Arnold Kling  

A Question for Paul Krugman

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Mark Thoma's Question... Oil: Some Tentative Conclusio...

Early in 2007, the price of oil was $60 a barrel. Recently, it has been above $130 a barrel. Which of the following does Paul Krugman believe:

(a) market fundamentals justified $60 a barrel then, and they justify $130 a barrel now; or

(b) market fundamentals justified a much higher price in 2007?

I believe that (b) is more likely to be true, meaning that we had what Tyler Cowen calls an "anti-bubble" in oil.

We know that Krugman does not believe that today's oil price is out of line with fundamentals. Krugman's view, in effect, is that if speculators artificially boost the price of oil, then supply will exceed demand, and the excess has to go somewhere. Where are the inventories? cUPDATE: I should clarify that "where are the inventories" is the question that Krugman is asking. It is not my question.]

This view ought to hold in reverse. If speculators artificially kept the price of oil too low early in 2007, then demand should have exceeded supply and inventories should have vanished. Yet they did not. So is Krugman forced by his model to conclude that the price of oil of $60 also reflected fundamentals?

My view is that inventories are not a reliable indicator of supply-demand balance vs. speculation. Inventories, and the futures-spot differential, also reflect interest rates and "convenience yield" (or option value).

Steve Randy Waldman writes,


Krugman says that futures prices are too low to cause people to withhold physical oil and sell forward, as required to affect spot prices. But whatever forward price curve he shows me, I can posit an invisible "convenience yield" large enough to make hoarding oil worthwhile.

I may have understated it when I wrote that "convenience yield" is "something of a fudge factor." Thanks to Mark Thoma for the pointer.

In a different post, Mark writes,


while it may be possible to store grains and other commodities in non-traditional forms, if the claim is that's what's gong on now, why store grains in (what I presume are) more costly non-traditional methods when, with stocks this low, there is plenty of storage space available?

That is another good question. I think that I have to argue that non-traditional storage methods (keeping oil under sand, storing wheat as crackers) are in fact less costly (at least for large adjustments) than are changes in the quantities held in storage tanks and silos.

On oil, I'll basically repeat myself.

Just suppose that the "true" long-term price of oil is $100 a barrel. But we had $60 in early 2007 and $130+ recently.

At the "too-low" price in early 2007, demand would be higher than it ought to be, leading to depletion of oil stocks. However, I would expect the depletion to take place under-sand, since there is not enough above-ground inventory to satisfy excess demand. In order to induce producers to deplete their reserves, we need either a high interest rate, a path of futures prices with little or no increase, a low convenience yield (or option value), or some combination of the three.

Fast-forward to today, with the price over $130 a barrel. At the "too-high" price, demand is now lower than it ought to be in the long run. Producers are leaving more oil in the ground than they would otherwise. To induce them to keep production low, we need either a low interest rate, a path of futures prices with an unusually high rate of increase, a high convenience yield (or option value), or some combination of the three.

There has been a dramatic decline in interest rates over the past two years, so that we do not necessarily need to observe an increase in the futures-spot premium to say that the incentive to hoard has increased. Moreover, as Waldman points out, we can always appeal to the unobservable "convenience yield" (or perhaps tell my option-value story).

The other folks (Krugman, most notably) seem to want to say about the commodities markets, "Silos and storage tanks are not filling up. The futures prices are not high relative the spot prices. So you can't blame the rise in prices on speculation about future demand and supply."

My reply would be that there are other ways to store commodities. Oil can be stored under sand. Wheat can be stored as crackers. Also, the futures-spot price differential is affected by interest rates and changes in the fudge factor known as "convenience yield."

What I say is that you cannot possibly have prices in these markets that fail to reflect speculation about future demand and supply. I do not think it is reasonable to claim that the oil market was in long-term balance eighteen months ago and is in long-term balance today. Either speculators vastly under-priced oil back then or they are over-pricing it now, or both.



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COMMENTS (16 to date)
shayne writes:

I haven't seen this mentioned, but I suspect one should consider petroleum-in-transit as 'inventory' as well - whether via pipeline, tanker or truck. The same applies to any refined derivatives in-transit. I have no data on what percentage of pumped petroleum stock is in-transit at any given time, but I know that any in-transit inventory is subject to very rapid diversion to alternate destinations based on market conditions.

JPC writes:

A couple of points on your general argument:

1. The spot and future price of currencies [and precious metals] are connected by the interest rate and storage costs only because they can be borrowed and stored, and therefore there is an executable arbitrage. In other commodities [like oil], that borrowing market really does not exist, and there is no arbitrage. Therefore, the prices along the forward curve reflect price expectations as opposed to financing and storage costs.

2. A tiny percentage of futures contracts actually go into delivery - for the oil contracts on NYMEX and ICE that percentage is

JPC writes:

1. The spot and future price of currencies [and precious metals] are connected by the interest rate and storage costs only because they can be borrowed and stored, and therefore there is an executable arbitrage. In other commodities [like oil], that borrowing market really does not exist, and there is no arbitrage. Therefore, the prices along the forward curve reflect price expectations as opposed to financing and storage costs.

2. A tiny percentage of futures contracts actually go into delivery - for the oil contracts on NYMEX and ICE that percentage is less then 1%, a completely negligible percentage of world oil supply. Therefore these contracts more accurately resemble the side bets that Krugman described in one of his posts.

3. A producer who enters into a contract to sell oil at $130 does not recognize that profit versus his cost of production, since he exits the contract before delivery. In fact, if the price rises after he enters the contract, he will lose money that can only be recovered by actually selling physical oil in the spot market.

4. Because the demand for oil is so inelastic, doubling the price only has incremental effects on the quantity cleared in the market. Conversely, incremental changes in demand can double the price. Therefore, it's a difficult estimation problem for the market to come up with a "fair" long term price.

5. It's difficult to say if the inflow of long only money ino the market has affected outright prices much. It is fair to say that it has affected the shape of thhe front end of the price curves, causing increased contango as the indexers pay up to roll their positions forward.

JPC writes:

One more point:

As commodity prices are denominated in USD, it is really only fair to look at the nominal price increases in the context of a dramatically weaker dollar over the past few years, and an expectation given the Fed's actions that this will continue....

Arnold Kling writes:

JPC,
You seem to be saying that oil futures prices and spot prices could be completely disconnected. We could have a spot price of $140 and a futures price of $80, or vice-versa. This is false.

Spot and futures prices are not *as closely* tied as they are in currency markets, but they are still pretty closely tied.

Tim Lundeen writes:

You seem to be ignoring the possibility that other things changed in the environment, such that (a) is correct. If the Fed's loose monetary stance has caused significant inflation in commodity markets, that would explain the apparent paradox. See Guillermo Calvo's article on "Exploding commodity prices, lax monetary policy, and sovereign wealth funds" for example.

shayne writes:

Thanks aaron.

Felipe writes:

I've read in a paper interview with two strategist from an investment bank that a couple weeks ago there was an article on Wall Street Journal saying that there is a glut os spot oil. Some Gulf states are hiring tankers to basically park their surplus oil in the gulf, because they cant find buyers for it

JPC writes:

AK:

I'm saying that exactly and it is not false in the first case [spot >> forward] for difficult to store, non-substitutable commodities prone to supply disruptions. There is no theoretical limit on backwardation for example. Ths has happened in the crude market [as well as others] many times [spot >> forward]. You should look at some historial crude price curves to see this.

JPC

JPC writes:

AK:

I'm saying that exactly and it is not false in the first case [spot >> forward] for difficult to store, non-substitutable commodities prone to supply disruptions. There is no theoretical limit on backwardation for example. Ths has happened in the crude market [as well as others] many times [spot >> forward]. You should look at some historical crude price curves to see this.

JPC

JPC writes:

I think some of the confusion about the difference between commodity vs say currency forward curves comes from a misunderstanding of most of the physical limitations on expanding and contracting commodity production in anything like real time. The time scale for that in many physical commodities is years, not days or months. Therefore there can be large disconnects across time in the forward prices. This also explains the large spot price volatility in many commodities.

Essentially many of these markets are out of equilibrium a lot of the time. Economists don't like that answer but it happens to be true.

Scott Anderson writes:

A recent (May 29) Wall Street Journal article "Oil Exporters Are Unable
To Keep Up With Demand" states -
"Fresh data from the U.S. Department of Energy show the amount of petroleum products shipped by the world's top oil exporters fell 2.5% last year, despite a 57% increase in prices, a trend that appears to be holding true this year as well." Most of the decline is in Saudi Arabia. Other exporting countries exports have dropped including Mexico, Venezuela,Norway, Nigeria, Kuwait,Iran,Qatar, and UAE.

RayJay writes:

AK writes:
The other folks (Krugman, most notably) seem to want to say about the commodities markets, "Silos and storage tanks are not filling up. The futures prices are not high relative the spot prices. So you can't blame the rise in prices on speculation about future demand and supply."

My reply would be that there are other ways to store commodities. Oil can be stored under sand. Wheat can be stored as crackers.

Maybe the problem here is the definition of a speculator. A very broad definition would have everyone involved in the oil supply chain defined as a speculator since their actions in the market are based on their expectations of future prices; this will include producers who may limit or expand production based on price expectations, and consumers who may add to or withdraw from inventory also based on price expectations. AK seems to have adopted this definition.

I think a much narrower definition is more appropriate, e.g. speculators are buyers and sellers who are not primary producers or consumers. Thus, investment banks that buy and store oil in storage tanks in Amsterdam with the intent of selling it later at a higher price are speculators; a refinery that buys and stores oil for future use is not a speculator. We can also try to account for the fact that producers and consumers may sometimes act as speculators. Krugman's seems to have such a narrow definition.

Does anyone have a better definition of a speculator?

Scott Anderson writes:

RayJay,

I'll give you my understanding of speculation first by stating that integrated companies are producers, consumers, hedgers and speculators, so I think that the definition of speculation depends on the intent of the transaction.

Some transactions are speculative when the intent is to provide a profit if there is a price change (up or down depending on which side is taken). Some transactions can be hedging transactions when the intent is to reduce the effects of a change in price. The hedger may have commodity that is hedged by selling a future to lock in the price or may hold product in inventory(convenience yield) for a production process to protect against a supply disruption. A consumer may buy product for a processing.

Integrated companies have resource portfolios, risk management (hedging) portfolios and speculative portfolios. They try to optimize risk adjusted profits by taking risks (speculating) where/when appropriate and reducing risks (hedging) where/when appropriate. Production, purchases, transprotation, processing and retail all can be modeled as transactions in portfolios that can can be optimized. Think of the term crack/spread, processing is an option on the difference between the input product versus the output product. If the spread is in the money, process, otherwise buy the refined product for transport to a later stage in the process.

Producing countries are begining to build down stream processes, so may be using more of their product for processing rather than export. They may also see holding product in their interest if the price is rising fast enough and holding at higher prices long enough. Think volatility and hysterious.

I don't know whether the above is in fact what or why exports have declined but may be part of the reason.

AJ writes:

Question for JCP regarding the link between US $ and oil. JCP, based on your posts you seem to have a good idea of what's going on in the oil futures markets (at least in my humble opinion). I was hoping you could weigh in on a theory.

As you noted, oil is priced in US $. The connection between oil and the $, whether spurious or related to fundamentals, has been a strong negative correlation. Whether one believes in causality or not, this correlation has been the case empirically. I have some friends who belive the correlation is completely spurious.

On the other hand, I believe there is causality that runs from the $ to oil. Oil is priced in $ as you note, so a falling $ will lead to higher oil prices. For example, imagine a classic economics 101 diagram of supply and demand, with an equilibrium where the two curves cross and a price associated with the equilibrium denominated in Euros. Further assume the Euro appreciates versus the US $. Given that oil is priced in $, wouldn't the appreciation of the Euro effectively disrupt the equilibrium in the simple supply/demnd diagram and lower the Euro price of oil and increase oil demand in Euroland?

If so, would the same increase in demand (driven by currency) occur wherever the $ was weakening versus the local currency?

Finally, could this dymanic have something to do with the current high levels of oil prices?

Thanks!

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