Err... is this thing on? Am I back?

I think I'm back.

I am periodically abducted by aliens, who do unspeakable things the details of which I can only guess from various aches and irritations.

In my absence, the comments on the previous more-than-a-month-ago post were remarkably good. The blog is better, actually, when I disappear. Smarter voices chatter.

The whole oil thing seems so, like, last month, although I notice there was some kind of deadhead revival in SoCal a couple of days ago. Some quick, crude thoughts: the whole "fundamental" vs "speculative" debate is terribly miscast, as emphasized most recently by Jeff Frankel (via Mark Thoma), but also by Tyler Cowen, and me too. What I liked best about the Thoma / Krugman model is that it gave us four lines to think about, two kinds of demanders (people who want to burn oil vs people who want to store it) and two kinds of suppliers (people who suck oil from the ground vs people who drain their tanks). An imbalance of speculation on futures (more longs than shorts) creates incentives for people with tanks to fill them, potentially shoving up one of the two demand lines (the one on the left-hand panel of the Thoma/Krugman graphs). But four lines iz a lot of moving parts. I think the really interesting line is the right-panel supply line. Rather than "speculation" vs "fundamentals", I wonder whether discretionary oil producers are flat-out producing as much as they are able, given the infrastructure currently in place, and whether over the past few years they have held back on developing capacity, or whether they are in fact eager to pump but hitting "peak oil" limits. Either story is consistent with James Hamilton's fundamentals, although one might call unenthusiastic production "speculative" in a certain sense. In the end, I think Paul Krugman wins the debate he started, if it was the left-panel demand line driving prices, the only piece futures-buyers can influence, we should observe storage in tanks. As both Robert Waldmann and Alea's jck (in a comment) point out, paper speculators only persuade oil producers to leave the stuff in the ground when they drive futures into something close to strict contango, because producers enjoy less of a convenience yield than people with tanks. Inventory should build in tanks before it builds underground, if increased stock demand is driving the story.

It's important to note that, just because futures buying / speculative storage probably did not drive the great oil price boom of early 2008, doesn't mean it could not affect prices. Imagine, in Mark Thoma's discussion, that rather than a parallel outward shift in demand, the slope of the stock demand curve flattens as well. The "flatness" of stock demand maps to speculators' conviction that prices will rise. If speculators are absolutely certain that (the present value of) future prices will be higher than the current price, then they would persistently buy as much as would be necessary to pull the flow market price to the expected future price. In Mark's scenario, speculators effectively choose a quantity they are willing to buy at above the spot clearing price, and prices revert once their appetite has been sated. But speculators might choose price rather than quantity. (Still, if they do, we should see inventory build.)

Of course, explaining the rise in oil prices is passé. Now it's all about explaining the fall. Is it demand destruction? an incipient long run? declining inventories? increased production? a speculative bubble going "pop"? I dunno. Do you? (Maybe it's those evil short-sellers.)

In the month-ago discussion, Arnold Kling was the first to point out the connection between option values and the convenience yield. That theme was developed quite extensively by commenters, especially anon and MG, and is common in the academic literature as well. The kind of option a convenience yield represents is fun to think about. It is an option whose underlying is fluctuating calendar spreads, rather than prices. There is a lovely symmetry, in that there is a positive convenience yield both on having the commodity available, and on not having the commodity (but having an place to efficiently store it). If that seems weird, recall how same-strike call and put options both have positive value, even though when one is in the money, the other cannot be. We can even derive a relationship between the expected value of these two convenience yields somewhat analogous to put/call parity.

This all seems very retro now, a month is a long time, in the blogosphere and in financial markets. If I can avoid the lights in the sky, perhaps I'll come up with something more exciting to write about soon.

Oh! Speaking of exciting, welcome Gabriel!

Steve Randy Waldman — Sunday July 27, 2008 at 5:49am permalink

"Welcome back,
Your dreams were your ticket out.

Welcome back,
To that same old place that you laughed about.

Well the names have all changed since you hung around,
But those dreams have remained and they're turned around.

Who'd have thought they'd lead ya (Who'd have thought they'd lead ya)
Here where we need ya (Here where we need ya)

Yeah we tease him a lot cause we've hot him on the spot, welcome back,
Welcome back, welcome back, welcome back."
7.28.2008 9:14am
anon (mail):
So which asset, exactly, is it that appreciates more than 10% per month that oil producers are supposedly incentivized to switch into? I'm really curious. Seriously, what is it?
7.28.2008 3:10pm
Steve Randy Waldman (mail) (www):
anon — ???

I'm not claiming that oil producers might not speculate by holding oil in the ground. If they think it'll appreciate 10% per month, even in USD terms, surely they would keep it in the ground.

But that'd be a speculative estimate, not an arbitrage or a convenience yield. (A convenience yield, like any option value, is in and of itself speculative, but it only requires speculation on a level of volatility, of which 0 would be a particularly unlikely estimate...) It would be unrelated to long speculation in futures markets, at least while those markets are not in contango.

I do think oil producers are underproducing, in a manner that can be construed as speculative based on an estimate of the likely relative performance of financial vs "hard" assets, as well as due to portfolio considerations (they have too many financial, especially USD, assets already). The only point I'm willing to concede is that financial investors long futures have not been the primary drivers of the oil spike. Less than enthusiastic producers might well have been. I think that's quite likely, in fact.
7.28.2008 3:52pm
"they have too many financial, especially USD, assets already" - so what's to stop Sovereign Producer from recycling those assets into long futures via their innumerable conduits?

Eventually, they produce less because it appreciates 10% and it appreciates 10% because they produce less. Yes, there is a buyer for every producer, but if producers aren't willing to sell, don't they control the bid?

Couple that with well-publicized price caps in EM's (see today's NYT...90+% new demand coming from price capping economies), and you have a disingenuous signal from demand as well as supply.

So how could a futures/forward/otc market (or any market for that matter) possibly elicit any sort of useful information when the underlying markets offers no useful information?
7.28.2008 4:44pm
Steve Randy Waldman (mail) (www):
anon — don't see why producers would want to go long futures, though they certainly could.

I'm not sure we're disagreeing... I think it's perfectly possible that producer reluctance, whether as strategic price manipulation or as a simple portfolio allocation decision, could be responsible for the spike. It's hard to distinguish don't-produce from can't-produce, but I'm with you in suspecting that don't produce is a lot of it. In the end, though, supply is set by suppliers, and they are selling what they're selling.

On the demand side, gov't subsidies creates a spike in present demand. That's real demand even if the government is paying part of the price (just as fuel taxes in Europe and the US blunt real demand).

What seems to be irking you is that whatever information there is in oil market prices is not only information about the physics (present and future) of the commodity, but also signals about strategic producer choices and consumer energy policy, which makes for an awfully hard to interpret mess. I'm with you, I hate that too. But it's real, isn't it? We try to tease the pieces out, we can argue about which policies are good or bad, legit or illegitimate, we can wish for a market where the price signalled only present and future physical scarcity relative to demand rather than political factors. But that's probably a lot too much to wish for.

After all, most economists support carbon taxes, don't they? Then they'd support subsidies, if they thought there were net positive externalities to energy use, which is exactly what has driven EM policy. There are no clean hand (or "free markets") in this messy business.
7.28.2008 5:07pm
7.28.2008 5:52pm
Steve Randy Waldman (mail) (www):
yeah... but do you think producers buy futures to hire storage, that is to sell oil while at the same time incentivizing 3rd parties to keep it in tanks? why not just sell less oil?
7.28.2008 7:11pm
From Krugman:

" The only way market manipulators could have been driving up prices was by keeping physical supply off the market. And they were in fact doing just that: there was huge unused generating capacity, consistent with the idea of deliberate withholding. Some years later we would actually get hold of control room tapes in which Enron traders called plants and told them to shut down, and boasted about cutting off Grandma Millie's power.

I'm still waiting for evidence that physical withholding is going on in the oil market. "

What the Saudi's say:

"King Abdullah of Saudi Arabia has commanded that some recent finds of crude oil be left untapped to preserve the nation's oil-wealth for future generations. Saudi is the world's greatest producer of oil at 11.3 million barrels per day which is predicted to be increased to 12.5 million bpd next year. The king is quoted as saying: "When there were new finds, I told them, 'no, leave it in the ground, with grace from God, our children need it'." World eyes are turned to Saudi to increase production to meet an inexorable thirst for oil, but when asked about the maximum likely production, the king said: "We'll get to 12.5 million barrels a day and then we'll see."

Why is Krugman having such a hard time figuring out where the "storage" is taking place?
7.29.2008 10:10am
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