Prometheus 6

Bob Herbert and Eugene Robinson must be hearing the same drums. 

I know, right?

What it must be like for people like Robinson and Herbert to cover and comment on this campaign.  They have a new voice and new role that many of the white commentators and journalists in print media and cable news cannot replicate and thus have to defer to.   

I have a question for you P6 if you don't mind. Do you think the current surge in commodity prices is due primarily to actual physical scarcity or to an increase in speculative investing? If the latter, do you think congress has the ability and wherewithal to place restrictions on speculative investing as they've recently proposed to do?

We're still paying people not to grow food. We have no shortages.

I suppose Congress could limit specualtive investment but in the USofA that would be a lot like limiting the number of days you can worship. I think that's all election year crap.

Do you think the current surge in commodity prices is due primarily to actual physical scarcity or to an increase in speculative investing[?]

Pardon my presumption in responding to the question, Solar Soul, but in the twelve or so years I've been researching economics I've never figured out a method by which speculators can drive up the price of a flow for more than a very, very short time (like part of a day of trading).  Here, I'm using the word "flow" to refer to a commodity that is produced and consumed at a relatively large volume, such as wheat or rice... or oil.  As opposed to "flows" are "pools," or items for which new supplies are very rare (or nonexistent).  This would include paintings by Rembrandt van Rijn, shares of Berkshire-Hathaway, ounces of palladium, and highrise real estate north of Market Street in San Francisco.  There is also the case of tradeable "streams" (like electric power), which I won't discuss because it's a huge subject.

"Pools" and tradeable "streams" can be subject to price manipulations; the one through corners, and the other through shorts and derivatives.  But "flows" are very difficult to manipulate.  Basically, you have to hoard the supply in some way; long-run price controls are really hard to do unless you're the government of a major country and can permanently interfere in the supply.  If you ever hear of a way that "flows" can be subject to speculative manipulation, please tell me because I've always wondered.

James,

If that's so, what do you make of the following paragraph from the article I linked:

A report released Wednesday by Greenwich Associates argued that surging commodity prices reflect rising involvement of speculative investors. Greenwich, a research firm, said a third of those investors had been in the markets for less than three years. Goldman Sachs Group and Morgan Stanley top the rankings of derivatives dealers, followed by Barclays Capital Group and JPMorgan Chase. Masters proposed that the government prohibit commodity index investing as a vehicle for pension funds, curtail swaps trading and reclassify some positions to distinguish between legitimate physical hedgers and speculators.

P.S. that's not a challenge to justify your argument or anything, I'm just trying to understand, and I appreciate your insights.

OK, I'm thinking about this and searching for literature on the subject. According to the rumors I've encountered (e.g., Advanced Trading, "The e-CBOT: The Evolution of Commodity Trading," Financial Times "Commodity prices part speculative - IMF"), non-commercial buyers, or speculators, are buying futures contracts on all manner of commodities as a flight from the US dollar (more on this, below).

One term of art I just picked up while researching this comment is "deleveraging," defined as "the gradual disappearance of liquidity in financial markets." IOW, a shift in investor preference from securities to tangible assets on balance sheets.

The FT article makes a passing mention of IMF claims that some of the runup in asset prices is due to financial speculatio, but of course the problem here is what to do with the physical assets. Oil can't be efficiently stockpiled since the volume consumed is so huge. I looked up the April 2008 World Economic Outlook (WEO) of the IMF, and on p.46 of chapter 1 it has a section on commodity prices. Here's the official explanation there:

Financial trends have also contributed to commodity price increases. The effective depreciation of the U.S. dollar in 2007 pushed up prices by increasing the purchasing power of oil users outside the dollar area (oil and other commodities are priced in U.S. dollars), raising the costs of inputs priced in other currencies and stimulating demand for oil and other commodities as inflation and currency hedges. Falling policy interest rates in the United States have also played a role, as lower short-term real interest rates tend to push up spot commodity prices—everything else being equal—by reducing inventory holding costs and inducing shifts from money market instruments to commodities and other higher-yielding assets.

Now, the two points of emphasis are these: as oil prices rose, they affected the marginal cost of extraction for other commodities like nickel or copper (mining is very diesel-intensive) or wheat, while commercial buyers did take up the excess capacity bought up by speculators (a crucial step no one else seems to point out).

What this means, is that the speculators' purchases of futures required that somebody ultimately buy the commodities from the speculators, or else the latter would be stuck with pools of oil, copper, and wheat that they couldn't use. That somebody was the usual commercial customer, who would store some of the stuff as an inflation hedge. This means that inventories of wheat, etc. are being kept much higher than usual, but at a certain point inventory expansion will have run its course since there's a finite amount of storage capacity.

Which means that actual speculators themselves, as a sub-sector of the financial sector, might be accidentally influencing prices through exaggerated price oscillations, leading to momentary bottlenecks in production.

Something I need to add: I was obsessing over the problem of storage. The reason is this: in the chart, when the demand curve slides to the right, the equilibrium price (P*) will rise, as will the equilibrium flow rate (Q*). It's possible, but highly improbable, that there's an absolute ceiling on Q; if so, the increase in price to p** would be enormous. That might be true for a few "flows" but not many, and I doubt it's true for any.

Now, under those circumstances, all that that is happened is that the increase in alternate uses for each unit of each commodity (or "an increase in demand") has resulted in a new equilibrium price. Nothing nefarious about that.

But let's now introduce financial speculators. Suppose they know the demand curve is actually concave with respect to the origin (i.e., instead of being a straight line, it sags so that an increase in p causes a modest reduction in Q, while an increase in Q causes a small reduction in p). If one really big investor could carry it off, he could buy a huge amount of the stuff, HOARD it somewhere, and then sell it. The price would go up a lot, which would make profit α, while the loss incurred selling the inventory on the world market would be the smaller amount β.

More realistically, speculators don't buy current flows, but future ones: say, oil in six months time. Now, there's no huge tank farms with sequestered inventory, but rather, a bubble in oil to be delivered in December '08. The problem, of course, is that this is always possible; and as the price gets more and more out of line, demand shrivels. But producers of either refined gasoline products, or products that require energy to produce, aren't in a position to know that. So they plan based on the forwards market rather than the spot (or current) price. When Dec '08 arrives, other commodities have gone up in price because production of them really has gone down, in response to the soaring costs of inputs. Of course, the oil producers (Kuwait, Venezuela, etc.) have to adjust production of oil downward in response to the pancaking demand.

If I understand you correctly, you're saying that commercial traders will increase their inventories in response to the excess "flow" created by speculators. Moreover, price increases created by speculators reduce demand, leading to reduced production. Eventually, the excess inventory and production capacity will lead to reduced prices, which means that speculation can only temporarily create price increases. But here's what I'm wondering. Isn't speculation an inducement for commercial traders to hoard their inventories in anticipation of price increases? I recently read an article that seems to describe that very phenomenon:

Normally in January and February cereal and grain prices in West Africa are driven down as harvests from the year before start hitting the markets. But production of cereals was low across the region in 2007 because of a late start and early end to the rainy season, which affected production of millet, sorghum and maize, and analysts say traders are seeking to maximise profit by hoarding stocks, because they know the low production will yield higher prices. "Traders are still buying in as much as possible to hold onto it until the price has doubled or more," said Salif Sow, regional representative of the Famine Early Warning Systems Network (FEWS NET) food monitoring group.

I recall hearing about similar happenings in India. If that's the case (admittedly my grasp of all this is tenuous), if commercial traders can create artificial scarcity by hoarding inventory, then wouldn't speculation induce traders to remove as much product from the market as possible? Incidentally, it seems to me that essentially, that's how a diamond cartel works. But nobody needs to eat or drive diamonds.

BTW, this is an extremely interesting discussion. I'm wondering, for example, if the decision by speculators to hoard inventories is related to the price elasticity of their product? It would not make much sense to hold onto a product in the hopes of obtaining a higher price if buyers could find suitable substitutes for the product or could dispense with it altogether. 

"flows" are very difficult to manipulate. Basically, you have to hoard the supply in some way; long-run price controls are really hard to do unless you're the government of a major country and can permanently interfere in the supply. If you ever hear of a way that "flows" can be subject to speculative manipulation, please tell me because I've always wondered.

Enron.

Their problem was they got greedy, but they had the manipulation of flows down to a science. And it was a commodity that CAN'T be stored.

Of course, they did have the government on their side...if I recall, they passed laws to enable them.

Enron actually succeeded in getting the government to force cities like Portland, Oregon to sell their public utility companies to them. Ain't free market capitalism great?

Enron, inter alia, was dealing in tradeable streams. That's VERY VERY VERY easy for skilled speculators to control and manipulate. It's really the easiest way to make money illicitly. The case of Enron's role in the deregulation of utilities was a huge case of congressional and legislative malfeasance.

If I understand you correctly, you're saying that commercial traders will increase their inventories in response to the excess "flow" created by speculators

Correct. But speculators don't need to because they're trading in flows that will arrive in the future.

Enron (and many other players) pulled off an amazing heist. By any standard it was Gilded Age corruption: "honest graft." Then and now, it was made possible through market fundamentalism and the total conquest of the state by corporate interests; also, by cult-like adherence to this ideology on the part of business managers.

Still, Enron could not manipulate flows, but rather, tradeable streams. The attempt to create a market in tradeable streams was an incredibly stupid idea. The problem is that electricity or PNG are not flow-commodities; they're necessarily streams of value. If you show up at a Union76 gas station and they suddenly decide they're going to demand $20/gallon, you leave and go to Citgo, where they sell it to you for $4. Your car can store gasoline for hours or days. But in order for electricity or PNG to be valuable, you need to have a stream. If the electricity wholesaler suddenly decides to pull the plug on the retailer during late summer afternoon, it's like being able to suddenly whip out a gun on the retailer. Any interruption in the stream is devastating. You need, in effect, to buy a commodity for delivery at second 1, another batch for second 2, ad seriatum.

James,

Are you saying that Enron took advantage of a nifty bit of regulatory arbitrage that was created by the utility companies and government regulators in the past but was not fully exploited until Enron came along and saw the possibilities?  

WARNING: Long comment; executive summary: Enron, Duke Power, et. al., heavily involved in the ultimate design and deployment of the California Power Exchange (CalPX). Legislators uniformly able to distance selves from actual bill, or (in the case of bill author Steve Peace), the FERC-mediated outcome.

One more thing: even in the anomalous world of tradable streams, Enron was NOT MERELY A SPECULATOR! It controlled physical streams of PNG and electricity, including pipelines and high-tension powerlines.  It also had physical possession of the servers and real-time processors for the CalPX.  I keep forgetting to bring this up.  Enron had the power to simply cut utility retailers off without warning and bid up the price several hundredfold.  A "speculator" can't do that.

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Bear in mind that California's and Alberta'a electricity markets were developed under extremely business-friendly governors (Pete Wilson in CA, Ralph Klein in Alberta). Both CA & Alberta have considerable local energy resources, although Alberta is extremely well-endowed. Wilson's second term conveniently ended on the eve of implementation (1999) and it fell to Grey Davis to handle the crisis. Premier Klein retired in '07 after 20 years in office, and Alberta's crisis was relatively milder; it occurred about the same time as California's.

Klein is generally known as a hardline market fundamentalist. He's a friend of Cheney (yes, really!), and so he did what you'd expect: when the market was wrong, he slapped it down and froze prices. You'll notice that Texas utilities are provided by a DFH cooperative, not the private sector. Hmmmm.

California's government was not able to alter significantly the terms of the agreement; while Wilson was partly responsible, it needs to be conceded that the main culprit in that crisis was the Federal Energy Regulatory Commission (FERC) and regulators of the California Power Exchange (CalPX). Beyond this, I'm still faced with a Rashomon quandary assessing blame in the crisis. FERC records (PDF) include numerous episodes of provisional pricing interventions and legal actions against individual suppliers, but nothing terribly robust.

Enron, Duke Power, et. al., were heavily involved in the ultimate design and deployment of the California Power Exchange (CalPX); so were existing utility companies. Since the utilities, such as PG&E, were the first to go bankrupt, it is commonly overlooked that they actually engaged in what be described as "equity-tunnelling," or using a complex post-deregulation capital structure to transfer the costs of bankruptcy to hapless small investors. I can explain ET another time, but it's a bit hairy.

All of the political figures involved--Gov. Wilson, Assymn. Steve Peace (bill author), FERC regulators, CalPX, and most spectacularly Prof. Vernon Smith (a luminary who designed the electricity market)--were able convincingly to disavow responsibility for the actual product. But clearly this was the most egregious malfeasance of governance in the history of the State of California.

See *Reshaping Narrow Law & Art * for more on this subject.  I created a post on it.

Thanks James, I think that's the most lucid explanation of commodity trading that I've ever seen. But I'm still left wondering, is it plausible, or even possible, that commercial traders themselves would hoard inventories of storable flows (like grains) in order to profit from anticipated price increases, and thereby put further upward pressure on prices?

But I'm still left wondering, is it plausible, or even possible, that commercial traders themselves would hoard inventories of storable flows (like grains) in order to profit from anticipated price increases, and thereby put further upward pressure on prices?

Yes.  It's rare, because the anticipated price increase is usually reflected in the current price; IOW, the current price reflects all available information on current market conditions, etc.  Also, there is time discounting for future income (usually 7% per year), and discounting for risk.  But it has happened.