Fundamental Misconceptions in the Speculation Debate

Today’s Wall Street Journal features a misguided editorial blasting the CFTC for considering constraints on oil speculation.  The piece serves as a good reminder of how often those schooled only in the stock and bond world misunderstand the function of the futures market and the role of speculators within that arena.  The Journal’s editors and others are trying to apply the rules of those capital markets to contract markets like commodity futures.  This makes no more sense than trying to play a game of baseball by the rules of football.  In real life, as in the sports analogy, playing by the wrong rules leads to chaotic consequences.

Misconception #1: who should determine price?  In the capital markets, speculators and investors determine the price of securities.   This is not the way the commodity futures markets are supposed to operate.  Commodities are consumables, not investment vehicles.  Economic efficiency demands that the price  be determined by those that produce or  use these resources.  The role of the speculator in price discovery should only be on the margin, testing the limits to see when commercial demand or supply enters the market.  Speculators in these markets should not be the primary determinants of price. 

“Overspeculation” or “excessive speculation” exists when speculators become primary drivers of price.  When this happens, commodities are no longer efficiently allocated —  if prices are driven below the point where commercial supply and demand meet, shortages result.  When prices are driven to excessively high levels, economically wasteful inventory buildup is created; Nobel laureate Paul Krugman recently reversed his opinion on the impact of speculation,  pointing to huge oil stores as evidence that oil prices have been artificially inflated.  More dire consequences also can be the result of these price distortions, including unnecessary and economically damaging price volatility and even the potential for a systemic crisis in the oil industry and it financiers.

Misconception #2:  We need all this speculation for liquidity.  The commodity futures markets absolutely need a healthy amount of speculation to bridge the gap between commercial interests who may not be in the market at the identical time.  But just like any powerful medicine, an overdose causes more harm than good.  Speculation is good only up to the point where speculation becomes the main determinant of price. 

There has been a great amount of confusion between volume, open-interest and liquidity.  Traditional speculators are short-term traders who are indifferent to being long or short the market — such volume indeed creates liquidity.  Much of the problem has been created by the new breed of non-commercial participant, particularly the commodity indexed funds which are long term holders and are overwhelmingly oriented to the long side of the market.  They represent not liquidity, but a big fat bid, which actually drains liquidity from the markets by crowding out long commercial interests.

Misconception #3:  Investors need unconstrained access to the commodity markets to protect against inflation.  The idea that commodities are the only inflation hedge available to investors has been heavily promoted by those that profit from selling commodity-linked products.  This is simply a myth promulgated by Wall Street marketing departments.  As I’ve written about before, investors have very real, and possibly superior, alternatives, from TIPS to commodity linked equities. 

Misconception #4:  Position limits are an abridgement of free market rights.  The confusion of capital markets with contract markets comes into play here.  The imposition of constraints on non-commercial participation is not about heavy-handed regulation, but about appropriate market governance.  In the capital markets, I know of nobody who complains about rules against front-running, touting or insider trading.  Those are rules designed to protect the integrity of capital markets.  Contract markets like futures exchanges need rules to protect their integrity as well.  It’s just that different markets require different types of rules.  In the futures markets, integrity implies that commercial interests determine price, and this requires governance that restrains non-commercial participants.  Speculative position limits are one of the time-tested ways to ensure this critical integrity.

Informed people of good will can argue whether the markets are indeed “overspeculated” at this point.  We can reasonably debate whether position limits are the appropriate response, or whether whole different types of governance are needed.  One can perhaps even argue whether the risks of overspeculation to the economy should be balanced against the risks to Wall Street profits from curtailing their activities.  However, those that argue that the futures markets should play by the rules of the capital markets merely reveal their ignorance.

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7 Responses to “Fundamental Misconceptions in the Speculation Debate”

  1. Randy Miller Says:

    Good comments Jeff. In a separate comment in the Financial Times, you discuss the need for integrity in futures contracts. Last year, during the big run up in oil prices, I calculated the volume of outstanding futures contracts for October, to put it simply, the amount of oil contracted was several times the amount that would normally be produced that month. These speculators seriously disrupted the oil markets, but that same class of speculators seriously disrupted the agricultural markets. Corn and soybean prices were driven to very high levels by speculation. The result was that many livestock feeders gave up hope and got out of the business. The stock cow herd in the US was culled to its lowest level since the fifties. Hog feeders were aborting pigs because there was no profit in feeding them out. The disruption to the market drove several ethanol producers into bankruptcy.

    And then ag prices went down, precipitously. It will take many years to rebuild the beef cow herd to reasonable levels. The hog farmers who got out will be very shy about getting back in.

    Investors build companies, new plants, new processes. Some speculation does provide liquidity. But the speculation we have seen in the last decade is closer to gambling at the race track, and the fact that pension funds and 401K funds get involved is very troubling.

  2. It doesn't add up... Says:

    It has long been the case that Wall Street Refiners have been able to abuse their NYMEX hedge limit exemptions, predicated on customer business, for private “proprietary” positions, taking big advantage of their perceptions of order flow. Many of the positions are off-exchange, in swaps and the like. Moreover, some of their customers are essentially sovereign = i.e. foreign governments – again something that is not new. Wall Street is of course indifferent to price trends, but benefits greatly from high volatility – especially where it controls it. Potential for volatility was greatly increased after prices bust through the historic $45ish highs from the Iran/Iraq war, and Kuwait invasion.

    Whether Wall Street was encouraged to persuade e.g. the Chinese to invest their surplus dollars in commodities – thus playing a game of spoof, perhaps intended to repatriate dollars, is a conjecture the truth or otherwise of which will be known to very few. It is perhaps slightly less harmful than encouraging surplus dollars to be invested in arms, as happened after oil quintupled in the 1970s, or in allowing the pain of a bond market collapse: the dollars are won back “fair and square” albeit in a rigged market, and help to recapitalise banks who are facing disaster on their mortgage books, whose loans were converted to import spending and Ponzi house price inflation. Those who ride the coat tails of such a tiger run great risks – ultimately personal as well as financial: its existence may make it difficult to get real traction for practical limitations on speculative limits (are you going to tell foreign governments they may not punt?). The stakes here are between governments and nations, not just distortions in consumer prices and industry investment.

  3. Randy Miller Says:

    How much of this is market “noise”? For instance, when oil was in that range of $110 bbl to $147 for a couple months, how many barrels actually exchanged hands in that price range? Did the typical refiner lock in his September supply at $70 much earlier in the runup?

    One of the problems for economists is finding out what the actual market price was. If the spot price in July of 2008 averaged $125, but 80 percent of the oil that actually exchanged hands at that time fulfilled contracts at a much lower price, perhaps $60, maybe the actual average price was $75.

    And the big problem for those of us who rely on market information is that we make business decisions based on prices.

    Transparency is the absolute key. I am being patient with the Obama people when they promise transparency, but the last thing that Larry Summers’ friends at GS want is transparency. Goldman Sachs was constantly predicting higher oil prices last summer, stampeding the herd, and then profiting from their own predictions. If everybody had the same information as GS, things would be much less volatile. A level playing field in the markets means that everyone has the same information, and the winners are those who analyze it the best.

    • It doesn't add up... Says:

      Refiners tend to price up their supply daily, being primarily interested in locking in refinery margins. Taking bets that prices will rise or fall is not what refiners do. Rather, they use futures markets to extract maximum value from any storage they own, and for margin hedging. It may interest you to know that Exxon avoided the use of futures markets: Lee Raymond, former CEO and previously in charge of refining and trading publicly stated “I do not believe in futures markets”.

      I agree that transparency is the key. Paradoxically, the market was most transparent in the days before the futures exchanges had much of a role, when it was quite unregulated and before the banks had much significant involvement. It was possible for the careful observer – e.g. a market journalist, and thereby anyone who wanted to know – to have a very good idea of the positions in off exchange forward markets held by users of those markets and the prices at which they traded. Nowadays, such knowledge is fragmented but mainly held by the banks that act as intermediaries to many trades. This fragmentation produces credit surprises (Long Term Capital Management was really one such – Wall Street didn’t conceive that they had large positions via all the banks in the same direction), and volatility from corners of particular market facets (e.g. the collapse of Amaranth trading March/April NG spreads – not even outright positions). A fair summary of Amaranth:

      http://www.businessweek.com/magazine/content/06_41/b4004071.htm

      It is the banks who have brought the money to the party. They have collateralized assets of hedge funds, index funds, sovereigns and others, to be grabbed when trading losses mount as happened with Amaranth (and many others – e.g. Metalgesellschaft in 1993/4). Banning the banks altogether might be an interesting way of tackling the problem. Their commodities trading operations would be wound up or devolved and separately capitalised and have to compete with the likes of Cargill and Glencore, BP and BHP without the benefit of preferential access to funds and knowledge of order flow. Taking the funding away will limit positions automatically, because counterparties will not accept large positions without adequate capital to fund potential losses.

    • Mike Dimmick Says:

      Virtually no actual barrels changed hands. The commodity markets are structured to *permit*, but not actually *require*, physical delivery. You have to specifically ask for an Exchange For Physical. Instead, a ‘buyer’ is supposed to cash out their position when they buy from another source, and the ‘seller’ likewise. The price they paid for the actual, off-market, barrel is guided by the futures price and the buyer recoups – or pays – any difference between the price paid at the point of purchasing the futures contract, and the price of the actual delivery.

      Almost the whole point is that the buyer identifies a need for, say, a few thousand barrels a year hence, the seller writes contracts for that number, then the buyer simply holds that contract for the year. They are of course free to trade that position if they think they can get a better deal, or if they need to increase or reduce their consumption.

      The volume of trading should actually be very, very low. On Friday, ICE’s trading of Brent Crude futures was 354,982 for monthly contracts and 262,520 for WTI, on an Open Interest in each case of less than twice that. Trading on UK Natural Gas was 4,265 while Open Interest was 95,669, only about 5% volume. UKNG is NOT an indexed commodity. Unsurprisingly the price trend has been DOWN for the last six months. OK, it’s summer, but last year prices went UP in summer.

      It’s clear that the actual volumes of consumption are way, way more than the futures markets. OI of 662,000 barrels is only a little over a third of the UK’s 1,763,000 barrels of oil consumed PER DAY (CIA World Factbook 2007 estimate). Even if the OI is counted in the minimum purchase of 100 barrels (not clear), it’s still only 37 days’ worth of one country’s consumption.

      There’s an argument that the problem is that real physical hedgers aren’t participating fully in the market. As such they are easily outweighed by speculators. Should everyone hedge their own petrol consumption? In my case just one contract is about 30 times my annual consumption of petrol! The small cartel of oil producers and refiners has no real interest in keeping prices down as it’s acting as both seller AND buyer – the motorist’s only bargaining tactic is to find the lowest-priced filling station in the area.

      Data from https://www.theice.com/marketdata/reportcenter/reports.htm.

  4. It doesn't add up... Says:

    Mick: with respect, I suspect you aren’t entirely familiar with these markets. Each contract is for 1,000bbl (or 100 tonnes in the case of Gas Oil = about 750bbl: 1bbl~=160 litres) – so you are underestimating by a factor of 1,000. Open interest in crude oil futures is around 2.4bn bbls currently (1.2bn NYMEX WTI (Light Crude), 700m ICE Brent, 500m ICE WTI): Options on the futures add a further chunk to this. That amounts to about 30 days’ global production, or twice all oil stocks in tankage and the Strategic Petroleum Reserve caverns in the US. Daily trade in these contracts alone is a multiple of global crude oil production – about a factor of 8-10 times is quite typical.

    Many of the futures are cash settled contracts where neither buyer nor seller has any right to physical delivery if his position remains outstanding on contract expiry: these contracts allow Exchange for Physical (and also exchange for swap) agreements to be registered, where two parties to a trade that has already been entered into agree to transmute it into a futures transaction, either entirely, or at least with regard to price risk as part of more complex pricing arrangements. EFP and EFS transactions are often motivated by credit risk, since the exchange clearing houses ensure that all futures positions are supported by margin payments to cover actual and potential losses from day to day via mark to market and initial margins. Only the net position is margined, which is more financially efficient and less risky than each entity trying to ensure adequate collateral from all its counterparties and having to provide collateral to them as well.

    ICE Gas Oil, and NYMEX Crude, Heating Oil and Gasoline are contracts with real physical delivery, although the volumes that go to actual delivery via the futures contracts are usually small (e.g. 10-15m bbl of crude against NYMEX WTI): most trades are offset with other trades prior to contract expiry. The main reason for this is that the actual contracts only make best sense for a very few producers, refiners or product wholesalers who happen to be ideally located to make or take delivery.

    In addition to the futures contracts there are many swap contracts: many of them cover some element of basis risk – e.g. the difference between jet fuel and gas oil prices, or between different kinds of crude oil, or between futures prices and some physical pricing basis. There are also huge volumes of fixed for floating swaps which is essentially what index funds are.

  5. Kenneth Cole Says:

    How much of this is market "noise"? For instance, when oil was in that range of $110 bbl to $147 for a couple months, how many barrels actually exchanged hands in that price range? Did the typical refiner lock in his September supply at $70 much earlier in the runup?

    One of the problems for economists is finding out what the actual market price was. If the spot price in July of 2008 averaged $125, but 80 percent of the oil that actually exchanged hands at that time fulfilled contracts at a much lower price, perhaps $60, maybe the actual average price was $75.

    And the big problem for those of us who rely on market information is that we make business decisions based on prices.

    Transparency is the absolute key. I am being patient with the Obama people when they promise transparency, but the last thing that Larry Summers' friends at GS want is transparency. Goldman Sachs was constantly predicting higher oil prices last summer, stampeding the herd, and then profiting from their own predictions. If everybody had the same information as GS, things would be much less volatile. A level playing field in the markets means that everyone has the same information, and the winners are those who analyze it the best.; How much of this is market "noise"? For instance, when oil was in that range of $110 bbl to $147 for a couple months, how many barrels actually exchanged hands in that price range? Did the typical refiner lock in his September supply at $70 much earlier in the runup?

    One of the problems for economists is finding out what the actual market price was. If the spot price in July of 2008 averaged $125, but 80 percent of the oil that actually exchanged hands at that time fulfilled contracts at a much lower price, perhaps $60, maybe the actual average price was $75.

    And the big problem for those of us who rely on market information is that we make business decisions based on prices.

    Transparency is the absolute key. I am being patient with the Obama people when they promise transparency, but the last thing that Larry Summers' friends at GS want is transparency. Goldman Sachs was constantly predicting higher oil prices last summer, stampeding the herd, and then profiting from their own predictions. If everybody had the same information as GS, things would be much less volatile. A level playing field in the markets means that everyone has the same information, and the winners are those who analyze it the best.;;

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