Arnold Kling  

My Question for James Hamilton

My Model of the Oil Market: O... Reasonable Economics...

The go-to guy on energy markets writes,

A key reason why oil prices have been going up is that Asia and the oil producing countries are consuming more while global oil production has stagnated. That means Europe and America had to consume less, and a very high price proved necessary to accomplish that.

My question is: what were speculators thinking a year ago, when oil prices, including prices for futures contracts expiring in 2008, were substantially lower than spot prices are today?

In my model, speculators understand that the flow production of oil is limited, that demand in Asia is increasing, that something has to give, and that mostly what has to give is demand in the U.S. So, starting last year, they bid the futures price of oil way up. Maybe, if my oil-expert commentators are correct, the futures price would have shot up relative to spot prices without causing producers to reduce production very much. And maybe this would have led to inventory increases.

But that process never got started. Instead, oil speculators acted as if high Asian demand and stagnant production was a huge surprise that only hit them this year. Oil speculators last year got it badly wrong. If you were "long" oil futures last year, you made a killing.

If you believe Hamilton's view of fundamentals, and you believe my view that it's the job of speculators to anticipate fundamentals, then what you should blame speculators for is keeping prices too low in 2006 and 2007 (in fact, in all previous years).

That is, in fact, the most plausible story. But it could be that today's speculators have it wrong, and that today's futures price for June of 2009 over-estimates the realized spot price that we will observe then. And if speculators do have it wrong, I do not know where to look for evidence of that.

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COMMENTS (11 to date)
jb writes:

I remember you telling people who were sure we were all going to die in a peak-oil catastrophe that they should buy oil futures. You pointed out that speculators should have the best information about the future of oil, and their prices are probably generally accurate.

I thought about going long on oil futures, and then demurred, since, as you pointed out, I didn't know as much about oil flows as the speculators do.

This is not a criticism of you - btw. What this is telling me is that futures markets are not nearly as well-managed as I thought. Apparently an entire class of investors can be massively incompetent.

The good news, for all of us, is that $4 gas is causing all those changes in behavior that Peak-Oil Catastrophists were convinced would never happen (and we'd eat each other's children instead).

Right now the score is:
+1 for the free market vs Peak Oil
-1 for the futures market vs Peak Oil

Brandon Thomson writes:

Keep in mind that while futures markets represent quite possibly the best information available, there's nothing to say that they won't be dramatically wrong from time to time.

A serious discrepancy like this one does not necessarily imply that the investors are incompetent, although that is one possibility. In my opinion it more likely reflects the difficulty of predicting future oil prices even for those who have studied all the relevant information.

Peter Twieg writes:

I find it unlikely that the price shocks reflect the market adjusting to new information, because I don't think there's really been any news in recent years that would could plausibly change investors' expectations about future oil supply/demand to such an extent as to cause these fluctuations. Right?

spencer writes:

I look at the past 25 year record comparing oil futures and spot oil prices. What it shows is when spot prices are rising futures prices say they will continue to rise. When spot prices are falling they say spot prices will continue to fall. Futures prices have completely failed to forecast a single peak or trough in spot oil prices. At every major peak or trough in spot prices the futures prices were wrong.

Although futures prices may be influenced by what traders expect the price of oil to be, they are not a forecast of oil prices. The spread between spot and futures prices is the price of hedging risk. It is the price where those trying to avoid the risk of higher prices and those willing to take that risk for a price agree to exchange that risk. The spread between spot and future prices is the price at which that risk is traded. It is not a price forecast.

The futures market contains no information that is not contained in the spot price.

8 writes:

Perhaps it is the process of price discovery? The jump in prices a few weeks ago was the largest single day move in recorded history. Markets have memory and I don't see how the price would rapidly move in one direction or another without a massive event (oil shock, war, huge discovery) or a sea-change in opinion. Changes in opinion take time in the absence of events. My theory is that speculators were nibbling at higher prices. They pushed them higher and higher, but they knew more than anyone that higher prices bring higher supply. They were searching for the tipping point that brought new supply online (or reduced demand). When the point was never reached, they grew bolder and pushed harder. Now they are in open defiance of the oil producers.

They knew about Asian demand all along, but the numbers didn't line up. As long as there is spare capacity, there's no reason to pay more today, and the oil producers might deliver more oil. Once the imbalance manifested, however, and the oil producers still weren't meeting the demand, there was less risk in taking a bold position.

Yes, they held prices too low in 2006 and 2007, but that is because they were being rational. I distinctly remember hearing economists and analysts predict that $80 would cause demand to fall. No, $90 oil. No, $100 oil. $120 has to cut demand! But the price was actually about $140, and the speculators found it.

Lord writes:

I don't think speculators anticipated the economy would still be growing, the reduction in Nigerian oil, or the possibility of an Iranian attack. They knew these were possible, but underestimated them. But one never blames people for fulfilling your wishes.

I would look at oil production and shipments to see if these were fluctuating with price or were more or less stable regardless of price. I believe the latter is the case.

James A. Donald writes:

You keep asking

what were speculators thinking a year ago, when oil prices, including prices for futures contracts expiring in 2008, were substantially lower than spot prices are today?

And I keep answering: They were thinking congress was not going to forbid shale oil, and that various third world countries were going to be able to maintain adequate security over their oil fields. Most recent major escalations in oil prices and oil futures were a direct response to some horrifying news item about war or politics. Obviously speculators were not expecting these news items, hence the rise on the news.

daddysteve writes:

I don't think you can look at the price of oil separately from the rest of the economy. That is, the rising prices of ALL commodities. Poor central bank policies and the danger of derivatives and alt-A portfolio meltdown seems to have a lot of money fleeing the financials worldwide. IMHO

anon writes:

This argument seems incomplete to me. Imagine speculators who have the views on fundamentals attributed to them in the post. But suppose further that they are uncertain about the amount of reserves/inventories, etc., or, in general, price deflationary measures available to all the main actors in this game.

Then, as the price of oil continues to rise, they observe what these actors are willing to do and what they are capable of doing. This is at least some information about the amount of reserves, etc. Presumably, this additional information can be quite critical to estimating the fair value of oil from the point of view of the speculators.

aaron writes:

When did we attack Iran?

Unless stocks can be/are increased, uncertainty should lower prices, not raise them.

aaron writes:

Hmmm... Could removing the uncertainty caused by the Saddam regime have lead to an increase in oil prices?

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