Arnold Kling  

Oil Speculation: Paul Krugman Mis-speaks

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Paul Krugman writes,


Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price.

He can't mean that.

Think of the foreign currency market. If speculators bid up the future price of Japanese yen, then the spot price of Japanese yen will go up. And you won't see any particular pattern of inventories among currency dealers. The inventory issue is much closer to a red herring than to the decisive empirical data that Krugman maintains it to be.

Krugman and I should both listen to the podcast with Tyler Cowen, linked in this post. Cowen's point is that when you disagree with someone, you tend to assign a probability that you are wrong that is too low.

Although Krugman and I differ on political issues, I cannot think of anything political in this argument. It seems purely technical.

My views on the oil market are almost the exact opposite of Krugman's. I believe that the futures price has to be the key determinant of the spot price. Because oil is a non-renewable resource, the oil market has to reflect expectations for demand and supply over the entire future time horizon, and those expectations ought to be embedded in futures prices.

Another way to think about futures markets is that they substitute for a central planner in the oil industry. If we had a central planner, he would have to decide how intensively to search for new oil reserves and how quickly to extract the oil from known reserves. Absent a central planner, the futures market sends those signals.

Go through the following thought-experiment. Suppose that the U.S. government were to stop filling its Strategic Petroleum Reserve (SPR) and perhaps even sell some of its existing reserve. However, suppose also that the U.S. government were to buy an equal amount of oil in the futures market.

If Krugman is right, and all that matters is that spot supply of oil, then this should lower the current price of oil. If I am right, then the effect on oil prices would be approximately zero.

I did not say which futures contract that the government speculates in. Suppose that there is a futures contract dated one week from now. Surely, if the government sells oil today and commits to buying an equal amount one week from now, there is essentially no effect on price. But Krugman's logic seems to force him to say that the spot price of oil will plummet when the oil from the SPR hits the market.

So this is an instance where I think that the probability that I am wrong is low.

I agree with Krugman that blaming oil speculators for the high price of oil is unhelpful. The politicians make it sound as though there has been a sudden outbreak of greed among oil speculators. Instead, there has been a change of expectations about future supply and demand. From what I can tell, there was no real news to cause this change in expectations. Either speculators were badly wrong six months ago or they are badly wrong today. It is more likely that they were wrong six months ago, but the probability that they were closer to correct then is far from zero.


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COMMENTS (13 to date)
Nick Rowe writes:

An increase in the futures price of oil affects the current spot price only because it increases the incentive to store oil instead of consuming it today.

If we observe an increase in the spot price, and in the futures price, but see no increase in storage (either in tanks or in the ground), then an increased demand for futures contracts cannot have been the cause of the increase in the spot price. That was the point made by Krugman (and others).

If the government were to sell oil from its strategic reserve, and buy an equal amount on the futures market, the immediate effect would be a fall in the spot price and a rise in the futures price. But this would give speculators the incentive to buy oil on the spot market, store it, and sell it in the futures market. With costless storage, the spot and futures prices would immediately revert to their initial equilibria, as would the total amount of oil in storage. But if storage were infinitely costly for the speculators, there would be no reversion of prices.

Marc Shivers writes:

I think your SPR example doesn't really capture what's going on with passive investors. If the SPR sells in the spot market and buys in the futures market, the presumption would be that they'll take delivery of the futures barrels. That's economically equivalent to the SPR paying someone to park their inventory for a while. No one should expect that to change spot prices. However, if they sold spot, bought futures, and committed not to take delivery of those futures (which I think is the right thought experiment), I think you'd be hard pressed to conclude that the spot price wouldn't fall...

ZH writes:

Krugman is looking at it from a trade economists standpoint. However, from a financial markets standpoint, it is a little different. In an efficient commodity futures market, which oil pretty much is, the difference between the spot and futures price should only be the costs of carry, which include two factors, time value of money (interest rates) and storage costs (warehousing, insurance, deterioration, etc). If expectations about what the price will be in the future lead the futures price to change, usually because of future supply-demand expectations, then by arbitrage the spot price will change to the futures price minus costs of carry. So it is possible for speculators to drive up prices as well as drive down prices depending on their expectations and the number of speculators. I work at a large multi-national commodities supplier and see this every day, although this is much easier to see this in the case of agricultural commodities, especially when bad weather destroys crops, drastically reducing expected future supply (literally overnight) and you see this happen almost immediately.

This still doesn't mean that we should blame speculators as they do often drive down prices if their expectations are such, and they provide much if not most of the liquidity in the futures markets.

j writes:

Presuming speculators are in for the money, they buy oil futures with the idea that prices will be higher than their contracts. Others sell futures because they think prices will be lower. This is a market of expectations, and if futures are high it is because the market decided that supply will be tight. High future prices may motivate actual producers of the liquid to reduce current supply and market it in the future. Viceversa, if the futures market decides that prices will fall, current production will increase and spot prices will fall. Market expectations of future events does impact current prices and re-inforces the trend. Markets behave like that, as documented many times from the Dutch tulip bulb craze. If history is relevant, then oil prices should keep inflating and then collapse by itself. Shooting speculators will only cause shortages.

Since inventories are normal, apparently there is no speculation going on with actual liquid. Are some consumers over-consuming now instead of the future? Are producers doing their best to supply the market or they are under-producing in the expectation that prices will improve in the future? Is it feasible to advance or to postpone consumption? Are producers (say the Saudis) producing less than they can? If they are not, then shooting speculators will not help to reduce oil price. But shooting speculators and burning witches are surefire and tried remedies to calm public anger. I may be wrong, but some people should lower profile and become invisible.

j writes:

Could it be that the American government is hoarding oil? It could sell some strategic reserve and stabilize the market. Could it be that the Chinese (too) are hoarding oil instead of buying American debt? In their place, I would do exactly that.

Matt writes:

If new information arrives that determine oil will be more expensive in the future, then the current and future price goes up. The time delay in adjusting current flow would cause inventory build up in the system.

Krugman cannot find the temporary inventory build up.

It is a matter of semantics. The definition of speculation that Krugman uses is defined by a rate of change in future prices larger than the rate of change in current flow.

When future prices and current flow equilibriate, then it is no longer speculation, it is real.

j writes:

Matt,

Beautiful.

If I am not wrong, the two lines (spot and futures) ran almost in parallel. So it must be real.

Dan Weber writes:

Could it be that the American government is hoarding oil?

I thought it was well-suspected that China is building up a supply in anticipation of the Olympics. They might not admit to it, but they don't want to be embarrassed by having any tourists be unable to buy gas.

Charlie writes:

"Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. And that’s true no matter how many Joe Shmoes there are, that is, no matter how big the positions are.

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."

The whole quote in context is a bit different than you represent it. I'm not sure the two of you even disagree.

Dick King writes:

Dan, would the amount of oil or gasoline China would stockpile to ensure that maybe a few million tourists visiting China for a month won't run out of gas any more than a drop in the bucket compared to China's routine consumption of substantially more than a billion people?

-dk

Dan Weber writes:
Dan, would the amount of oil or gasoline China would stockpile to ensure that maybe a few million tourists visiting China for a month won't run out of gas any more than a drop in the bucket compared to China's routine consumption of substantially more than a billion people?
Given that China's uses fuel at a per-capita rate less than 1/10th the US, and the Olympics will last for a month, and that demand is very tight -- yes, the fuel used for the Olympics is probably more than "a drop in the bucket."
Ferdinand E. Banks writes:

In commenting on this topic, I would like to put on my LEADING ACADEMIC ENERGY ECONOMIST IN THE WORLD hat.

Krugman is almost completely right. Opening a position in the futures market is a bet (unless the issue is hedging price risk). Of course, futures bets might change expectations and thus e.g. influence inventory increases or decreases, but that is small beer compared to the present movements in the supply and demand of physical oil.

Professor Ferdinand E. Banks

Ferdinand E. Banks writes:

Well, as the leading academic energy economist in the world, allow me to say that your point of view about speculation versus fundamentals (where the oil price is concerned) is very wrong. Sorry, as much as I hate to say it, Paul Krugman is right. You can find the elementary argument by going into Google and checking ou "321 Energy".
My short paper is called "Myth and meaning...."

At one time it pained me to note how little financial economics even economics graduates know, but it doesn't pain me at all any more. What gets me now is how little their teachers know.

Ferdinand E. Banks

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