23 June 2008

Does Paul Krugman Understand the US Commodity Markets? Do We?

We keep thinking that somehow we have misunderstood him, that somewhere we are speaking two different languages. After all, he is the renowned economist, and we are but humble traders.

Paul Krugman's contention seems to be that the futures market is some sort of off-track betting parlor, that has little relationship with the physical or spot market, as the betting parlor has little to do with the outcome of the horse race.

Where does Paul think the price discovery for commodities occurs? At the local flea market? His analogy in his writeup is utterly inappropriate for the case at hand. His entire case really demands that he show a 'spot market' where prices are set separately and without regard to what he calls 'the futures market.' That's it in a nutshell. We don't think he can do that.

We're more familiar with the metals markets than we are with oil, but we assume the principles are similar.

Yes there are wagers about the 'future' course of prices, but there are wagers down to the near term or 'front month' which in many cases IS the spot price with an adjustment for time values.

The commodity exchanges provide significant delivery and inventory capability for commodities in most cases of which we are aware.

The futures exchanges are the locus of price discovery because of their predominant role in the exchange of information on supply and demand, present and future.

We are not saying that oil is subject to speculative pressures since we have not looked at it closely. But the effects of speculation, both long and short, on a number of the commodities especially the metals is absolutely unmistakable.

Lets consider a case similar to the one posited. Joseph has a few gold coins, and Quigley wishes to buy them. The transaction occurs, but does it really exist if no one 'hear it' at least in terms of price discovery? Other than a hardship sale, what do Joseph and Quigley use to determine the general market clearing price at least as a reference?

Markets are far more than individual transactions, they are the sum of the information contained in those transactions, the resonance of supply and demand. Where that information is accumulated and who manages its distribution has a great deal to do with market prices. Prices are not independent in their entirety within the mesh of a defined market. Markets of one are inconsequential by their nature, outside their defined framework, if unreported.

Markets tend to be 'efficient' but with a lag, and sometimes that lag can be considerable. There is further evidence that special sets of circumstances can come together and the lag can be extraordinary. After all, markets are primarily driven by the exchange of information and value, and the shaping of perceptions.

Information can and is manipulated to advantage. And this is how bubbles are created...

Conscience of a Liberal
Paul Krugman
June 23, 2008, 4:38 pm
Speculative nonsense, once again

OK, one more try.

First of all, I don’t have a political dog in this fight. I’m happy to believe that crazy speculation distorts markets. And I do think it’s likely that oil prices will come down, for a while, once consumers have a chance to respond more fully to high prices by changing their driving habits, switching to smaller cars, etc..

But the mysticism over how speculation is supposed to drive prices drives me crazy, professionally.

So here’s my latest attempt to talk it through. (There is something to be said for practical knowledge, for having gotten your hands dirty, for not being the man with the briefcase from over a hundred miles away - Jesse)

Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil — the actual price people pay to have a barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference. (How about if they are in the same marketplace where the price is set via supply and demand as the fellows who DO have the stuff and DO need the stuff, and where price discovery actually occurs and the market clears, even for the transactions occurring short term? - Jesse)

Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. (Absolutely positively NOT true in a number of markets that come to mind - Jesse) And that’s true no matter how many Joe Shmoes there are, that is, no matter how big the positions are. (Krugman's ignorance here of the futures market and its relation to the spot prices is almost embarrassing, or mine is. LOL. Are we speaking about different markets? - Jesse)

Any effect on the spot market has to be indirect: someone who actually has oil to sell decides to sell a futures contract to Joe Shmoe, and holds oil off the market so he can honor that contract when it comes due; this is worth doing if the futures price is sufficiently above the current price to more than make up for the storage and interest costs. (Yes, but what happens as the future date approaches near to delivery, and the contracts continue to be traded? Where IS the 'spot price' set Paul? Where is the information collected and disseminated? - Jesse)

As I’ve tried to point out, there just isn’t any evidence from the inventory data that this is happening. (There IS plenty of evidence that paper markets influence physical markets. Gee, ever hear about the London Gold Pool? How about the Hunt Brothers, or the big cotton traders? Are you an efficient pricing true believer? - Jesse)

And here’s one more fact: by and large, futures prices over the period of the big price run up have been slightly below spot prices. The figure below shows monthly data from the EIA; as the spot price shot up, the futures price (that’s contract 4, the furthest out) actually lagged a bit behind. In other words, there hasn’t been any incentive to hoard. (Again, where is the spot price set and how? You don't think the decision to sell and price is influenced at all by what one thinks they might obtain by holding the same commodity for another week or two, or a month? - Jesse)

As I’ve said, I don’t have a political dog in this fight. But the nonsense in this debate makes me want to shoot someone in the face. (Rather than narrowly focus on the oil market and proving there is not speculation, why don't you take a look at markets in general, with some history, and see how prices have been manipulated in the past, and how you might manipulate them if you'd a mind to it, and then look to see if its there, with an open mind, not the hard head of one who demands the irrefutable smoking gun. - Jesse)

Update: I see that Michael Masters, about whom I had some flattering things to say a few days ago, is now telling Congress that gasoline will go back to $2 a gallon if we crack down on speculators. He forgot to mention that cold fusion will solve all our energy problems any day now. (Nice ad hominem touch, Paul. No dog in this fight? - Jesse)