Arnold Kling  

Oil: Where Krugman and I Disagree

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Financial Flows and Regulation... Bubbles vs. Non-Bubbles...

As expected, Paul Krugman clarifies his thinking.


there are only two things you can do with the world's oil production: consume it, or store it.

If the price is above the level at which the demand from end-users is equal to production, there's an excess supply -- and that supply has to be going into inventories. End of story.

First, let me reiterate that I do not believe that the oil price today reflects a bubble. So in that respect, Krugman and I are not on opposite sides. Nonetheless, I do think that his model of the oil market has some strange properties.

Krugman ignores two elements of the oil market. Explictly, he ignores forward prices. Implicitly, he ignores the decision by producers either to pump oil or keep it in the ground. As Tyler Cowen put it,


Isn't it easy enough to argue that the relevant hoarding is of oil in the ground rather than oil in strategic reserves or panic stockpiles?

Tyler goes on to cite a number of reasons why oil suppliers might not be rational. I can come up with others, such as suppliers doing a naive comparison of cost of production compared with the current price of oil to determine production levels, rather than taking into account the opportunity cost of leaving more oil in the ground and selling it next year. If producers ignore opportunity cost in that sense, then the market really does not depend on future conditions, and forward prices may be irrelevant. But, again, in that case the market is not rational.

Perhaps Krugman believes that oil producers are irrational in some specific way. If so, then I do not think that his simple exposition is sufficient to articulate his model.

If Krugman believes that producers are rational, then the question I have for his model is this: what does it predict would happen if everyone's estimate for oil demand in the year 2010 were to jump suddenly?

In my model, the estimate of high oil demand in 2010 would lead to a rise in futures prices. At existing spot prices, this would make it rational for producers to leave oil in the ground, rather than sell it today. This in turn would cause the spot price today to rise. Then, at today's (slightly) lower production level and (much) higher spot price, the market would operate as Krugman postulates--oil would be either consumed or stored in inventory.

This model does not rule out the possibility that the futures market reflects a speculative bubble. It could be that estimates of future demand for oil are exaggerated. As it happens, I do not believe that estimates of future market conditions are erroneous. However, one cannot rule it out simply because we do not observe bulging inventories at oil refineries.

If there is a bubble, then at some point market expectations for future oil demand will decrease. That would cause futures prices to fall. This would lead producers to want to pump more oil now, before prices drop. That in turn would cause the spot price to fall. In a bubble scenario, the price drop would be dramatic. Once again, let me say that my guess is that this will not happen. I would assume that the market has it about right.


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COMMENTS (23 to date)

It's a real shame that a mind like Krugman's has become so ideologically-driven as to no longer be able to think clearly about much of anything anymore. Other than my own readings of people like Mises, Hayek, Friedman, Walter Williams, et al, the extent of my economics education was to take an Econ 100 class -- and still I can see the economic holes in this Nobel Prize winner in Economics' arguments.

rjp writes:

I wonder if there is enough "panic stockpile" of gas in the tanks of people's cars? That is, if everyone fills up sooner than usual, there might be millions (billions?) of gallons of gas in people's tanks that are not usually there.

I have no idea if this would be enough to create a significant increase in price and cause inventory problems for the industry.

Arnold Kling writes:

rjp,
In the 1970's, with price controls and rationing, the phenomenon of "rolling reservoirs" was noteworthy. I don't think so today.

aaron writes:

I just added this to the previous Oil Bubble thread:

Beyond storing oil, what about storing fuel?

Kevin Drum recently posted that driving and fuel production are down with gas prices being up.

I responded that driving is down several time more and fuel production (and noted that economic growth is down along with production and driving).

His reply was not satisfactory to me. He claimed that fuel consumption may be less than production (inventories increasing) and that people may be cutting long efficient trips more than others. While both of these are plausible, they are far from adequate. First, I found it hard to believe that several percent of fuel production is going into reserves. Second, I find it even harder to believe that most of the driving we cut is long, efficient trips and that the difference in efficiency between these and normal driving is great enough to make such a big difference.

[Even if consumption were down 3% (production is down .7% according to Kevin), that would mean that all the trips we cut would have to be 60% more efficient than our compulsory driving to achieve the 5% decline in driving that Kevin notes.]

Is it possible people are hording large quantities of fuel, not oil?

eccdogg writes:

"In my model, the estimate of high oil demand in 2010 would lead to a rise in futures prices. At existing spot prices, this would make it rational for producers to leave oil in the ground, rather than sell it today. This in turn would cause the spot price today to rise. Then, at today's (slightly) lower production level and (much) higher spot price, the market would operate as Krugman postulates--oil would be either consumed or stored in inventory"

But this is not what is happening. You are describing a contango foward curve, but today the crude oil curve is backwardated.

Crude for Jun delivery is at 125, Jun 2009 is at 121, and Jun 2010 is at 116.

http://quotes.ino.com/exchanges/?r=NYMEX_CL

Besides I think what Krugman is arguing is that financial market speculators (or oil traders) are not causing high oil prices not that national oil companies are refusing to drill because of expections of higher prices. The only way that speculators could push up the spot would be by buying spot and storing it.

Lord writes:

I hesitate to call production decisions speculative. They are foremost business decisions. Larger producers (one who don't need cash) are likely rational. Smaller producers are confronted with other considerations such as how much of current production they should devote to future production.

You assume producers produce to maintain a specific spot/future price spread. Is there evidence of this? If they don't, refiners doing the same could lead to inventories.

With record number of people running out of gas on the freeway, no it is not going into gas tanks.

Andy writes:

If the problem is that people are speculating by storing oil in the ground, then at least you can't blame hedge funds, right? The speculators are Exxon and Aramco, not Wall Street types. That may be true -- Exxon is already doing plenty of speculating about the price of oil when it makes its R&D decisions -- but I think the conventional view that Krugman is railing against is that it is Wall St. sharpies who are speculating, just like they did with tech stocks and RMBS -- and those guys can't speculate without physically storing oil since they don't own any oil fields themselves. Right?

Fpferguson writes:

As a PhD Economist from UW Madison, I've had over 30 years esperience teaching and studying this subject (still teach). My conclusion, after all these years, is that economics is bullshit. It's an Enlightenment model, an equilibrium system, which resonated with the intellectuals of the time. By now, it's a system that doesn't work. Check this out:
http://www.debunking-economics.com/

All this BS about the "rational man" is about 200 years out of date.

Oil prices are where they are because big oil put them there. That's why exxon earns 10-15 billion dollars a quarter in profits.

OIl prices are where they are because 2.5 billion people from China and India suddenly entered the world economy in a real way. Everybody's bidding on the oil, and bidding drives up prices. I agree with you about rational "economic man," since there are other factors, ranging from emotions to loyalties, which also affect choices -- but oil companies are making a killing because a whole lot more people want their product than just a few years ago. It's no mystery to me why oil prices have gone up in the past few years.

Snark writes:

fpferguson,

As a PhD Economist from UW Madison, I've had over 30 years esperience teaching and studying this subject (still teach). My conclusion, after all these years, is that economics is bullshit

For God's sake man, if you feel that way about it then quit, because (if you're sincere) you're doing a disservice not only to yourself and your institution, but more importantly to the students you pretend to teach. If you've lost your faith in economics, find it somewhere else.

If, OTOH, you're simply trolling for fish to fry, one just got off the hook.

j writes:

Third World Governments (and politicians) exist in constant desperate need of money and are unable to speculate on the oil market. In my opinion, storing oil in the soil is a legend. They are pumping it all out as fast as they can.

macquechoux writes:

rjp I was a lubricants & fuel jobber (Wholesaler) during the Arab oil embargo. I sold fuel to farmers, businesses, agricultural processing plants and the like. Most of my customers depended on me to keep them in fuel, they didn't call when their storage tank was empty...I never let it get empty. A small minority called when their tanks were empty and expected prompt service to fill it. This was the way it had worked for a goodly number of years. When the embargo hit this all went to Hell quickly. First all my customers filled their vehicles no matter how much was already in their tanks. All the route customers called and wanted a fill up immediately. Many went out and bought additional storage tanks which immediately caused a shortage and a great run up in price. The call when empty people immediately called and wanted a fill up. Many had large tanks, say 4000 gals, but never ordered more than 2000 at a time; they called and wanted to fill up the whole tank and please keep it filled. Everybody drove around with a full tank and did their best to keep it filled. Some businesses made their fleet operators fill up daily.I ran out of regular gasoline the first day. It took another day or two to run out of diesel and the other fuels I had stored. This pretty much happened to all the other jobbers around me and of course we all called our suppliers for more fuel and then there was a twofold problem. There wasn't enough transport trucks to get fuel to all of us that didn't own their own transport truck and if the refiners and refiners large depots filled all the orders than their stocks would have been dangerously low and in some cases depleated. If everybody decides to drive around with a full tank it can cause problems.

fundamentalist writes:

An important point not considered is the shortage of skilled labor needed for drilling. Oil companies laid off huge numbers of skilled drillers and geologists during the 90's, when the price of oil was extremely low. Living in an oil producing state, OK, I am familiar with the volatility of employment in the oil industry. I used to work with a PhD petro geologist who got tired of the regular lay-offs and went to work for a small software company for lower pay. In Oklahoma, it was common knowledge that when oil prices climbed a few years ago oil companies couldn't find geologists and experienced drillers to operate the rigs, which were in short supply, too. Rigs had accumulated a lot of rust in the 90's. Oklahoma based companies have tried to solve the shortage by establishing a vo-tech type school in Oklahoma City to train people for working on drilling rigs, but it hasn't helped much. Few people are interested in the work. Traditionally, oil field workers go into construction and trucking when laid off from oil field work. Until recently, the pay and demand in those industries have been too good to lure workers back into the oil fields, which is dirty, hard work in remote areas and workers spend a lot of time away from family.

In short, Krugman may be looking in the wrong place, again, for an explanation of oil prices. It will take a while for oil companies to hire and train the crews needed to drill for oil and expand production.

Marcus writes:

No doubt the increasing demand in China and India is putting an upward pressure on price. Yet, that does not explain what we are seeing. China and India did not suddenly start consuming oil in August of 2007 and that is when oil prices went vertical.

Here are two charts:

1-month T-bill yield
Crude oil prices

The first one is of 1-month T-bill yields. Notice the spike downward in August. That is the credit markets breaking, when 'liquidity' dried up. That spike marks the start of the 'credit crises'.

Where did all that 'liquidity' go? It had to go somewhere. People weren't pulling their money out of the credit markets and stuffing it under their mattresses. Where did they put it?

The second chart answers that question. Oil prices went vertical at precisely the moment the credit markets broke. That is not a coincidence.

Mind you, oil is not the only commodity affected. Gold, corn, wheat, soybeans and sugar have all been affect similarly and starting at the same time.

So, I ask, how is that not a bubble?

Again, that is not in contradiction with the fact that there is a long trend of upward pressure from demand. But I think it clearly shows that there is a bubble involved also.

Mick Rolland writes:

We are talking about a crucial question here. Some commentators like Krugman, Martin Wolf or the Fed discard the notion that there is any 'speculative' element in commodities prices right now just because there is no sign of hoarding -on the contrary, stocks are tight.

I've done some work studying futures markets and had direct contact with commodities traders in futures and forward markets -particularly oil traders from a refining company. One important feature of their 'long' and 'short' positions is that they used their futures positions (which have the advantage of being very liquid) only to hedge their 'exposures' (estimated real crude needs). They preferred never to let their contracts go to maturity in order to avoid accumulating or handling stocks (something which is enormously expensive and difficult to manage). Usually if a futures trader wants to keep a long position, he unwinds it before maturity and then rebuilds his position with maturity at a further point of time.

This way of trading has an important implication: Speculators can keep substantial long positions in futures commodities markets without hoarding. Stocks can be perfectly unrelated to the amount of speculative positions.

But that may not be sufficient to explain the connection with spot prices. The channel is essentially through expectations. The futures market is the main source of information, and spot markets follow quite closely the main trends of the futures markets. Rises in futures prices motivate both buyers and sellers in spot markets to accept higher prices.

This supports Arnold's position that a speculative bubble cannot be ruled out and expectations play a key role, although there are strong fundamental (that is, nonfinancial) factors that are surely very important.

eccdogg writes:

Do we all agree that for any month in the spot market

1) That in the spotSupply=Consumption + Change in Stocks
2) That ths spot price is the price that makes this true.
3) That you have the option to take physical deliver from a forward contract at expriry (or sell it to someone who wants to)
4) That for every buyer of a futures contract there is a corresponding seller.

Given these facts I don't see a way that Wall St. speculators can be pushihg up the price of oil in the spot market without storing oil.

They could be pushing up the futures market, but ultimately they either have to buy back their position or take them physical. The fundamentals rule in the cash market.

Mick Rolland writes:

To eccdogg:

You precisely set out the reasons why there is no need to hold stocks for "Wall St speculators": If they don't want to hold stocks (which is what you expect of a financial trader) but want to keep a long position, they "buy back" (i.e. cancel, unwind, reverse) their position when it approaches maturity (if the liquidity in the market allows it -it normally does in deep markets) and then form the position again (they "roll it").

Sellers of the standardized futures contract will do the reverse (as your point 4) reminds).

You have to keep in mind that in major futures markets, very few people ever take their contracts to maturity -which would force them to physical delivery and expensive and burdensome stock management. The use of futures markets is mainly financial -the real exposures are set in (less liquid) OTC forward markets or bilaterally with established suppliers and clients with locations more adapted to each company's network than standard futures locations.

As for your points 1) and 2), supply and demand are not fixed mathematical equations or curves as undergrad textbooks seem to suggest. Expectations on tons of variables (inflation, future conditions, etc) and liquidity are also major price drivers. Prices are, in most cases, "discovered".

eccdogg writes:

Marc I understand that, actually I work on an energy trading floor. (not Crude, but Heating Oil, Natural Gas, and Power mainly)

Lets look at a speculator who buys the prompt month contract one month before expiry. He can push up the forward price by buying, but ultmiately he has to buy back that contract or take delivery.

If he bids the price up initially by buying the contract he must bid it down when he sells it unless their is a buyer who is willing to buy it at a higher price.

Why would someone buy it at expiry? They could buy it to close out their short position or to take it to physical. You have to remember that there is a physical arbitrage at expiry. If the futures is above spot physical players can buy the future and deliver. So at expiry the spot=futures.

And yes the spot market really is governed by that simple of an equation.

There are a certain amount of barrels delivered each day by producers to different locations, there are a certain amount consumed by refiners etc. if the amount produced is more than the amount consumed stock must increase (uless the producers just let the oil run out onto the ground).

Clearly the speculators do not have to hold stocks to affect the futures price, but they absolutely have to hold stocks to affect the spot price and the spot price is high currently.

eccdogg writes:

"If the futures is above spot physical players can buy the future and deliver. So at expiry the spot=futures."

Should have been sell a future and buy spot

Mick Rolland writes:

Your points are good, eccdogg -you know your business. The existance of arbitrage between futures at delivery and the spot price is indeed essential. That also determines the progressive convergence of futures and spot prices as maturity approaches.

You recognize and know well that speculators do not have to hold stocks to affect the futures price (we agree), but you disagree that what we could call an "autonomous speculation" could be transmitted to the spot price. I defend that this can happen. Why?

Your equation "Supply=Consumption + Change in Stocks" and the consideration "the spot price is the price that makes this true" is of course correct but does not address any of the factors that drive the willingness to both supply and consume in relation to price.

In the spot market, it is just as possible that, say, Supply=10, Consumption=9, Stocks=1 and Price=15; as having the same quantities (Supply=10, Consumption=9, Stocks=1) and Price=20. Why is it possible? Many factors, but I would highlight the one most pertinent to the debate: expectations -or what we call in micro "subjective valuations". These expectations or subjective valuations can be substantially affected (and usually are) by the behaviour of speculators -mainly active in the futures market-, that are considered purveyors of information (and liquidity) to these markets.

Thus the spot market can react very fast to developments in the futures market, depending on spot traders' valuation of what's happening in each market -whether they consider developments structural or conjunctural, for instance. In this way, 'autonomous' rises in futures prices can raise spot prices without any stocks involved.

The necessary element for this to happen is that the spot traders consider futures market developments as indicative of real conditions. It can happen that autonomous developments in the futures markets send distorted signals to the spot market, and these signals be interpreted as valid, since they usually are valid. Hence the possibility of "bubbles" and some part of the volatility of prices due to the interplay of bets and speculations regarding future demand and supply, inflation, or the dollar -as well as the relative availability of 'liquidity' (money and credit).

eccdogg writes:

Good post Marc,

I understand where you are coming from and do believe that the mechanism you describe may be able to bleed financial speculation into the spot market. Especially since some markets (Heating OIL)treat the prompt as if it were the spot.

However, I would still contend that the spot phenomenon is one of fundamental supply and demand. In your case either the forward price intices suppliers to supply less (because the forward price is high) or demanders to demand more because the (forward price is high). I can see how this would be the case in a contango market, but what about one that is backwardated like today? In that case the forward is under the prompt/spot. So the market is giving the signal that prices will be LOWER in the future not higher so there is no icentive to not produce today to bet on higher prices. If you want to bet on higher prices there is a much more economical way. Sell all you can today and buy the futures contract.

eccdogg writes:

Sorry meant to say Mick

Hélcio writes:

With an increase seeking of new alternative of energy source from now to almost ten years oil price will dumb charply. Oil Co's are saving to divesificate our sources , its a real thing.

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