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.

It is rare when I read something with which I agree 100%. Here is such a case, this succint interview with Jeremy Grantham (in the Globe & Mail).

You draw comparisons between what’s happening today and the start of the Great Depression.

We’re in that 1929-30 window, where we’ve had a shock to the system. But the secondary effects - less consumption, lower profit margins, lower GDP, lower employment, lower global trade - are beginning to work through the system. They’re steadfastly ignored because they’re still quite slight. It takes a year, 18 months [or] even longer for some of these effects to show up.

As the article notes, Jeremy, like me, got out of the NASDAQ bubble way too early. However, it is encouraging to note that his analysis and mine come up with the same answers.

The program pumpers are able to move the market, as always, but as soon as they stop it sags. The problem is the banks. The banking index ($BKX) and the regional bank HOLDRs (RKH) are well below their March lows. People are starting to realize how widespread the problems are. The problem assets of the big money center banks like Citi are well known, as are the mortgage problems of the S&Ls like WaMu. But also coming to light are the developer and builder loans. These are especially poisonous because, like neg-am mortgages, the banks often add the interest to the loan (called an interest reserve) during its life. This means everything looks good until the project is finished, but unsold. All of a sudden the developer needs to start paying down the loan, but he can’t. Something like 60-70% of the assets of the smaller banks are real estate related.

Even without actual defaults, these banks are going to have their balance sheets loaded with loans just sitting there waiting for something good to happen. And that means their capacity to make new loans will be impaired. Given that this economy depends on perpetually increasing debt, this is a huge problem and the semi-smart money is starting to figure this out. (The smart money is long gone, or short; the dumb money is buying “beaten-down values” from the semi-smart money).

And the TICK skyrockets as yet another jam job program runs. In the meantime, members of Congress are leaning on the CFTC to find evidence of “speculation” in the oil market. Morons. What do they expect? They let the Fed run the dollar into the ground, and then get all surprised when people put money into something they think will keep its value

Don Coxe’s May Recommendations. Don’t blame me, blame him.

The PCE statistics were released this morning, including a claim that PCE inflation for April was 0.2%. Including food and energy. All I can say is that the government inflation figures are becoming more and more unrealistic in the face of rapidly rising prices.

Obviously it is in the government’s interest in many ways to keep reported inflation low. And in my view, they’ve moved beyond statistical games to outright falsification.

The University of Michigan consumer survey this morning reported that inflation expectations were the “highest in 20+ years.” I guess the consumers aren’t fooled.

For a good read on the actual effects of energy price inflation, Desmond Lachlan:

Past experience suggests that if the recent run-up in oil prices is sustained, it alone will subtract more than a full percentage point from U.S. GDP growth in 2008. That experience also suggests that, over the longer haul, the recent doubling in oil prices will subtract another full percentage point from U.S. GDP growth beyond 2008. Since these oil price increases have occurred in the context of a housing bust and a credit crunch, one must assume that the U.S. economy is facing the real risk of a recession that is both deeper and more protracted than the postwar average. And if the recent spike in oil prices threatens to tip the U.S. economy into recession, just imagine what a further run-up in prices—say, to the $150 to $200 a barrel range—would do.