
to this latest of the series i responded.
"Whatever you say about the futures market, it can only drive up the spot price by causing physical hoarding of physical goods."
this is the doctrine i question, dr. krugman. why should price setting in reality be as reductive as a supply/demand curve in a world so plainly complex? that is the model and it is easy -- too easy -- to understand. but it is not the reality.
i think it more honest to say that the supply/demand curve demonstrates the pressure applied to the extant price to rise or fall because of the realities of supply and demand -- but does it determine the price? no. the price is determined by one thing only -- the sum of the expectations of market participants.
if me and my supplier friends are bringing commodity x to market to sell to buyers, we settle on a price to exchange the commodity. that price is not determined by supply and demand -- there's no equation that says "if you bring five this is worth $30". the price is the reflection of the sum of our expectations.
for any commodity that has a perceived range of cost of production, the price is normally above that cost or supply will fall incrementally until the price rises. and for any commodity that has a perceived range of benefit of ownership, the price is normally below that benefit or demand will fall incrementally until the price lowers.
but if the spread between the perceived cost of production and the perceived benefit derived is wide -- and for oil, it clearly is -- where exactly the price falls between the two limits is driven as much or more by the psychology of the participants as the realities of cost. and where mania takes hold, price movement temporarily outside the boundaries of cost/benefit are not uncommon.
i don't dismiss the supply/demand reality -- oil is getting scarcer vis-a-vis demand and cost of production is rising and will continue to rise. but neither do i think one can dismiss the speculative fervor that has taken hold in the oil market and say it has no effect simply because every long in the futures has its short. the price of oil between the margins of cost and benefit is defined largely by the expectations of the participants in the futures market -- for the spot market as well as the derivatives.
this behavioral component of trading has little or no place in the conventional view of efficient-market economics, but is nevertheless an obvious reality. i think the role of market participant expectations is being underestimated vis-a-vis the supply/demand argument.
yves smith relays thomas palley and others, entering the fray against krugman and efficient-market notions. one of smith's commenters notes a conundrum that can only be the product of a temporary dislocation in the price of oil:
That is, the total refined products have been selling for less than the price of raw oil...that's why refiners are at sub-90% capacity (and bottomed in the low 80%'s...aka Katrina/Rita levels).
Put another way, there is more demand for oil than there is for the actual distillates...or, one more way - the distillate paper market isnt responding like the crude paper market is (aka one of them might be broken).
as notes smith:
This is not definitive, but the fact that refiners are getting squeezed is not consistent with the notion that crude prices are driven by end market demand.
furthermore, says palley -- echoing some of my own thoughts as commented on krugman's blog:
Reflecting their faith in markets, most economists dismiss the idea that speculation is responsible for the price rise. If speculation were really the cause, they argue, there should be an increase in oil inventories, because higher prices would reduce consumption, forcing speculators to accumulate oil. The fact that inventories have not risen supposedly exonerates oil speculators.
But the picture is far more complicated, because oil demand is extremely price insensitive.
certainly supply and demand play a big role. i myself think that slackening demand is likely to curb real prices. and i've looked for hoarding too. but expectations of seeing the hoarding in a bubble should be modest:
the truth is that commodities DO boom and bust -- they always have. it may be important to argue about the mechanism, as waldman here does and cogently, but not as important as simply realizing that -- because it has happened -- there IS a mechanism. and that one is in a speculative bubble is NEVER simply as obvious as looking for invenory buildups, for if it were so easy there would never be a speculative boom in the first place.
some have pointed out that supply may in fact be held off the market and kept in the ground -- a good hiding spot, as national production figures are not entirely reliable. others have noted that iranian sour crude is sitting in tankers, and that strategic stockpiling around the OECD is going on. so perhaps the hoarding that dr. krugman needs to see to be convinced is in fact before him. more from palley, in a bit saliently contextualized by the testimony of phillip verleger exerpted by yves smith:
Unfortunately, proving that speculation is responsible for rising prices is difficult, because speculation tends to occur during booms, so that price increases easily masquerade as a reflection of economic fundamentals. But, contrary to economists’ claims, oil inventories do reveal a footprint of speculation. Inventories are actually at historically normal levels and 10% higher than five years ago. Furthermore, with oil prices up so much, inventories should have fallen, owing to strong incentives to reduce holdings. Meanwhile, The Wall Street Journal has reported that financial firms are increasingly involved in leasing oil storage capacity.
The root problem is that financial markets can now mobilize tens of billions of dollars for speculative purposes. This has enabled traders collectively to hit upon a strategy of buying oil and quickly re-selling it when end users accommodate higher prices – a situation that has been aggravated by the Bush administration, which has persistently added oil supplies to the US strategic reserve, further inflating demand and providing additional storage capacity.
as an aside, an increasingly mentioned and somewhat compelling complementary argument notes that, because of refinery mismatches to output type, sour crude is having a hard time finding a market while light sweet is in much higher demand. as the economist notes:
Saudi Arabia's motives for wanting to lower prices are clear. The trouble is that it cannot manipulate markets as before. The kingdom has a fifth of known reserves. It supplies an eighth of the world's oil and remains, crucially, the only producer with at least some spare capacity. A huge investment plan under way should raise its capacity from 11.3m barrels a day in 2007 to 12.5m by next year. Noting pleas from George Bush and Ban Ki-moon, the UN's secretary-general, the Saudis have upped actual production twice in the past month, raising it by 500,000 barrels a day to its present level of 9.5m.
But much of that new output, and most of the reserve capacity, is in the form of heavier oils that are costlier to refine and for which there is less thirst. The Saudis are unlikely to bring new, lighter crude, or bigger refining capacity for their heavier oils, onto world markets until next year. Even then the incremental rise may not offset demand. So energy watchers hope the Jeddah conference will reveal something bolder than promises of more oil.
in any case, i went short the oil sector through the proshares' DUG this morning (too late). we'll see how it pans out -- playing in a bubble is always dangerous.