Saturday, August 29, 2009

A long-winded reply to the Beast on oil "speculation"

Nice, Beasty. Feel free to drop mulitple meaty, heavy issues on my plate after midnight.

Let me start with this point: the Reuters article tells me little. It states that oil prices "could collapse" as a result of impending changes in commodity regulation, but (A) not does not tell me what those changes are, and (B) glosses over the fact that Goldman Sachs (with all of their direct and indirect influence) sees unfettered growth in oil prices over the next 12 months. The case would not appear to be a slam dunk that new regulations (of some variety) = a decline in oil prices.

The article argues that that "speculation" is leading to increased volatility in oil prices. But who defines "speculation"?

Apparently, a recent Rice Univ. study says 50% of oil traders are "speculators." Noncommercial traders are up to 71% of the volume in the commodity, up from 30% at the beginning of the decade. Sounds ominous.

But let's remember a few things: There has been a proliferation of financial instruments--ETFs, ETNs, managed futures programs, alternative asset class mutual funds, just to name a few--that are allowing the both the retail investor, and the institutional money manager, to participate in the oil market as they never have before. Investors with brokerage accounts can now add a GSCI Commodity ETF, or a Crude Oil linked exchange traded note, to a portfolio without the magnified risks involved with options or futures trading. Institutional money managers can find liquid investments to meet specific goals, such as a low correlating asset to U.S. stocks that can bow the efficient frontier can create more favorable risk-return relationships.

Are these people speculators? If the Reuters article's implied definition of speculators as "noncommercial traders" holds up, then yes. But that hardly seems to meet the idea that most folks have of speculators.

My guess is that, to the casually informed observer, "speculator" means something else entirely. They would be considered gamblers who bet long or short positions becuase they: (1) enjoy high-risk, high-reward propositions; (2) have inside information; (3) are seeking to maniuplate the market; or (4) all of the above.

This definition hardly seems to fit the way many, if not most, investors seem to be incorporating oil into their portfolios currently: as a hedge against a dollar collapse, and/or a long-term play with an eye towards the BRIC nations economic growth and global resource scarcity.

But, you may be wondering, what to make of the seemingly irrational run up of oil from 50 to 150 in 2008, only to tumble back to its starting point? Did the supply/demand balance of oil, from an economic standpoint, change that drastically, and that quickly?

Probably not. But when viewed in light of what was going on in the broader capital markets, there is some logic to it. After all, by mid '08, U.S. and foreign stocks had already suffered large losses, and the worst was yet to come. Equities were losing their appeal. Fixed Income values were suffering as credit spreads balooned, and investors worried about a flood of defaults over the horizon. Short-term cash instruments were paying near zero interest rates. For a brief period later in the year, treasury bill yields actually went negative, meaning investors were willing to tie up their money for some period of time, with the guarantee of a small loss, but preferred that to the risk of larger losses elsewhere.

Amidst this backdrop, oil seemed to have a lot going for it. It had positive price momentum for a time, while equity markets were moving in reverse. The "peak oil"/resource scarcity story resonated with many investors, who felt the commodity would sustain its value even if certain economies were contracting. After all, the "awakening" of the Chinese and Indian economies were creating vast new demand for oil, and there would continue to be plenty of price support for oil if the American economy (and dollar) hit the skids, b/c SWFs might decide it makes more sense to stockpile a valuable asset if prices decline, than invest in low-interest rate notes that are creating cash flows in a diminishing currency.

Basically, plenty of investors, including hedge funds and institutions, looked out there and saw oil as the one reasonable "story" they could justify loading into when the rest of the world seemed to be going down the drain. Hence, a bubble shift.

The problem with defining the above ativity as "speculation" is that it does not differ from what goes on in any other marketplace: equities, fixed income, real estate, etc.

If people think that an asset can appreciate or improve their overall portfolio, who is to tell them they are wrong? Should regulators make the call that a stock, commodity, or personal residence is "overvalued" and investors must be turned away? That sounds good if you were the person loading into oil at $140, but how would it sound if you were the person trying to buy Microsoft in 1987, or Dell in 1993, when the stocks had already appreciated by hundreds of percent from their IPO price, and plenty of folks probably were screaming their P/E's were unsustainable. If you were locked out of those stocks by regulations that said "no more speculators", you would have missed out on the thousands of percent that the stocks appreciated from there. And more importantly from the policy perspective, you would have choked off the easy and cheap availability of capital to these firms, and potentially stymied their growth. Poor policy when one considers how integral these firms and their products were in improving productivity in the economy at large. To me, I'll always trust a free-market price over the judgment of some bureaucrat to tell me how valuable any asset is--be it a stock ot the future delivery of a barrel of oil.

The flip side is when the investor is colluding with others, or even acting on their own to intentionally skew the price of an asset for their own gain. How to differentiate this type of investor from the type described above is the job of a regulator, in a nutshell. But that is the case where regulations and regulators can be worthwhile. In those circumstances, it becomes a simple cost-benefit analysis: is the money we are spending on enforcement acutally worth it? In reducing market manipulation, are we actually producing a net gain to the economy through a more efficient distribution of capital, that it more than counterbalances the cost of enforcement?

Unfortunately, on this last point, the Reuters article gives me little to go on. What is the cost? Who are these manipulators, and what strategies can you lay out that would lead me to believe they could be caught and/or deterred from engaging in nefarious behavior at an acceptable cost to the taxpayer?

I don't see much in the article addressing those issues, only a range of opinions from the investment banks about what could happen. Brodman's comments hit closest to home:

"there's a growing political imperative out there. An oil price rise of $30 a barrel would offset 40 percent of the stimulus spending. That's not what these countries are looking for"

Just as I thought, it's concern that Obama's political narrative (e.g., the "success of the stimulus") could unravel that is driving the train. Who knows whether Brodman's $30 a barrel increase would have happened on its own; what's important to the administration is that it can't be allowed to happen. And rather than increasing the supply of oil, we'll just put de facto price caps in place by gutting the buy-side of the market. Because price controls have always worked so well in the past.


ManBeast said...

Thanks for setting me straight. My instinct against regulation will remain intact.

Fredo said...

In fairness, I'm not universally against regulation. I might not even be against these new regulations. I'm just skeptical b/c of the way the timing coincides with the new administration, and their other political goals. In addition, the Reuters article spells out neither the nature of the new regulations are (i.e., is this a Nixonian "secret plan for success"), nor the chances that they end up succeeding.

Fredo said...

Also noteworthy: remember Obama's statement on high oil prices during the primary campaign? "I think they rose too quickly", or words to that effect. The upshot being that while he wanted to sound like he was on the side of consumers angry over $4 gas and blaming Bush, he actually agrees with the idea that higher oil prices are helpful as a means to re-train the American consumer. Less oil, more alternative energy and conserve on consumption.

While I'm all for more energy options and smart conservation, the idea of getting there through bankrupting the average citizen (and industrial producers) is absurd. Why not get the alternative energy supply up and running before putting the economy behind the 8-ball of rising oil costs? Oh yeah, b/c the left-wing Gore-icans take it as a matter of faith that the Earth is 6 years, 150 days, and 13 hrs from extinction if we don't act NOW.

And into the hands of those who believe in this radical form of environmentalism, we're going to surrender control of the price of oil. Jobs and growth be damned.


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Always sniffing for the truth

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