Archive for May, 2008

When the Rivers Run Dry

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Steve Darden
on 5/31/2008
in Water Policy
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My own hunch is that climate change is going to be a major issue over the next few decades, but we will experience it less through warming itself – changes in temperature – and more through changes to, if you like, the hydrological cycle. In other words, more droughts, longer droughts, occasionally more floods, rising sea-levels. In other words, it’s water that’s going to be the prism if you like through which we see and experience global warming. And if you add that to damage to our soils and the land around the world, which again is going to be exacerbated by water shortages, I think water becomes the focal point. I think many environmental issues are going to hit us most seriously through water shortages. — Fred Pearce

We learned of Fred Pearce’s book from an excellent podcast interview [MP3] by Tom Keene’s Bloomberg on the Economy. There are a number of reviews of the book — try this one at Salon, which begins:

Pearce, a longtime editor for New Scientist, who is now an environmental consultant for the magazine, calculates that it takes 40 gallons of water to grow the ingredients for the bread in a single sandwich, not to mention 265 gallons to produce a glass of milk and 800 gallons for a hamburger. And that’s just what’s for lunch. Don’t get him started on what you wear to this water-rich feast. Even a simple cotton T-shirt bearing some hopeful green slogan like “Save the Bay” is a huge water user. Pearce figures it takes 25 bathtubs-full of water to grow the scant 9 ounces of cotton for such a shirt.

Water is the ultimate renewable resource, literally falling from the sky back to earth after it evaporates. And since it’s so heavy and cumbersome to move great distances, it’s also a local resource. Yet, start quantifying the water embedded in foods and goods, the “virtual water” as economists call it, and water is fast becoming a global commodity like oil. There’s Brazilian water in the coffee beans grown for an American latte; there’s Pakistani water in the cotton in that T-shirt.

…If there are 650 gallons of water in a pound of cheddar cheese, is it futile to make small gestures like turning off the water when you brush your teeth in the name of saving it?

It helps with water bills, so it makes sense in that way. And it may make sense with local water resources, which may be constrained, just within a small town, or even a community.

At the global scale, no, it doesn’t make much difference. Most of the water that each one of us uses comes from the water used to irrigate the crops that we consume. That’s principally food, but not only. Cotton for our clothing is a major user of water around the world.

The irrigation water usage is about 2/3 of the global water consumption.

There is a good introduction to Pearce’s research in this interview by Jim Puplava at FinancialSense.com — quoted above. Another interview to read is at the California Literary Review — this excerpt discusses one of my favorite worries, the Yellow River:

You call the Yellow River in China, the “hanging river.” What does that mean and what is the potential for disaster?

For thousands of years, the Chinese have controlled the Yellow River as it crosses its floodplain on its last several hundred miles’ journey to the sea, by constraining it within artificial banks, levees. The idea is to prevent floods. But the river is the world’s siltiest and through time it deposits this silt on its channel bed, which rises higher and higher above the surrounding floodplain. The Chinese have kept the river on its course by raising the levees ever higher. Hence the term “hanging river”. But this is a “double-or-quits” strategy. Chinese history is peppered with disasters when the river breaks its levees and floods across the land. But the worst disaster happened deliberately, in 1938, during the Sino-Japanese war. To halt advancing Japanese troops Chinese generals dynamited the levees and flooded the land. The Japanese were only held up for a few weeks, but the floods were so great that almost a million Chinese died. It is said to have been the most destructive single act of war ever. And it took engineers ten years to put the river back into its old channel.Today the risks are if anything higher. A combination of persistent drought and rising demand for water for irrigation leaves the river virtually empty by the time it reaches the “hanging river” zone. That sounds comforting. But the slow, feeble river drops even more of its silt on its channel than before. So the hanging river has been rising ever higher (it is now in places 70 feet above the floodplain) and, despite constant levee raising, the capacity of the channel is diminished. The risk is that one year there will be major upstream floods that dams cannot contain, and the levees on the floodplain will once again be overwhelmed, with dreadful consequences. Chinese engineers have been trying to manage dams on the river so as to create an artificial flood to flush out some of the silt and increase the capacity of the channel. But this has had only limited success, however.

Let’s Try Market-Oriented Market Reform

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Steve Darden
on 5/31/2008
in Economics
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What is wrong with Bert Ely’s proposed reforms? The list makes a lot of sense to me.


…The mess in the financial system today is the result of previous government rules that pushed markets in the wrong directions. To prevent another crisis we need to change the rules, aligning the incentives of financial players with optimum market outcomes. Here are some key changes:

- Scrap the antiquated leverage-ratio requirement for bank capital.

- Encourage banks to use “covered bonds” to fund – and hold onto – the fixed-rate mortgages they originate.

- Eliminate the double taxation of corporate dividends.

- Modify fair-value accounting rules.

- Hold bond-rating agencies more accountable for their ratings.

Read the essay to see if you agree with Bert’s arguments for each of the above.

UPDATE: I see that Greg Mankiw likes (at least) “covered bonds” and “eliminate the double taxation of dividends”.

Better biofuels?

Published
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Steve Darden
on 5/31/2008
in Energy Policy
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MIT Technology Review has a three-part series on new approaches to biofuels, including Amyris Biotechnologies — whose fermenter is pictured at left. There is a suite of excellent graphics and multimedia associated with the series.

Ethanol, after all, is hardly an ideal fuel. A two-carbon molecule, it has only two-thirds the energy content of gasoline, which is a mix of long-chain hydrocarbons. Put another way, it would take about a gallon and a half of ethanol to yield the same mileage as a gallon of gasoline. And because ethanol mixes with water, a costly distillation step is required at the end of the fermentation process. What’s more, because ethanol is more easily contaminated with water than hydrocarbons are, it can’t be shipped in the petroleum pipelines used to cheaply distribute gasoline throughout the United States. Ethanol must be shipped in specialized rail cars (trucks, with their relatively small payloads, are usually far too expensive), adding to the cost of the fuel.

So instead of ethanol, the California startups are planning to produce novel hydrocarbons. Like ethanol, the new compounds are fermented from sugars, but they are designed to more closely resemble gasoline, diesel, and even jet fuel. “We took a look at ethanol,” says Neil Renninger, senior vice president of development and cofounder of Amyris Biotechnologies in Emeryville, CA, “and realized the limitations and the desire to make something that looked more like conventional fuels. Essentially, we wanted to make hydrocarbons. Hydrocarbons are what are currently in fuels, and hydrocarbons make the best fuels because we have designed our engines to work with them.” If the researchers can genetically engineer microbes that produce such compounds, it will completely change the economics of biofuels.

Of course Vinod Khosla is interviewed — he had some very sensible comments on scalability of transport solutions to China and India.

Khosla seems exasperated by the biofuels naysayers. Climate change, he says, is “by far the biggest issue” driving his interest in biofuels. If we want to head off climate change and decrease consumption of gasoline, “there are no alternatives” to using cellulosic biofuels for transportation. “Biomass is the only feedstock in sufficient quantities to cost-effectively replace oil,” he says. “Nothing else exists.” Hybrid and electric vehicles, he adds, are “just toys.”

In particular, argues Khosla, any transportation technology needs to compete in China and India, the fastest-growing automotive markets in the world. “It’s no big deal to sell a million plug-in electrics in a place like California,” he says. The difficulty is selling a $20,000 hybrid vehicle in India. “No friggin’ chance. And any technology not adoptable by China and India is irrelevant to climate change,” he says. “Environmentalists don’t focus on scalability. If you can’t scale it up, it is just a toy. Hence the need for biofuels. Hence biofuels from biomass.”

… “The reason that I like [corn ethanol] is that its trajectory leads to cellulosic ethanol,” he says. “Without corn ethanol, no one would be investing in cellulosics.”

I don’t understand the logic of that last statement. To me corn ethanol is just “liquid pork” — a scandalous waste of taxpayers hard-earned money.

If Khosla’s projections prove out, “then wonderful,” says the University of Minnesota’s Runge. “Meanwhile, we’re stuck in reality.” Perhaps the main point of contention, Runge suggests, is whether corn ethanol will in fact lead to new technologies–or stand in their way. “It is my opinion that corn ethanol is a barrier to converting to cellulosics,” he says, pointing to the inertia caused by political and business interests heavily invested in corn ethanol and its infrastructure.

Runge is not alone in his skepticism. “Unless the cost is reduced significantly, cellulosic ethanol is going nowhere,” says Wally Tyner, a professor of agricultural economics at Purdue University. Making cellulosic ethanol viable will require either a “policy mechanism” to encourage investment in new technologies or a “phenomenal breakthrough”–and “the likelihood of that is not too high,” Tyner says.

Back in Part 1 of this series, there is a devastating critique of corn ethanol with predictions from 2007 of how the world’s poor were going to pay the price for the fat-farmer subsidies. Here is Dr. Runge

In the May/June 2007 issue of Foreign Affairs, C. Ford Runge, a professor of applied economics and law at Minnesota, cowrote an article titled “How Biofuels Could Starve the Poor,” which argued that “the enormous volume of corn required by the ethanol industry is sending shock waves through the food system.” Six months later, sitting in a large office from which he directs the university’s Center for International Food and Agricultural Policy, Runge seems bemused by the criticism that his article received from local politicians and those in the ethanol business. But he is steadfast in his argument: “It is clearly the case that milk prices, bread prices, are all rising at three times the average rate of increase of the last 10 years. It’s appreciable, and it is beginning to be appreciated.”

The recent OECD report, released in early September, is just the latest confirmation of his warnings, says Runge. And because a larger percentage of their income goes to food, he says, “this is really going to hit poor people.” Since the United States exports about 20 percent of its corn, the poor in the rest of the world are at particular risk. Runge cites the doubling in the price of tortillas in Mexico a year ago.

Oil prices: the Hotelling model and scarcity rents

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Steve Darden
on 5/31/2008
in Economics
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James Hamilton examines the scarcity rent concept:

Does the market price of oil reflect a recognition that the resource is fundamentally limited?

Dave Cohen, writing at the Oil Drum, has been doggedly wading through the writings of economists on resource scarcity, going the extra mile (and then some) trying to understand how those on the other side of the river from him have thought about the issue of resource scarcity.

As Dave nicely explains, the traditional Hotelling model reasons that market forces will cause there to be a “scarcity rent” incorporated in the price of an exhaustible resource. The observation is that someone who sells a disappearing resource today is thereby surrendering the opportunity to sell that commodity in a future market in which it might be more highly valued. As a consequence of owners bringing more or less of the product to the market at each date on the basis of such calculations, the theory predicts that the scarcity rent should rise over time at the rate of interest.

Dave then runs into the same stumbling block as anyone else who has tried to apply this elegant theory to reality– if you look at the inflation-adjusted price of what should be exhaustible commodities over the last century, there’s no hint at all of an upward trend:



Dave concludes that sellers have been regarding the day of exhaustion as so far off in the future, that, given also advances in the technology of extraction, a scarcity rent has made essentially no contribution to the price. But Dave’s geological assessment is that in the case of oil at least, declining annual production rates in fact are going to come relatively soon. He concludes that perhaps the scarcity rent is not making the contribution that it should for oil due to possible factors such as investors too heavily discounting even relatively near-term events, or deliberately misleading data provided by oil producers such as Saudi Arabia in a strategic game to prevent investments in alternatives to conventional oil reserves.

James does not believe speculation is a big part of the recent price trends. In his earlier post “Oil Bubble” he wrote:

Let me repeat here that I do not believe that speculation is the reason oil went from $60 to $120 a barrel. The biggest part of that longer term trend is due to fundamentals, not speculation. Notwithstanding, it does appear that speculation has gotten ahead of those fundamentals in the most recent developments.

For the bubble to continue, we would need to see ever-increasing volumes of investment money pouring into the futures markets, and continuing stagnation in global production to ratify them. Even if the former occurs, my best guess is that the latter will not.

Commodity prices: how much of the increase is speculation? Part 3

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Steve Darden
on 5/31/2008
in Economics
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In “Those Nasty Index Speculators” John Mauldin offers a counterpoint to the Michael Masters thesis. Mauldin included some useful commentary from Bob Greer, executive vice president at PIMCO. The PIMCO guys are razor sharp in fixed income — I don’t know Bob Greer’s expertise in commodities, but his commentary on oil prices makes sense — Greer argues that the causal arrow goes the other way, from rising commodity prices to increasing index investment:

…(Greer) rebuts Masters arguments in a very cogent paper recently sent to me. He argues that index funds do not affect the price but may contribute to volatility.

“Some market observers have tried to tie the level of inventories to index investment, most notably in crude oil. Their arguments take one of two forms:

“1) The indexer’s act of selling the nearby and buying the distant contract forces the futures curve to be upward sloping (future price is higher than nearby price). This creates an incentive to own inventories and earn the “return to storage” represented by the slope of the futures curve. The act of increasing inventory keeps the commodity off the market, thus decreasing supply.

“2) A variation of the above argument is that the short seller, who takes the other side of the indexer’s purchase, needs to protect their position by buying and holding the physical commodity.

“It would be nice if either of these arguments were true, in which case, the developed world would not be hostage to the Organization of the Petroleum Exporting Countries (OPEC). Any time we needed to increase crude inventories, we need merely to bring in more indexers, and the inventory would appear. In fact, the explanation for inventory levels of any commodity is much simpler. If, in the cash markets, production exceeds demand, inventories will rise. Otherwise they will fall. That is why, in six of the last eight years, global wheat inventories fell, regardless of index investment (USDA). That is why from 2006 to 2008, crude oil inventories declined and the crude oil curve went from upward sloping to downward sloping, in spite of increasing index investment (EIA). Furthermore, the second argument above breaks down when applied to non-storable commodities such as live cattle.”

Further, Greer shows a chart from Deutsche Bank which highlights the fact that many commodities which are not in the index fund portfolios have risen higher than exchange-traded commodities (rice, for instance). Look at the chart below:



Greer concludes with these important paragraphs:

“Regarding intrinsic value, commodity futures prices converge to cash prices, and cash prices are set by the level of demand to consume physical goods such as steak, gasoline, and Wheaties. The price setting mechanism is not based on possibly erroneous assessment of a financial statement, nor on irrational exuberance. In commodities there is an outside measure of intrinsic value–the cash market–that is not dominant in equity, real estate, or tulip bulb markets. As actual commodity prices go higher or lower, they reflect consumption requirements for actual products, many of which are not very storable.

“This is a sharp contrast from internet stocks or vacation condos, which are subject to speculative bubbles. Unfortunately, our conventional wisdom regarding factors that create bubbles is rooted in asset classes like stocks and real estate, asset classes that have fundamentally different characteristics than physical and futures markets.

“Coincidence is not the same thing as causality. It is a coincidence that commodity index investment has increased in the last few years just as commodity prices have increased. If there is any causality, it is the other way around. Rising commodity prices have caused an increased interest in commodity investment. And it is certainly causality that fundamental supply, demand and inventory factors have driven commodity prices in many markets higher, whether or not those are markets in which index investors participate. This is the same causality that has driven commodity prices both higher and lower for many decades.”

Chandler on Fed policy and the US Dollar

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Steve Darden
on 5/31/2008
in Economics
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DollareuroMarc Chandler, chief global currency strategist at Brown Brothers Harriman, will receive this week’s Best Chart prize [PDF] . Click on the graphic at left to enlarge.

Recall that we are looking at two variables, the dollar’s value and the direction of short-term interest rate differentials. With two variables there are four possibilities: There are times when there is a weak dollar while interest rate differentials move against the US, which has been the case in recent quarters. The dollar may remain weak as interest rate differentials begin moving in its favor. The dollar could strengthen as interest rate differentials continue to move in its favor and later the dollar could strengthen when interest rate differentials begin moving against the US.

Since the late 1970s, the dollar appears to be moving consistently and sequentially through the four different phases. We are not pretending to offer some kind of Holy Grail. The limitations of this conceptualization are stark. It says nothing about the duration; how long the dollar spends in any one phase. It also says nothing about magnitude; how much the dollar appreciates or depreciates in any phase.

Nevertheless, the dollar’s location in its super-cycle helps identify the underlying trend and may be more useful for long-term traders than short-term speculators. In particular, recent developments lead us to believe that the dollar may be moving from what we have labeled Phase 4, where short-term interest rate differentials are moving against the US and the dollar is falling to Phase 1, where short-term differentials begin moving in the US favor, but the dollar remains soft against the euro.

…The economist’s equivalent of Occam’s Razor, the philosophical principle that the simple solution is preferable is that cyclical explanations ought to be given precedence over structural explanations and only when the former prove unsatisfactory should the latter be relied upon. We have maintained that the dollar’s decline was largely a cyclical phenomenon, largely a function of growth differentials mediated by interest rate differentials and divergence in monetary policy between the Federal Reserve on one hand and the ECB on the other.

The structural reasons other observers cite, like diversification of reserves or the loss of the dollar’s status as the numeraire in the world economy we find lacking much evidence. The most authoritative data, which comes from the IMF shows central banks hold more US dollars than ever before. The US does of course still run a large trade deficit, even if it has fallen in recent quarters. Nevertheless we have found that over half the trade deficit can be accounted for by the movement of goods within the same companies. These intra-firm movements of goods, as trade has been in effect in-sourced, often do not require countervailing capital flows but are rather book entries in corporate accounts. In addition, while the US is the world’s largest exporter, its companies rely on local affiliate sales rather than exports as the chief method of servicing foreign demand. Sales by the majority owned affiliates of US multinational companies will sell something on the magnitude of four-times the amount the US will export this year.

The US dollar bottomed against half of the non-US G7 currencies, sterling and the Canadian dollar, last November. The dollar’s location in its super-cycle does not preclude a marginal new low against the euro. It does support our view, however, that the dollar’s multi-year downtrend is nearing an end. The shifting of interest rate differentials, which investors should continue to monitor, is another piece of the jigsaw puzzle falling into place for a broadening of the dollar’s base in the period ahead.

For an illuminating interview with Chandler I recommend Tom Keene’s May 28 podcast at Bloomberg on the Economy [MP3], offering lots of statistics comparing US and EU performance. And how the Euro has not helped EU productivity. How US productivity growth over the past 3 decades has continued to outpace the EU countries.

BTW, Chandler is not a member of the “US Dollar is finished” club — e.g., see this April 4th analysis [PDF]

Much foreign exchange commentary these days reads like eulogies for the US dollar. Central banks are diversifying reserves away from the dollar. OPEC countries are increasingly worried about the decline of the dollar and the inflationary implications and may break the pegs and possibly even begin benchmarking their black gold in euros rather than dollars. The aggressive US policy easing and the financial crisis, which none less than former Federal Reserve Chairman Alan Greenspan has said is the worst since the Great Depression, contributes to the lack of attractiveness of US assets. The low rates of return in the US will make it increasingly difficult to fund its large current account deficit, which in turn will continue to undermine the dollar. This pessimism is exaggerated and ignores evidence to the contrary. Moreover, the very fact that sentiment is so poor and short dollar positions so extensive may be more symptomatic of a market extreme than the beginning of a trend.

One of the weights on the US dollar has been the belief that foreign central banks have a clear alternative to the debt-ridden greenback as a reserve asset. Yet the evidence for this is sketchy at best and depends on when one wants to begin counting from. The IMF recently reported the allocation of reserves for Q4 07, which of note excludes China as China does not provide a break down of its reserves. The share of allocated reserves accounted for by the dollar actually rose slightly to 63.9% vs 63.8%. Given the dollar’s depreciation in the quarter, the fact that its share actually rose suggests, contrary to conventional wisdom, that reserve managers are reluctant to sell dollars at these levels.

That is clearly the message coming from foreign officials. On March 12, speaking at an ECB conference, the head of the Saudi Arabian Monetary Authority, Hamad Saud al Sayari, explicitly stated that the dollar was a “good buy”, as the rout looks overdone and the dollar under-valued. Less than two weeks later the head of Kuwait’s Investment Authority, thought to be one of the largest sovereign wealth funds, indicated that he was going to boost investments in the US because the weaker dollar made US assets more attractive.

…We would recast the debate over if and when the US dollar will bottom. We argue that it is already bottoming. Not including the dollar, there are four other currencies in the G7 and the dollar appears to have bottomed against two of them, the British pound and the Canadian dollar. If it has not bottomed against the other two, the euro and Japanese yen, we suspect it has come close to what will likely be the cyclical low. The Australian and New Zealand dollars may find it difficult to rise through the Q1 highs set near $0.9500 and $0.8215 respectively. We also believe the US dollar has bottomed against several of the major emerging market currencies as well, like the South African rand and Turkish lira.

…Instead of intervention, our more positive dollar argument is based on its relative cheapness, the changing behavior of investors and businesses, and the fact that the bad news from the US is widely known while the magnitude of the challenges faced elsewhere do not appear to be generally appreciated. The dollar has already bottomed against half of the G7 currencies and several key emerging markets. We expect that bottom to broaden out in the period ahead.

I do hope Chandler is right that the AUD run is over.

The Everhouse, a market solution for coastal housing

Published
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Steve Darden
on 5/31/2008
in Economics and Katrina
. 12 Comments

Not just Katrina recovery — but any coastal, high-risk, high insurance zone. John Sawyer’s Everhouse is exciting — manufactured housing designed for the coastal risk profile and a delivery pipeline that make sense. The hundreds of millions of your money [aka “Government Assistance”] has failed to produce affordable housing that can be insured at affordable rates. But a New England entrepreneur seems to have innovated a solution - at $68/square foot — about one-half the going rate in New Orleans.

The upshot of the house’s durability and cost is that it’s easy to insure. Just ask Shorty Sneed, a local insurance broker who lined up a deal with Travelers that will cover all Everhouses.

“I have been in this business for 35 years, and we see a lot of big hat but no cattle,” says Mr. Sneed. “But these guys impressed me because they had done their homework.” He says the Everhouse, built “with steel and concrete like a New York skyscraper,” is “far superior” to anything else on the market. According to Mr. Sneed, the annual cost of insuring a $150,000 Everhouse would be $1,355. The going rate for insuring a conventional house of equivalent value would be $3,425.

To put together the Everhouses, Messrs. Sawyer and McKenna are recruiting local residents currently living in FEMA trailers and training them in construction. (Mr. Sawyer struck a deal with the United Brotherhood of Carpenters, which will be sending 20 trainers down to Mississippi.) The hope is that the new construction workers will buy the houses they help build. Mr. Sawyer will pay them union wages for as long as they work for him. Afterwards, the newly trained workers will have a skill that is in demand.

“The plan is very unusual,” says Kay Kell, Pascagoula’s city manager. “John Sawyer is the first developer who . . . looked at this as a complete process. He wasn’t trying to come down here and sell houses quickly – he was here to solve a problem.”

Caveat — this is a startup — it’s not clear from the article how well-proven are the economics and the delivery system. Also, when looking for background on Environmental Building Systems and Everhouse’s, I discovered that both are rather invisible in Google’s index.

Oil prices: Where Are All the Tankers?

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Steve Darden
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I’m not forecasting here — just found this an interesting anecdote:

For a few weeks now, observers have noticed that Iran is leasing tankers and storing oil in them. At about $140,000 a week or so, that is expensive storage. At first, conspiracy theorists were wondering if they were preparing for some kind of war or attack. But more conventionally, it may be they are having problems selling their oil. Their oil is not very high-quality, and there are only a few places that can take it and refine it. India, China, and the US are among the countries with refineries that can take Iranian oil. (And yes, George Friedman of Stratfor tells me some of it does end up in the US from time to time.)

India’s refiners are telling Iran they no longer want their oil, preferring the higher-quality oil that is readily available in the area. So Iran has to decide whether to send it to China or “repackage” it so that it can end up in the US, while they try to get refiners in India to change their minds. Thus, they are leasing tankers to store the oil they are pumping.

I called George about six this evening and asked him about the Iranian situation, as that is a lot of oil that could come on the market at some point, as well as a possible reason that oil supplies are down. George has analysts on top of this situation.

He told me, “John, it’s more interesting than that. It is not just Iran. Today we started checking on how many tankers Iran had, and soon discovered that there is a serious tanker shortage. Lease prices have soared in the past few weeks. It is clear there are a lot of speculators betting that oil is going to rise to $150 or so and are willing to pay very high prices for keeping the oil on the seas waiting for higher prices. It is a speculative boom.”

He then told me about flying into New York in the early ’80s. Outside the harbor were 30 or so tankers just sitting, waiting for prices to continue to increase as they had been doing for some time. When they did not, they all tried to get into the harbor at the same time, and of course they couldn’t. It was the top of the market. Prices dropped, and the owners of the oil had to go to the futures market to hedge what they could. I had heard that story, but George saw it with his own eyes.

Almost everyone (except the stock market) is convinced oil is going higher in the near term. As I noted above, this week’s rally was partially due to short covering by large institutions and companies which had sold production far into the future at much lower prices. They finally threw in the towel and took off their hedges.

Battered Consumers to Console Themselves With TVs

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Merrill Lynch economist David Rosenberg … writes: “In order to get from point A to point B without spending $75 filling up the tank, households now seem bent on cocooning by staying at home to watch television rather than drive to the local theater and shell out more than $11 to watch a film (and an extra $5 on gas to get there). Travel plans have sunk to their lowest in 30 years, so what else is there to do but stay home and watch TV?” –Sudeep Reddy

Uh, read a book? Edit and post your photos on the web? Go sailing? Learn something new?

Commodity prices: how much of the increase is speculation? Part 2

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The market can stay irrational longer than you can stay solvent. — John Maynard Keynes

Yves Smith at Naked Capitalism has contributed to the analysis of the speculative component of commodity prices with this May 27th piece. Smith isn’t a one-handed economist — she looks at both sides of the arguments for/against the importance of speculation. E.g., several economists that I read have been saying “piffle — if it were speculation, then inventories would be growing”. Or as Smith puts it:

The argument against the notion that oil prices are distorted (which clearly is possible given the weight of money in the futures market versus the actual value of the physical commodity traded) is that if prices were too high, you’d see physical hoarding of the commodity.

What exactly are the inventory numbers? That turns out to be very difficult. In part because “the IEA only counts primary inventory as inventory. Anything else is demand … Thus any end user inventory, which is one place you might see hoarding, would not be included as inventories.” Further, there are plausible arguments for reserves as hidden inventories — i.e., don’t pump the oil, leave it in the ground.

George Soros is quoted saying to the Telegraph “Speculation… is increasingly affecting the price”. Of course it does — the question is how much? Soros is a fount of happiness:

“‘We face the most serious recession of our lifetime’” … “You had the nice decade,” he said. “Now that is over and you are in a straitjacket.”

Smith examines how the commodity futures market work [only two markets are visible and regulated, NYMEX and ICE, the rest is OTC and invisible], and how big the markets are relative to the physical commodities [in the case of oil, maybe 20 to 90 times bigger, not counting the OTC futures trading — so could be much, much bigger than that range]. Does that mean that price discovery happens in the futures markets — more significantly than the physical markets? I don’t know.

I thought that arbitrage to the physical was supposed to keep the futures market anchored in physical supply/demand. Is that still true?

There are two arguments made against the speculation thesis. One is arbitrage: if oil was too high, someone would go short the future and buy oil in the cash market cheaper, and earn the arbitrage profit.

The problem with that logic is that price discovery happens in the futures markets; there isn’t another venue for setting the price and thus arbitraging it against futures. Worse, a substantial amount of that trading is either over the counter (hence not reported to US futures regulators) or on the ICE exchange in London (ditto).

Broadly I don’t rely much on “Senate investigations”, but they are sometimes a good source of expert testimony. Smith refers to a 2006 Senate investigation. I found their report The Role of Market Speculation in Rising Oil and Gas Prices: A Need to Put the Cop on the Beat [PDF]. This report seems to summarize much the same information you would assemble from a long session of Googling — including the development of the “invisible” OTC futures markets. I think this quote gets to the problem, on the CFTC Commitment of Traders Report:

Oil industry consultant and analyst Matthew R. Simmons characterizes the COT report as, “In the Land of the Blind, it is the ‘One-Eyed King.’” The report “tells who the players are,” provides a “snapshot of Tuesday market close,” and can “spot some long-term trends (after the fact).” — Matthew R. Simmons, Oil Prices, Volatility and Speculation, Presentation at the IEA/NYMEX Conference, New York, New York, November 23, 2004.

A point to keep in mind — yes, there is unreported futures trading in the OTC market. But I’m pretty sure the institutions Michael Masters discussed in Part 1 of this post are buying on NYMEX or ICE. So their contracts should be visible in the open interest statistics.

The bottom line is that Smith is not confident of the answer to the speculation question either. Her evidence leans pretty heavily in the “speculation important” direction. I’ve been in the “piffle” camp — now I’m waffling, but still inclined towards the fundamentals. If speculation is, in fact, a big part of the recent price runup, then we are likely looking at another bubble bursting. For another view, see Steve Randy Waldman — another excellent essay.

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