Friday, September 12, 2008

More on Financial Speculation and Oil Prices

Two new reports contradict each other regarding whether financial speculation was behind the rising price of oil earlier this year.
Conventional wisdom in Washington holds that speculative money flooding into the market from index funds pushed up oil prices earlier this year.

But a regulatory report released Thursday shows that those funds actually were cutting their stake in the oil market as prices were soaring.

That data, based on private trading data gathered by market regulators, contradicts parts of a report released by Washington lawmakers on Wednesday.

That earlier report, by Michael W. Masters and Alan K. White, blamed high commodity prices on the growing role of institutional investors, specifically index funds. It was cited by several lawmakers as proof that new rules were needed to curb the impact of speculation on commodity prices.

But the new 69-page study, by the Commodity Futures Trading Commission, shows that, rather than rising, the stake of index funds in the oil market actually declined in the first half of this year.
Regarding the Masters report, you should know that Princeton economist Paul Krugman has taken Michael Masters to task in the past:
Some correspondents have asked me what I think about the Congressional testimony of Michael Masters, who told a Senate subcommittee that “index speculators” — institutions that buy commodity futures as an investment — are responsible for the price surge.

The short answer is that I think his testimony is just stupid. Here’s what he says:
Index Speculators’ trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.
That quote pretty much epitomizes what’s wrong with a lot of what people say about speculation. Buying a futures contract for oil does not reduce the quantity of oil available for consumption; there’s no such thing as "virtual hoarding".

And Masters really is confused about the difference between paper contracts and physical stuff. He compares the growth in the futures market with increased consumption from China, and says
The increase in demand from Index Speculators is almost equal to the increase in demand from China!
Again, the fact that someone bought a futures contract (which means that someone else sold one) doesn’t reduce the amount of oil available to consume.

I’m willing to listen to serious arguments about how speculation might be affecting the price, but you do see a lot of dumb stuff. And this is really, really dumb.
Krugman attacked Michael Masters' reasoning in a bit more detail here.


  1. The beauty of economics is that explaining jargons can be so confusing it creates a smokescreen for the truth, until everyone are walking blind. I am an economist, and so is Krugman, and Mr. Masters im sure employs Economist with PhDs. We can debate all day, and all night, insist on our truths based on logic, churn our graphs, data, numbers and what not.

    So it boils down to the consequence as the primary indicator of the preceeding action.

    I dont believe in any CFTC data, nor would I believe in what the Energy Secretary will say after he so confidently declare that "there is no correlation between the volume of speculative trading and the price of oil" last June. Master may have a vested interest in his studies, but one only has to take a look at the dossier of the Energy Secretary to know where he would side with, the public or the investment banks. The CFTC on the other hand will have the motivation to hide certain facts and save some top honcho's head.
    And as for Mr. Krugman, his statement that a futures contract does not reduce the amount of barrels left to consume, is exactly the reason why oil was priced so high. No one understands what he is saying, not the motorist or airline companies, not the public, not the senate. It is an argument understood only by hedge fund managers, the CFTC and the Energy Secretary.

    Oh I perfectly understand what Mr. Krugman is saying and believe me, I can pick one Phd Economist to argue that speculation is the cause for price increase for every Phd Economist he can take to his side.

    Bottomline is, regulate the market and stop the confusion.

  2. You must go back to Henry Kissinger and his phrase "the structure of the oil market is so little understood". So little understood! those revealing words , written by a man who clearly did understand. Therefore, It does not surpise me all the confusion. I would suggest readers take a look at a great resource I have come across. There is a great new book "The Big Gamble" by Jose Roncal and Jose Abbo that will provide anyone with critical insight and perspective on the difference between investing, speculating and gambling. It has help me to make better inform and rational decision during the current economic turnmoil