Monday, September 19, 2011

A real (oil) shock!

The oil price spike of 2008 was definitely driven by more than the "fundamentals of supply and demand". Speculation by such notables as Koch Supply & Trading LLP and Boone Pickens appear to have had a lot to do with the 2008 spike. Read this article by Lee Fang of Thinkprogress.

An excerpt: "Professor Michael Greenberger: When you look at it carefully, the speculative money has all been heavily weighted in the favor of buying in the direction of the price going up. […] They go in and buy long in the regular futures market, which sends a long signal to the market, that there’s a supply problem that really doesn’t exist. To keep their long bets in place, they have to do something called the “Goldman Roll,” which is these contracts don’t go on forever. They expire. So what they have to do is sell short to get out of the contract when the expiration takes place, then roll around and buy long again to keep the long bet on the books. So the long bets are predicated on intermediate short bets, that are canceled out within three or four days of each other".


Anonymous said...

So does this mean that prices reflect true supply and demand when Goldman and others short their position just before they expire?

wh10 said...

I think you still need to prove that there has been physical hoarding of commodities. How else do you explain the price change?

Tom Hickey said...

Anonymous, by definition market price is set by supply and demand. However, it is possible to manipulate this. There are rules against manipulation. But if one can skirt the rules, it's OK. Companies like GS have armies of lawyers figuring out the grey area, as well as the likelihood of getting caught out and what kind of smokescreen to put up if caught.

Just because something is legal doesn't make it ethical, but as Bill Black points out, there is a variant of Gresham's law operative in the financial market, in which unethical players drive out the ethical ones. This gets especially problematic when the market makers like GS are involved.

Right now it's a morass in many markets, and it is very difficult to sort out given the state of regulation and oversight, which remains lax to non-existent.

Anonymous said...

Thanks for answering. The way I understand it there are two types of participants in futures markets, those who intend to produce or take delivery and those who have no intention to do either of those things. So when the goldman roll occurs, who is buying the contracts they are selling?

sforst said...

Bottom line, we need higher energy prices to get us off our oil addition. I personally like the Pickens plan as a transitional phase to a longer term sustainable solution; which has got to involve some form of nuclear energy.

Tom Hickey said...

Anonymous, commodities is not my thing. I'll pass it on to Yves Smith below.

Why the Krugman “I See No Commodities Speculation” Analysis is Flawed

“Summer” Rerun: Is the Commodities Boom Driven by Speculation?

mike norman said...


Hoarding is evidenced by the Saudis keeping their oil "hoarded" in the ground. They consistently produce below capacity and that's because they get a "signal" from the market to do so.

Shaun Hingston said...

Is there any economic work done on handling a shortage of essential resources?

Shaun Hingston said...

IMO economics is incomplete without a theory for handling a shortage of essential resources.

Let me propose a theory. Since an essential resource is something that is needed for economic agents to survive, then as the supply for such a resource diminishes they will be forced to pay a higher price. This price approaches infinity as the amount of suppliers diminishes. Once a supplier has monopoly over the resource then the price becomes infinity. This causes financial assets to flow towards the supplier, and starts to destroy the financial system. At the same time economic agents will start to fail or die(depending on if they are firms or people), and eventually supply and demand equalize.

This outlines why stagflation can occur. As more money is created it flows towards the supplier, without any real economic output being created. Instead today, interest rates usually rise when prices rise regardless of if inflation is caused by financial asset expansion or a essential resource shortage. This has the effect of causing economic agents to fail sooner, and reallocate demand towards resources that are available. This response works as long as there is no social unrest.

There would need to be a new measure(perhaps it already exists) that measures the effect essential resources are having upon general inflation. Once the rate of inflation for a particular resource goes above 'some' threshold, its distribution must be handled by 'resource guardians'. As mentioned before, as the supply for a resource is monopolized it will start to cause significant damage to the financial system.

'Resource Guardians' must be carefully choosen. Since they will be given the power to distribute the essential resource, they have the opportunity to exert disproportionate control over the population. 'Resource Guardians' must exhibit altruistic behavior.

The distribution of the resource will be done via some form of rationing. I have not given much thought to the effects of trading the essential resource, but presume that such trading will not cause stress upon the financial system given the fact that economic agents will have the necessary amount to survive. I would expect that the resource would begin to function somewhat like a secondary currency.

As the supply of the essential resource begins to increase above the 'minimum survival level' private parties will begin to distribute the resource. This signals the time for the 'Resource Guardians' to exit and allow for market distribution of the essential resource.

BTW IMO no theory can handle essential resource distribution without the concept of a 'Resource Guardian'.

Tom Hickey said...

'Resource Guardians' must be carefully chosen. Since they will be given the power to distribute the essential resource, they have the opportunity to exert disproportionate control over the population. 'Resource Guardians' must exhibit altruistic behavior.

How would you do this in a global economy in which nations compete for real resources?

Shaun Hingston said...

How would you do this in a global economy in which nations compete for real resources?

Pray or perhaps hope. Obviously won't happen in today's world without a true democratization of society.

However if there is a conflict between two countries for a resource. Assume that both countries have the same 'ability'. The country that internally distributes the resource via a 'rationing system' using 'resource guardians' will gain control of the resource first. This assumes that 'resource guardians' are chosen 'fairly', and that they distribute the resource according to a community mandate. So the first country to move away from market distribution, and utilize a 'rationing system' will become the most competitive country. A bit of a contradiction compared with most economic thought.

This is because the damage to the financial system is reduced by utilizing a 'rationing system', and the financial system can therefore function efficiently in distributing other goods and services.

Such behavior has been exhibited before in wars and resource shortages.

It is also important to highlight the unlikeliness of finding altruistic guardians.

Altruistic Guardians are unlikely to be good performing participants of the market economy, which is based on selfish competition. By definition a good market performer is one who utilizes resources before competitors or suffers the consequences. Therefore if a capitalist is assigned the role of resource guardian then they are likely to behave in the same way. They will view the economic agents who require the essential resource as a 'labor resource', and will act according to capitalist principles. I suspect this effect will be exacerbated if multiple capitalists are assigned the role of resource guardian, there will be a higher competitive incentive to utilize this labor resource before opponents do.

So it will be difficult to find Altruistic Resource Guardians as they must be a non-exploiter yet still capable of distributing resources effectively. There is generally not many places in society that encourage such behavior to be exhibited.

Encouraging the development of Altruistic Resource Guardians serves a preventative measure for when such scenarios arise.

Aside: There is a third source of inflation/deflation: financial asset speed.