19 April 2012

A Study On Speculation in the OIl Market For Those Economists Who Have Apparently Not Seen It

Here is a study from the St. Louis Fed on Speculation in the Oil Market that indicates that speculation contributed about fifteen percent to the increase in prices in the oil market during a recent price increase.

Anyone who trades these markets and follows the real economy does not require such a study to tell them what is plainly visible to their own eyes, especially when the studies always seem to come out five years after the fact, in the manner of regulatory actions against market manipulation.

The markets have become deregulated to the point where hot money from big hands can push prices around at will, especially using large positional advantage and High Frequency Trading.    And even if traders are caught blatantly rigging the markets and painting the tape bringing in hundreds of millions in profits, they will only be chastised, make a hollow promise to do better, and endure a wristslap fine that is a very modest cost of doing business.

Granted, the larger markets cannot be moved for long against the primary trend, and the trend in oil has been higher for any number of long term fundamental reasons.    But traders feed on volatility, both up and down. And they introduce faux inefficiencies to take profits for themselves, adding no value, as a tax on the real economy.

And of course no financial engineer wants to discuss the effects of money printing on the price of real goods and services.

In the smaller commodity markets the scams can go on for longer periods of time creating more substantial damage to fundamentals of the related industry. I would love to show you the CFTC report on the effect of absurdly large positions in the silver market, but it has been sitting on that report for four years.

We have to ask ourselves, what are markets for? Are they fulfilling that function honestly and efficiently? What is the benefit of speculation and what are its limits?

Even Bernanke has seen the effects of speculation in the markets, and this from a man who ordinarily could not find a bubble with both hands as he expels it.

It is harder to get an answer to this now, because like some periods in history prior to this, the markets and the public are awash in hot money looking for an easy path to enormous returns as quickly as is possible. And that money flows through the avenues of Washington and Wall Street, and the media, and the universities and think tanks, distorting perception and public policy discussions.

And that is the danger of speculative excess, against which we have been warned time and time again.

Now the Fed will likely point to ETFs and blame investors who flocked to commodities to protect themselves from money printing. But that is only part of the story.

If you want to know who is benefiting from this, follow the profits. Look at the big trading desks who are gaming the system, and not at the small fry trying to find some investment haven in the storm of paper games.   And the reason they are so desperate is because of the reckless and irresponsible actions of the government in allowing the overturn of Glass-Steagall and the unbelievable growth in the unregulated derivatives market which even now poses a clear and present danger to the financial system.

And if you want to know who is to blame for that, skip the study, and go ask Brooksley Born.

"The increase in [oil] prices has not been driven by supply and demand." — Lord Browne, Group Chief Executive of British Petroleum (2006)

"The sharp increases and extreme volatility of oil prices have led observers to suggest that some part of the rise in prices re‡ects a speculative component arising from the activities of traders in the oil markets. " — Ben S. Bernanke (2004)

The run-up in oil prices since 2004 coincided with growing investment in commodity markets and increased price comovement among different commodities. We assess whether speculation in the oil market played a key role in driving this salient empirical pattern.

We identify oil shocks from a large dataset using a factor-augmented autoregressive (FAVAR) model. This method is motivated by the fact that the small scale VARs are not infomationally sufficient to identify the

The main results are as follows:

i) While global demand shocks account for the largest share of oil price ‡uctuations, speculative shocks are the second most important driver.

(ii) The comovement between oil prices and the prices of other commodities is explained by global demand and speculative shocks.

(iii) The increase in oil prices over the last decade is mainly driven by the strength of global demand. However, speculation played a significant role in the oil price increase between 2004 and 2008 and its subsequent collapse.

Our results support the view that the financialization process of commodity markets explains part of the recent increase in oil prices.

Speculation in the Oil Market - St. Louis Federal Reserve, January 2012

And I have to offer a bit of an apology to Paul Krugman. As you may recall, I have taken issue with his absurdly incorrect description of the relationship between spot prices, inventories and the futures markets in the past when he stated emphatically that he saw no speculation in the oil markets.

Apparently he did see speculation and admitted it later on. He just didn't think it was a problem.

Oil speculation
By Paul Krugman
July 8, 2009

Oil speculation is back in the news. Last year I was skeptical about claims that speculation was central to the price rise, because what I considered the essential signature of a speculative price rise — physical withholding of oil from the market, in the form of high inventories — just wasn’t showing.

This time, however, oil inventories are bulging, with huge amounts held in offshore tankers as well as in conventional storage. So this time there’s no question: speculation has been driving prices up.

Now, “speculation” isn’t a synonym for “bad”. If the underlying assumptions that seem to have been driving oil markets were right — namely, that a vigorous recovery is just around the corner, and demand will shoot up soon — then it would be perfectly reasonable to accumulate oil inventories right now. But those assumptions are looking less reasonable by the day.

Anyway, the moral of this post is that the oil story this time looks very different: this time, the signature of large-scale speculation is clearly visible.

Paul Krugman saw no issue with it because he wanted to see a recovery in the economy at that time, to prove in the benefits of the financial engineering being done by the Treasury and the Fed. Alas, it was a phantom.

Hey Paul given this admission, that 'withholding' is a signature of speculation to the upside, would you consider creating 'phantom inventory' and 100:1 leverage of existing inventory to be evidence of speculation and manipulation to the downside?  And brazenly bombing quiet markets with enormous sell orders that crush price lower without even the appearance of legitimate price seeking?

If so, you may wish to talk with Bart Chilton about the silver market. That is, if you were interested in reform and not just proving some economic theory about stimulus.

Few care about genuine reform of the financial system and the markets, caught as we are in a credibility trap. But that is the only path to sustainable recovery. And therein lies a tragedy.