A B Post

My first post as an official member of the Angry Bear Team is up.

Speculation About Oil.

I'm not cross-posting here because the original draft was posted here back in May.

The new one is better.

No Speculation About Oil Prices

I think I can show that oil prices are not behaving in a completely supply-demand determined way.  We'll look at price activity, volatility, and an estimate of what rational pricing might be.

First, here is Brent Crude spot price activity since 1987, data from the U.S Energy Information Administration.  I've taken a weekly average of daily data, and plotted it as of each Friday (it was just a lot easier than trying to work their data table into a daily data plot.) Also included is a 55 week moving average.

As you can see, the price really took off after 2000.  Coincidentally, the Gramm–Leach–Bliley (Financial Services Modernization) Act of 1999, which undid portions of the Glass-Steagall of 1933, was signed into law on Nov 12 of that year, and the Commodities Futures Modernization Act of 2000 was signed into law on Dec 21 of that year.  These new laws allowed mega-consolidation in the finance industry and prohibted the regulation of certain speculative activities.

Here is the same data, separated into two graphs around the year 2000.  Also shown are the 55 week moving average, and an envelope one standard deviation above and below the average.  St Dev is based on the same 55 data points as the moving average.  The sections of the price line that extend above the {Avg + St Dev} line are highlighted.

The entire data set contains 1166 points.  Of these, 428, or 36.7%, lie more than 1 Standard deviation above the moving average.  For the segment through 1999, 156 of  574 points, or 27.18%, lie above the St Dev envelope.  For the segment 2000 on, 227 272 of 592 points, or 45.95%,  lie above the St Dev envelope.

For data normally distributed around the mean, about 1/3 of the data points should lie outside the 1 St Dev envelope, half above and half below.   I'm no statistician, but this is not a well behaved data set.  Clearly, there is a powerful high-side bias.  What could be the cause?  Here are some possibilities.

1) Supply-demand forces in a growing world economy are so skewed to the demand side that this is that natural result.
2) External forces, such as panic due to war and instability in the Middle-East, have irrationally raised prices.
3) Speculative forces with a strong long-side bias have skewed the market away from a supply-demand determined price level.
4) Withheld supply due to OPEC activities, contango (hoarding on leased tankers), and the disruption of Iraqi supply for the last decade have unnaturally skewed the supply component.

My view is that possibilities 2 - 4 are all operating to some degree.

I have no way of evaluating 2 and 4. However, 4 seems reasonable, in view of the classic description of inflation: too many dollars chasing too few goods.  This effect could also spill into into futures speculation, where the amount of oil traded is finite, but the amount of speculative money available appears not to be.

Update:  To be clear, I'm not talking about CPI inflation, I'm talking about commodity-specific inflation.   I believe that financial tail-chasing has not been limited to oil speculation.  There is enormouse wealth in the world, and to a large extent, it is not being devoted to legitimate investment.  It is being devoted to computer generated program tradign that skims tiny fractional percentage gains thousands of times per day to skim money away fro tose who use eschanges for valid purposes.

And maybe we can get a handle on speculation.  My hypothesis is that deregulation in the 1999-2000 time frame has enabled and encouraged speculative rent-seeking activities in the oil futures market, which has inflated the price of crude.  One way to go at it is to have a look at volatility.  We already have standard deviation in our hip pocket.  Let's see what we can do with it.

Here is standard deviation, based on 55 consecutive data points, divided by the average of those data points.  Just for kicks, included are a 55 point moving average of the St Dev in red  (for what it's worth -  not much, I'd say) and a best fit (least squares) trend line. 

Well - the trend line slopes up a bit, but that's not really a lot to go on.  On the other hand, the entire 90's lie below the trend line.  In fact, except for the 1990 price spike, most of the of the St Dev values prior to about 1999 lie below the trend line.  Let have a closer look.

Here, the data are divided into two segments,  up through 1999, and 2000 and beyond.   For the early segment, the St Dev/ Price line is in dark blue and the 55 week average is in red.  For the latter segment, the lines are light blue and yellow, respectively.  Now, the trend lines tell an interesting story.  For the early period, the trend line is essentially flat, with a slight downward slope.  For the latter period, the slope is clearly upward.  Despite the localized gyrations, we can see that prior to deregulation, volatility had no trend.  After deregulation the trend is up.

Up to 1999, St Dev / Price averaged 12.65% (exclusive of the 1990 spike, taken as August, 1990 through January, 1991 the value is 12.01% )  From 2000 until now, the St Dev / Price averaged 15.06%.

So, what we see is that since since deregulation, prices have gone up, volatility has gone up, and upside bias in the data set has gone up.  Let's resurrect possibility 1) and see if demand pressure can be the cause.  To get a handle on this, I took a closer look at my speculative idea from the previous post, and extrapolated prices forward from 1990, based on hypothetical constant growth rates.  Originally, I took a SWAG at the 1990 average price, and came up with $30 per barrel.  With a growth rate of 4% over 21 years, that would result in a current price of $68.36.  The 4% growth rate came from a generous estimate of World GDP growth over the period, assuming a direct, linear link between GDP growth and demand for petroleum.

Here is a graph based on the data instead of a SWAG.  It shows constant price increase rates of 3, 4 and 5% per year, based on the actual 1990 average price of $23.66.  The first thing to note is that my $30 SWAG was more than $6 too high.  The next thing to notice is that 1990 was the worst possible year to select, given the point I'm trying to make.  Due to the local spike, the 1990 average of $23.66 is almost $5 higher than the 1987 to 1993 average of $18.84.  So, if anything, my estimate of $68.36 is artificially high.

Still, I went with the 1990 average for this chart.  Extrapolations are based on growth rates of 3 (yellow), 4 (red) and 5(green)% from the 1990 average of $23.66.  This gives current price estimates as follows.

At 3%   $43.34
At 4%   $53.02
At 5%   $64.09

I'm not suggesting that this is a fool-proof method.  However, it is gratifying that it is more-or-less consistent with the oil industry estimation of a supply-demand determined price.  Further, these price growth estimates are quite generous, since estimates of petroleum demand growth are in the range of 1.6 to 2.3 %.

My conclusions:
1) The price of oil is far above rational, market-based pricing.
2) While other distortions and manipulations are likely to play a part in an inflated price, it's not clear how they could contribute to increased volatility.
3) Unregulated, excessive speculation, with a long side bias is indisputably taking place.  I believe this is a major contributor to excessive price inflation, and the sole contributor to excess volatility.

Do you have a better idea?  Let's hear it.
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Speculation About Oil Prices

Some of the crazed Democrats and  liberals (Ed Schultz and Bernie Sanders spring readily to mind) who have somehow resisted the enlightenment of unfettered free markets now have suggested that high oil prices are  due to speculation.

Noah Smith took this subject on recently, asking the question: "Do speculators cause oil and/or gas prices to rise above their "natural" or fundamental level?"   I left a long, thoughtful comment, which evidently evaporated in the Blogger glitch (aka "Blitch") that happened around that time.  Alas, it is gone forever. Noah's take is that speculation is innocent, and he cites some corroborating experimental evidence.

This, however is missing the point, I believe.  First, I'll state right up front that futures markets play a vital role in allowing the producers and first-line purchasers of various commodities to be able to stabilize their cash flows and construct realistic business plans.  So - yes, futures markets are a good thing.

On the other hand, when quizzed by Senator Cantwell last week on why big, trans-national oil companies should continue to receive multiple billions of dollars in tax breaks, Exxon CEO Rex Tillerson admitted that a good estimate of a supply-demand determined price (considering the price of the next marginal barrel)  for crude is in the range of $60 to $70 per barrel.





For reference, here is a chart and data table for Brent crude, going back to 1987.  At the depth of the global recession, on Boxing Day 2008, when the world was coming to an end, the price dipped below $34.  Be that as it may, with recent prices in the $110 to $120 range, we're looking at premiums over a rational value estimate of from 57 to 100%.   Let's just call it 75% for convenience.

Now, back to the point that Noah misses, and that Senator Cantwell suggested.  What is the effect of unregulated speculation on the price of oil?  The Senator estimates 30% activity by concerned stake-holders, and 70% by profit-seeking (in my view rent-seeking) speculators who are after a quick and easy buck.  This financial tail chasing, aided and abetted by deregulation and frankly regressive tax policy, is a direct manifestation of the asset misallocation that, in my view, is the real cause of The Great Stagnation.

A look at the oil price chart shows 10 to 15 years of more-or-less flat line in the range of $20, followed by a classic bubble and post bubble bounce.  (As an aside, this is typical Elliott wave behavior.  I can easily trace a five wave rise to the peak, and what looks like the recent end of a counter-current B-wave since the Dec. '08 bottom.  If this is anywhere near correct, the price of crude a decade from now will be eye-poppingly low, and fundamentals be damned.)

But let's look at fundamentals, anyway.  Global GDP growth since 1980 has been in the range of 2 to 5%.  Let's generously call it 4%.  (Interestingly, it was much higher in the 60's and 70's - hmmmmm . . .)  The price of crude in 1990 varied from about $15 to $40.  Let's generously call it $30, on average.

If we compound $30 at 4% for 21 years we get (are you ready for this) $68.36.  And this is based on generous numbers.

Not a rock-solid price algorithm, for sure, but I think it easily passes a laugh test.  Maybe it's just a coincidence that this number corroborates Rex Tillerson's off-hand estimate.

Maybe it's another coincidence that oil prices took off after Phil Graham pushed through legislation (signed by Billy-Bob Clinton at tail end of his battered term) that eliminated regulations from speculative trading.  One of these is removing this requirement "Either way, both the buyer and the seller of a futures contract are obligated to fulfil the contract requirements at the end of the contract term."  In case this is not crystal clear, it means that a contract  must be closed by executing the opposite transaction from the original prior to expiration, to avoid either supplying or receiving the physical amount of the contract - unlike any other commodity future.

Maybe it's another coincidence that Morgan Stanley became the largest oil company in America.  Oh - another point that Noah explicitly missed is that big, speculative finance entities did, in fact engage in physical hoarding.  Here is a 13 month old news flash.

Oil traders are taking advantage of a market condition known as contango, in which the price for future delivery is greater than the price for spot (immediate) delivery. If the difference between the two prices is more than the cost of chartering an oil tanker, traders stand to profit. The difference between the price of crude oil for June delivery and the price of crude oil for July delivery is more than $2.00 a barrel; that’s enough to defray the cost of chartering a very large crude carrier (VLCC), which holds about 2 million barrels of oil and, as of April 23, cost $43,876 per day, according to the Baltic Exchange.

How much of an incentive to keep prices artificially high do you suppose is provided by a cost of $43,876 per day?  That's $1.31 million per month.

And that's why I think Ed Schultz, Bernie Sanders, and Maria Cantwell are a bunch of damned fools!
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Tea Party

I'm spreading the word.

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Food and Energy Costs

From Daniel Carroll, via Mark Thoma, via James Hamilton, a deep insight into how headline inflation affects the life styles of the poor and obscure.

Food at Home as a share of Income:

Bottom quintile -- 23.5%
Top quintile      --  3.9%

Energy Expenditures as a share of Income:

Bottom quintile -- 20.6%
Top quintile      --  3.9%

The bottom quitile spends 44.1% of income on subsistence.  And this doesn't include housing.  Or clothing. 

Sucks to be them, doesn't it.
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What The Hell?!? Friday - - What the Hell is up with Gold ?!? Edition

Ever since Auric Goldfinger we've wondered who put the Au in the Aura of GOLD.

Certain varieties of Neanderthal consider the barbarous relic to be REAL MONEY.  Well - remember the functions of money.  It operates as -

A medium of exchange
A unit of account
A store of value
A standard of deferred payment

If you think we live in a Lepriconomy where gold functions as money, try to pay for your next trip to the grocery store with a chunk of bullion, or a shiny American Eagle.

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One might reasonably consider gold to be a store of value, but it is inadequate in fulfilling the other functions of money.   It's more reasonable to think of gold as what it actually is - a physical asset with uses in industrial applications and as jewelry.  Gold is a great thing to hold onto during inflation, and especially hyper-inflation.  Other times it's usually as dead as any other rock.  Right now, we're on the edge of deflation, and holding gold will make little sense.

A Closer Look at Commodity Prices

Yesterday I took a sardonic look at commodity prices.  Let's dig in a bit deeper.

Update: In the original post I forgot to give a H/T to Krugman.  Better late than never.

There are cool graphs, and pointed opinions below the fold.

Commodity Prices and Why the World Is About To End

There is a lot of opinion being offered these days to the effect that the sky is falling as a result of Obamanomics - first fiscal stimulus, and now QE II.

Well, wait a minute.  Since nobody has actually been hit by a chunk of the celestial ceiling since that scene in Chicken Little . . .




. . . maybe we should subject this notion to some sort of rational analysis.

One thing that is usually cited as evidence is the behavior of commodity prices since the inception of Obama's ill-advised quasi-tragic idiotically Keynesian stimulus package.   Well, since the International Monetary Fund conveniently has that information readily at hand as both a graph and a table of monthly values, (2005 Avg value = 100, includes both fuel and non-fuel) let's have a look.

OH MY GOD, IT'S UP OVER 50% IN LESS THAN 2 YEARS.  THE SKY IS FALLING!

After a bit of hyperventilating, it occurred to me that some skeptic out there might think I was cherry-picking the data.  We certainly can't have that.  And Krugman - who I have been known to disagree with - is not particularly concerned.

Given all that, let's look at the whole data set, which starts in 1992.

See - after 10 years in the doldrums, commodity prices really took off just about when we invaded Iraq, and then went through the hole in the roof made by that piece of falling sky!   

Oh - wait a minute.  That was in July, 2008.  And by the end of the year the index value was cut in half.

Damn. . . the data isn't fitting my narrative very well.  I know!  Let's change the data.  Here is just 2010.

See -The index has gone from 142.34 in January to 147.74 in September (latest data available.)  That's almost 3.9%!  Annualized, it's almost 5.2%!  And it's up fully 13 1/3% from the pre-bubble August, 2006 high of 130.37!  Doesn't that look like hyperinflation to you?

I suppose at this point some smart ass is going to point out that since April the Index has declined from 153.27 to 147.74, and that's negative 3.6%.

Look, we're on the verge of hyperinflation.  Just don't mess with a beautiful idea, dammit.
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