Sometimes I Wonder
June 23rd, 2008 by 
reality
Paul Krugman, New York Times columnist and supposedly an expert, heaps scorn on the idea that trading in futures contracts might affect the price of a commodity, specifically, crude oil.
Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil — the actual price people pay to have a barrel of black gunk delivered?
The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference.
Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. And that’s true no matter how many Joe Shmoes there are, that is, no matter how big the positions are.
Paul, that is nonsense and if you don’t understand the futures markets you have no business writing about them. Some futures contracts are bets. An obvious example is the S&P 500 futures contract, which is a bet on the value of the eponymous index on a future date. However, the crude oil contract is not. It is a contract for the delivery of 1000 barrels of light crude oil to Cushing, Texas. Every contract is between a buyer and a seller of crude oil.
Any effect on the spot market has to be indirect: someone who actually has oil to sell decides to sell a futures contract to Joe Shmoe, and holds oil off the market so he can honor that contract when it comes due; this is worth doing if the futures price is sufficiently above the current price to more than make up for the storage and interest costs.
As I’ve tried to point out, there just isn’t any evidence from the inventory data that this is happening.
Paul, this is also nonsense. The reason it is called a futures contract is because it is about the future. Futures contracts originated as early as the 17th. century in Japan for the delivery of rice. A farmer making the financial commitment today to plant his rice crop wants to be assured that he will be able to sell his harvested crop, and at a price where he will make a profit. So he sells a futures contract to lock in a sale of his future harvest. He doesn’t have the rice until he has harvested his crop. If his crop fails, he will have to buy rice from some other farmer to settle the contract (or pay someone else to take over his commitment). It is common for lenders financing mines to insist that the mining company sell the output of the mine in the futures market. Oil producers can sell their future output for the same reasons and in the same way. None of these futures sellers hold inventory against the contract, they are simply pre-selling their output. It is not rocket science to figure out that, for example, when a futures contract is deliverable, and the seller doesn’t have enough production because of, say, a strike in Nigeria, that seller will have to go to the spot market to buy crude to meet his commitments and thereby affect the spot price. Or maybe the seller was the aforementioned Joe Shmoe, who never had any crude to deliver in the first place? That’s the difference between a cash settled futures contract, which Joe could settle from his bank account, and the physically settled contract, where Joe has to go buy some crude oil. As the Nymex.com site says:
Crude oil is the world’s most actively traded commodity, and the NYMEX Division light, sweet crude oil futures contract is the world’s most liquid forum for crude oil trading, as well as the world’s largest-volume futures contract trading on a physical commodity. Because of its excellent liquidity and price transparency, the contract is used as a principal international pricing benchmark.
Now it is true that there are crude oil contracts that are cash settled, that are just bets. And it is also true that a seller of crude futures can offset his commitment at any time by buying a matching contract. But it is naive to think that the futures market does not affect the spot price.
Posted in Commodities, Energy, experts | 
June 24th, 2008 at 3:07 am
If I correctly understand, the question of the day is whether a better regulated futures exchange can improve price of oil.
Theoretical answer - price can be “improved” if only market mechanism can be improved. It’s not impossible. But if the talk is about protection of markets from wrong/bad investors/speculators (Shmoes and Shmoe’s pension funds), then it’s simply a call for one additional form of protectionism.
Protectionism, by definition, is the way better organized groups robbing the remaining society. Overall effect to economy and common wealth is negative, of course.
June 24th, 2008 at 7:32 am
Mostly politicians looking for a scapegoat to shift the blame away from government incompetence.
June 24th, 2008 at 11:04 am
It seems to me that a simple way to regulate all of the markets in finance and banking is just to lower the amount of leverage allowed to 2:1. This works with Joe Shmoe’s margin account, why can it not work with all other trading.
It seems to me that excessive leverage and credit is what got us into this mess and is what is continuing to allow the bubbles to get blown. Let’s take away the leverage. It will also strengthen our banking systems if the fractional reserve requirements are 50%.
June 24th, 2008 at 3:16 pm
To iTod
Modern economic is complex, and leverage is a natural part of high organization. Obviously leverage is related to risk. Business in general is (and should be) risky, as we know.
Recent deleveraging of financial-nonsense investments does not mean business (even financial) should became simple and understandable to everybody, nor the levels of leverage in anything should be regulated.
Nobody should have the monopoly or exceptional rights to regulate business contracts, leverage, deleverage, money, credit, IOU’s, financial reliability ratings. The free market can do it by itself.
The main reason of recent (global) financial crisis is not too big leverage, but the injustice, the deficit of freedom in modern societies, and particularly in modern finance.
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By the way, I feel it’s useful to think about a leverage as a general function of business complexity from pure practical investment perspective. It helps to avoid some unnecessary dogmatism and risk.
June 24th, 2008 at 8:40 pm
Vytas,
Leverage IS regulated. The Basel agreements and fractional reserve system set capital limits as does the FED on margin brokerage accounts. Off balance sheet crap is a way around the regulations and look what it has done for investment funds, Enron and the banks. Easy credit spurs excessive leverage which creates bad investment and moral hazard.
There is no free market in existence in the world and probably never has been one. It is capitalist marketing bullshit. The existing market is socialist capitalism. The “free market” capitalists take excessive risks, keep the winnings and socialize the losses on the taxpayer.
Free market systems should not have a central bank controlling and distorting interest rates and monetary policy, they should not have tax policies that distort savings and investment and subsidize industries such as petroleum, agriculture, healthcare, housing, etc. Free markets should not allow powerful interests to game the system so they can commit fraud (california energy crisis, housing bubble, etc.).
Regulation is an important requirement of free markets to maintain an even playing field so they are truly free. What we have now is one step from a nationalized banking system. It is a complete fraud. Regulation and some planning is required to make sure that a free market economy meets the needs of society otherwise it inevitably ends in disaster. It is the balance of regulation and planning with freedom that is difficult to impossible to achieve due to the inevitable corruption.
Capitalists don’t want a free market. They want a market that they can control and manipulate. Adam Smith himself felt that capitalists were just too greedy and whenever they got together they would collude. When I hear people talk about a free market in the context of the USA I want to puke. We have no such thing.
June 25th, 2008 at 4:06 am
To iTod:
“Leverage IS regulated.” - There are regulation frameworks for some well understood sorts of leverage, and as we know even that frameworks are widely violated by all leading financial institutions. “It is a complete fraud.” Cannot agree more.
Do you thing we need better regulation frameworks (lower leverage levels)? Or may be better regulation, which could be impossible to circumvent for major players?
I am convicted we better need deregulation and even more market freedom, especially more and better free market information (honest competition field for rating agencies).
And the term ‘leverage’ means not only banking leverage. For example employee compensation schemes based on stock options. Doesn’t society need more regulation there too? Sarbanes-Oxley Act obviously is not enough, society needs something more and better?
What personal level of leverage has average investment fund manager? May be it should be regulated to 2:1?
Let’s prohibit any investment, where fund managers personal stake is less than half of capital. Or at least do not allow them to invest in strategically important sectors (oil futures). Or allow to invest to anybody, but just require leverage of oil futures not to be less than 50%?
What about natural gas, coal, alcohol, uranium?
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My personal choice would be total deregulation of everything and freedom of contract to everybody. Central regulation and control is just a wast of resources, including human time.
June 25th, 2008 at 4:58 am
And speaking practically, capital always flows from over regulated jurisdictions to less regulated, and even from ~modestly regulated exchanges to “black pool” clearing houses.
No way to prevent this. The only ones you can ~efficiently regulate are poor Joe Shmoes. These are not capitalists, and can be regulated up to death.
June 25th, 2008 at 5:16 am
OK, may be not up to death, but to “acceptable” level of consumer demand and price inflation, by the way rising the level of ‘economic productivity’, as it is defined at present.
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I should stop this flow of my anarchistic comments, before Mr.Reality not decided to block me as comment spammer :)
June 25th, 2008 at 10:21 am
I think that the problem of regulation is not that regulation is unneeded but that anytime the govt. gets involved they introduced something that is so manipulated by special interests that it completely distorts the market it was intended to regulate. I don’t know if it is possible to have regulation that really works but I know that completely free markets will never happen and what we have as a result is an abomination.