Scott Irwin takes down Michael Masters

Econbrowser is pleased to host another contribution from Scott Irwin, who holds the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois. Today Scott offers a critique of a recent report by Michael Masters on the role of commodity speculation.

The Misadventures of Mr. Masters: Act II
by Scott Irwin

The impact of speculation, principally by long-only index funds, on commodity prices
has been much debated in recent months. The main provocateur in this very public
debate is Mr. Michael Masters,
a hedge fund operator from the Virgin Islands. He has led the charge that
speculative buying by index funds in commodity futures and over-the- counter (OTC)
derivatives markets has created a “bubble,” with the result that commodity prices,
and crude oil prices, in particular, far exceed fundamental values. Act I of the
Masters farce was his testimony to the
Homeland Security Committee of the U.S. Senate in May of this year. Act II is now
upon us in the form of a lengthy research report co-authored by his
research assistant, Mr. Adam White, and his testimony this week to a subcommittee of the
Energy and Resources Committee of the U.S. Senate.

My purpose in writing this post is to show that Mr. Masters’ bubble argument
does not withstand close scrutiny. He first makes the non-controversial observation
that a very large pool of speculative money has been invested in different types of
commodity derivatives over the last several years. The controversial part is that
Mr. Masters concludes that money flows of this size must have resulted in
significant upward pressure on commodity prices, which in turn drove up energy and
food prices to consumers throughout the world. This argument is conceptually flawed
and reflects a fundamental and basic misunderstanding of how commodity futures and
related derivatives markets actually work. It is important to refute Mr. Masters’
argument since a number of bills have been introduced in the U.S. Congress with the
purpose of prohibiting or limiting index fund speculation in commodity futures and
OTC derivative markets.

The first and most fundamental error Mr. Masters makes is to equate money inflows
into futures and derivatives markets with demand, at least as economists define the
term. Investment dollars flowing into either the long or short side of futures or
derivative markets is not the same thing as demand for physical commodities. My
esteemed predecessor at the University of Illinois, Tom Hieronymus , put it this
way, “for every long there is a short, for everyone who thinks the price is going
up there is someone who thinks it is going down, and for everyone who trades with
the flow of the market, there is someone trading against it.” These are zero-sum
markets where all money flows must by definition net to zero. It makes as much
logical sense to call the long positions of index funds new “demand” as it does to
call the positions of the short side of the same contracts new “supply.”

An important and related point is that a very large number of futures and derivative
contracts can be created at a given price level. In theory, there is no limit.
 This is another way of saying that flows of money, no matter how large, do not
necessarily affect the futures price of a commodity at a given point in time. Prices
will change if new information emerges that causes market participants to revise
their estimates of supply and/or demand. Note that a contemporaneous correlation can
exist between money flows (position changes) and price changes if information on
fundamentals is changing at the same time. Contrary to what Mr. Masters asserts,
simply observing that large investment has flowed into the long side of commodity
futures markets at the same time that prices have risen substantially does not
necessarily prove anything. Mr. Masters is likely making the classical statistical
mistake of confusing correlation with causation. One needs a test that accounts for
changes in money flow and fundamentals before a conclusion can be reached (more on
this later).

Mr. Masters’ second error is to argue that index fund investors artificially raise
both futures and cash commodity prices when they only participate in futures and
related derivatives markets. In the very short-run, from minutes to a few days at
most, commodity prices typically are discovered in futures markets and price changes
are passed from futures to cash markets. This is sensible because trading can be
conducted more quickly and cheaply in futures compared to cash markets. However,
equilibrium prices are ultimately determined in cash markets where buying and
selling of physical commodities must reflect fundamental supply and demand forces.
This is precisely why all
commodity futures contracts have some type of delivery or cash settlement
system to tie futures and cash market prices together. (This is not to say
that delivery systems always work as well as one would hope. See my earlier
post here.)

It is crucial to understand that there is no change of ownership (title) of physical
quantities until delivery occurs at or just before expiration of a commodity futures
contract. These contracts are financial transactions that only rarely involve the
actual delivery of physical commodities. In order to impact the equilibrium price of
commodities in the cash market, index investors would have to take delivery and/or
buy quantities in the cash market and hold these inventories off the market. There
is absolutely no evidence that index fund investors are taking delivery and owning
stocks of commodities. Furthermore, the scale of this effort would have to be
immense to manipulate a world-wide cash market as large as the crude oil market, and
there simply is no evidence that index funds are engaged in the necessary cash
market activities.

This discussion should make it crystal clear that Mr. Masters is wrong to draw a
parallel between current index fund positions and past efforts to “corner” commodity
markets, such as the Hunt brother’s effort to manipulate the silver
market in 1979-80
. The Hunt brothers spent tens of millions of dollars buying
silver in the cash market, as well as accumulating and financing huge positions in
the silver futures market. All attempts at such corners eventually have to buy
large, and usually increasing, quantities in the cash market. As Tom Hieronymus
noted so colorfully, there is always a corpse (inventory) that has to be disposed of
eventually. Since there is no evidence that index funds have any participation in
the delivery process of commodity futures markets or the cash market in general,
there is no logical reason to expect their trading to impact equilibrium cash

A third error made by Mr. Masters, and unfortunately, many other observers of
futures and derivatives markets, is an unrealistic understanding of the trading
activities of hedgers and speculators. In the standard story, hedgers are benign
risk-avoiders and speculators are potentially harmful risk-seekers. This ignores
nearly a century of research by Holbrook Working, Roger Gray, Tom Hieronymus, Anne
Peck, and others, showing that the behavior of hedgers and speculators is actually
better described as a continuum between pure risk avoidance and pure speculation.
Nearly all commercial firms labeled as “hedgers” speculate on price direction and/or
relative price movements, some frequently, others not as frequently. In the parlance
of modern financial economics, this is described as hedgers “taking a view on the
market.” Just last week, when commenting on new
survey results of swap dealers and index traders
, the CFTC stated that, “The
current data received by the CFTC classifies positions by entity (commercial versus
noncommercial) and not by trading activity (speculation versus hedging). These
trader classifications have grown less precise over time, as both groups may be
engaging in hedging and speculative activity.” (p. 2)

What all this means is that the entry of index funds into commodity futures markets
did not disturb a textbook equilibrium of pure risk-avoiding hedgers and pure
risk-seeking speculators, but instead the funds entered a dynamic and ever changing
“game” between commercial firms and speculators with various motivations and
strategies. Since commercial firms have the considerable advantage of information
gleaned from their far-flung cash market operations, they have traditionally
dominated commodity futures markets and speculators have tended to be at a
disadvantage. (If you are skeptical, I recommend reading the classic study by
Michael Hartzmark about who wins and loses in futures markets.) In this light, entry
of large index fund speculators has the potential to improve competition in
commodity futures and derivatives markets, particularly as index funds become
smarter about moving in and out of their positions.

I believe the points made here already build a persuasive case against Mr. Masters
and his bubble theory. But there is more. It is possible to conduct a formal test of
the hypothesis that money flows from index funds aided and abetted the recent boom
in commodity prices. This can be done by running what are known as “Granger causality” tests
between futures price changes and index fund position changes in commodity futures
markets. To begin, the evidence available before the current commodity price boom (
) would lead one to be highly skeptical of the hypothesis that positions
for any group in commodity futures markets consistently lead futures price changes
(this will not be true for individual traders with real skill). The CFTC has
conducted thorough Granger
causality tests in the crude oil futures markets
, and guess what? They found
absolutely nothing using non-public data on the daily positions of commercial and
non-commercial traders. I am working with a Ph.D. student here at the University of
Illinois to extend this testing to other commodities using the same daily database
of trader positions, including those for index fund traders. As you might guess, I
do not expect to find much evidence of a connection between index fund trading and
futures price movements in other commodity markets. If we find anything, I expect
the relationship to be small and fleeting.

While it is always possible to dither over the power of Granger causality tests or
whether the specifications adequately control for changing fundamentals, I think
most unbiased observers will reach the same conclusion: there is virtually no hard
evidence to date of a link between index fund investment and commodity price
changes. Isn’t it about time for Mr. Masters to exit stage left?

35 thoughts on “Scott Irwin takes down Michael Masters

  1. Joseph

    Masters is a guy who incorporated in the Virgin Islands to reduce taxes and has been a hedge fund manager for a whole 12 years. Certainly we should defer to his vast experience. And his testimony was completely without bias, despite the fact that his fund has made huge, risky bets on United Airlines, American Airlines, Delta and U.S. Air. Seeking government regulation against speculators to push down the cost of fuel is merely a coincidence.

  2. tinbox

    It is clear that indexes brought new investors into commodities-new demand into commodity futures. So, yes, the market supplied new shorts. And so academics need to explain why it didn’t require higher prices to draw in the new sellers. Particularly since there are no “index shorts” and the index buyers must find offsetting sellers in each individual market.
    For example, a college endowment decides to allocate $50MM to a commodity index-the investment is made across commodities including, say, 100 sugar futures. Why would a seller of 100 sugar contracts suddenly materialize at current market prices? If the college decides to triple the allocation to commodities, now the seller is happy to sell an extra 200 at the same price? If the college liquidates its position, now the former seller wants suddenly to buy everything back?

  3. ReformerRay

    Where did I read that the Saudia oil minister looks at the price in the futures market to determine the price for selling his oil?
    Is this just an urban legend? How do the Saudias establish the price for their oil? Auction? Bids? What?”??
    You say: “In the very short-run, from minutes to a few days at most, commodity prices typically are discovered in futures markets and price changes are passed from futures to cash markets.”
    Then you say prices are ultimately determined in the cash market. That sentence suggests that something intervenes between the futures price and the cash price. In that case, some qualification is needed for he phrase “price changes are passed from futures to cash markets”.
    Please explain.

  4. GNP

    Masterful. Ordinary economists do not understand futures and derivatives markets particularly well. Perhaps we ask too much of the general public?

    “You may be the most powerful guy in Washington right now,” Sen. Claire McCaskill told Mr. Masters at a June hearing about the impact of investments on oil prices. -WSJ Now that is a scary thought.

    Up here in Canada, our economist-trained policy wonk Prime Minister Stephen Harper recently cut the federal value-added sales tax (GST) during an out-of-control commodity-driven boom, and in the current federal election campgaign has promised to cut diesel fuel taxes, and is now promising a $5,000 giveaway to new homeowners. (Sound familiar?) A while back, he was quoted as saying: “Trust me, I’m an economist.”

    Western Canadians love PM Harper. But then they appear ideologically disposed to privatizing public wealth–quickly–and seem to take some perverse enjoyment from highly volatile economic fluctuations.

  5. Wall Streeter

    Did Scott Irwin participate in the crude oil run-up? Yes or no?
    His piece is quite laughable for those who were investing heavily in crude oil futures. And, no, the demand & supply arguments don’t cover the spread, so let’s not jump back to talking about that elementary nonsense.

  6. Scott Irwin

    Reformer Ray,
    You raise a good point that deserves further clarification. In the short-run the evidence is pretty strong that causality in terms of price discovery in commodity markets runs from futures to cash. When I stated that equilibrium prices ultimately are set in the cash market, I meant this to imply that if there is a notable difference in price levels between futures and cash prices for a commodity, then as my old friend Tom Hieronymus was fond of saying, the matter would be settled by commercial forces in the cash market. To summarize my view, the norm is for prices to be discovered in futures markets (at least for larger, liquid commodity futures markets) and then the discovered price is passed on to the cash markets. However, if for some reason, there is a “large” wedge between futures and cash values, then the cash price is where the true fundamental value is discovered and the futures will eventually have to move back towards this value. This is not as neat of explanation of price discovery as one finds in most academic papers on the subject, but I think it is realistic.

  7. anon

    “These are zero-sum markets where all money flows must by definition net to zero.”
    Well, that’s interesting. So are stock markets. And Nasdaq 5000 wasn’t speculation?

  8. jg

    Spurious correlation, then, the cut in the Fed Funds Rate last fall and the rocketship ride up in gold and oil? Spurious correlation again that, when we began this latest phase of the credit contraction six weeks ago or so — resulting in the demise of LEH, FNMA, FMAC, AIG, and with hedge funds ‘blowing up’ in the background — that gold and oil came running down?
    Looks to this layman like speculation funded indirectly by the Fed, channeled into commodities, and only squeezed out as banks and hedge funds failed.
    But, hey, I believe in the Plunge Protection Team, too, who appear, to me, to use S&P 500 futures purchases to keep the market from crashing.

  9. Energyguru

    Scott, you leave out a couple of pieces of the puzzle.
    First, let me say to many, Mr. Masters doesn’t have an agenda other than to see a serious problem rectified.
    Now, Scott, you do not seem to mention that the creators of the “Index Funds”, old Goldie Himself, in their propectus to invest in the GSCI cites the creation of “the passive long investor” and says that this is possible because they will provide a “swap” for them. So where is your answer to the role the swap plays in the mix? For every long there is a “swap” and for every ‘swap’ there is a ______??
    Further, in the propectus (June 2005) the language suggests that this in order for the Index to work, there needs to be the PLI, and that prices of the commodities need to, and SHOULD rise over time. If they don’t there simply is no need to be in the index, the goal being to allocate a portion of one’s fund to this ‘asset class’, leaving it in the fund. Well, since the futures contracts have short shelf lifes, someone has to intercede and take the PLI’s contract to spot. Enter the swaps dealer….this is where your trail seems to end. The other blogger asks also, Where’s the “Index Short”??
    So by design, the creator of the Index Fund has to play a role in keeping the Pension Fund in the game….the rises have to go up or there is No Need to Stay invested…
    Also, inflation is defined as Too many dollars chasing Too few goods….and the arrival of a lot of new pension, endowment and sov wealth fund money at the doorstep created new demand for a certain amount of goods-(physical barrels of oil)-thus creating a chase for futures contracts…hence the rise in the price…
    Don’t you think that maybe the fast decline in prices was the fact that the swaps issued in April and May and June went over the top of the price peak of early June and came due quickly on the spot side where real demand price was pulling it down. So, maybe the rise was due to the CIF and influx on new money and the fall was real world demand prices and the squeeze was on the firms holding the swaps…..course these are the managers of all the contracts held by the players and they are savvy enough to have set up short positions in May and June to offset the swaps that they took in, thus neutralizing the losses.
    But, some of their fellow WS buddies who were playing the futures games and were not managers of the funds and didn’t know ‘that the big short’ was going to occur in July, got burned abd have crashed.
    Don’t you think those golden boys had a hand in all this? They pulled a good one on the gasoline futures in the funds a year ago and there has been something hideous about those insane $149 to $200 prices they kept putting out in their “analyst reposts”, that got so hyped, this spring….
    And finally, are you not aware that these financial houses that run the Index Funds and swaps have physical storage for oil, etc. Pipelines and even have an interest in a refinery? Hmmm…
    Finally, there is a lot of time, energy and money going into making sure that the CFTC does NOT do a complete and thorough investigation into just what went on this year in oil trading, especially in looking at the activities of the firms that manage the Index Funds and swaps.
    I look forward to your response.

  10. Climateer

    Nice exposition.
    I am confused when market participants like Paul Tudor Jones and Wilbur Ross say that there was indeed a bubble and bet money based on their theses.
    Does Professor Irwin participate in the markets with his own money?
    How is he positioned today?
    Still learning. Thanks.

  11. Stormin Norman

    Do what? Silver can’t be manipulated? Boy have you got some research to do Mr. Irwin.
    I will use the silver market as that was one of your examples – back during the building of the first nuclear bombs silver was a main ingredient for the cyclotrons to process the nuclear material – the general in charge of the manhattan project needed massive amounts of the stuff – he went to all the finance boyz and had them play with the markets so that the nazis and japs wouldnt catch on that large amounts of silver were leaving the market place – effectively they were able to keep the price of silver unchanged for several years even though they had taken most of the supply out of circulation – there was a tremendous shortage – now who was it that said you cant keep a big conspiracy like that secret for long? (snicker) anyways after the war they dismantled all those cyclotrons and the silver was returned and general market participants never knew. has a lot to say about oil and the dieoff of modern civilization. I watched this movie once with matt damon about “the good shepherd”
    Sorry professsor Irwin, guys with guns that kill and like to keep secrets often seem to have the edge over academics in their ivory towers with their models and theories.

  12. MarkS

    James – The CFTC arguement that declining inventories should occur with higher prices is dependent on the elasticity of demand. If you look at Figure 14 in the CFTC report, US oil inventories went from the top-end to the bottom-end of their Historic Range during the financial market volatility beginning in early 2007. (Producers, realizing a recession was coming began to trim inventories). Falling inventory and falling yields in other investment classes was in my opinion, the stimulous for the 2007-08 oil price spike.

    Tinbox – You da man! Thanks for injecting some common sense into the discussion. It was amazing how fast oil prices dropped in July when the SEC banned shorts on financials… this forced hedge funds to unwind their long positions in oil at the same time. Now, with the liquidity crisis, Hedge Funds have lost their line of credit. They can’t re-enter the oil commodity market with the same leverage as they had previously…

    Climateer – Your investment blog is easily the most entertaining I’ve ever encountered… Or maybe I’m over-stimulated after watching Economists Warn Anti-Bush Merchandise Market Close To Collapse.

  13. markg

    I would think that anything (oil, stocks, houses, tulip bulbs) could have the price driven by speculators anywhere between the marginal cost of production and the price users are willing to pay or can cost effectively substitute another item. I agree the price will eventually move to some equilibrium, but I do not think this is a matter of hours or days. It could be months or years depending on how long it takes for supply or demand to adjust.

  14. EnergyGuru

    Tinbox –
    You point below is definitely a part of ‘the myth’ and very much supports the fact that Non-Traditional FUND Specs have been very heavy in the market the past 12 months.-
    “It was amazing how fast oil prices dropped in July when the SEC banned shorts on financials… this forced hedge funds to unwind their long positions in oil at the same time. Now, with the liquidity crisis, Hedge Funds have lost their line of credit. They can’t re-enter the oil commodity market with the same leverage as they had previously…”

  15. jg

    Oh, and the price action in gold and oil these last two days sure seems speculator-driven, funded by the cheap money that the central banks are flooding the financial system with.
    How else do you explain the big move in oil these last two days?
    Rate cuts/emergency lending –> inflation.
    Thanks, Ben, you schmuck.

  16. Brian D. Quinn

    I generally am skeptical of most of the theoretical arguments as to why or why not new money in the commodities futures markets could have been responsible for the huge price increases we saw in the broad spectrum of commodity prices over the past few years, particularly in the last year before they tumbled. I trust what the markets tell us about these movements relative to inventory and other fundamentals.
    I will use the example of natural gas:
    As you can see, natural gas from about March until July that carried it in a very steady pattern from about $9 to around $13.50. In little more than a month natural gas was below where it had begun the rally at, plunging extremely dramatically almost straight down without a major pause on the way. It that time, there was no meaningful change in the supply and demand situation either way. I can see no cause other than speculation that is even possible to explain this movement.
    I do agree that in the long run it is impossible to keep prices up through speculation. Indeed, the collapse in commodities prices in the last two months bears that out.
    If the commodities rally was not a bubble, I fail to see what possibly could be. The charts demonstrate a classic bubble pattern and the rapid collapse can not be ascribed to any fundamental change in inventories or demand data. Some things have happened at the margins to be sure, but not to that extent.

  17. DickF

    Scott Irwin,
    Outstanding discussion. I am surprised that so many cannot understand such a clear analysis. It seems that there is a persistent desire to equate futures contract with actual deliveries.
    Folks, if you buy a futures contract at twice the price of the commodity and you can never sell it to someone else, you will receive delivery on your doorstep of what ever the commodity is and you will pay twice the price for the commodity. Not a smart move.

  18. TedK

    >>Folks, if you buy a futures contract at twice the price of the commodity and you can never sell it to someone else, you will receive delivery on your doorstep of what ever the commodity is and you will pay twice the price for the commodity. Not a smart move.>>
    What if you think prices will keep going up? You may think that even twice the price is worth if there exists an expectation prices will only go up more? As happened during the housing bubble?

  19. Josh Stern

    Here’s a link to a blog article about the somewhat parallel gold and silver markets.

    I don’t know for sure which theories are correct, but I don’t find anyone’s arguments entirely persuasive. It seems to me that there must be some threshold over which if enough people buying and selling anything (including buyers and sellers in the physical market for commodities) come to believe that trending (or even oscillating) TA is predictive then TA trends (or oscillations) become part of supply/demand fundamentals. In the case of the gold story, it may be true that even if the bulk of evidence about supply/demand for gold was bullish in a given period, if enough sellers believe that the futures smart is smart and that its downward trend is predictive, then they may be willing to sell at a lower price or wait to buy.

    I believe that economic analysis should not take trading psychology as something which remains constant over time. It may well behave differently in different periods, and thus it could be true that speculator beliefs drive prices in time period A and not in time period B, and an analysis which starts from the premise that it must be either a factor in both periods or neither may start from a false premise.

  20. HB

    No matter how visible, it seems second-rate to address a weak proponent of some idea instead of the first-rate proponents.
    In other words, if I want to challenge an idea, my best self-respecting strategy is to find the absolute best, most knowlegeable proponent of that idea, and argue with him.
    So, seeing this blog not do this simply lowers the importance of this blog for me.

  21. HB

    e.g. — While it makes some sense to address the ideas of a prominent individual, it makes far more sense for those who care to gain further insights to instead ignore the most prominent and focus on the best available arguments instead. That is, the arguments that actually matter.
    In fact whether oil prices were divorce from fundamentals is indeed a truly open question, and so *that’s* the issue. Substance before ego.

  22. HB

    Finally, this is an *important* error:
    “As you might guess, I do not expect to find much evidence of a connection between index fund trading and futures price movements in other commodity markets.”
    The error is fundamental: Psychology *always* influences even scientific investigation. For this reason, every type of strategy to avoid mental prejudice is central to getting meaningful results.
    In other words, never *expect* a particular result, due to risk of completely wasting your time via unexamined presumptions. Instead, presume you might be missing something. Try to prove *your own idea* wrong. This helps avoid wasting your time.

  23. Scott Irwin

    Stormin Norman
    I believe that the silver market was indeed distored by the Hunt’s trading in 79-80. My intention was to contrast this dramatic example of a real manipulation with the activities of index funds. I did not intend it to imply that the Hunts did not manipulate silver prices. For an alternative “grey” view of the Hunts trading adventures I highly recommend the book “Manipulation on Trial” by my colleague at UC Davis, Jeffrey Williams. It is a ripping good read and very well documented.

  24. Scott Irwin

    An interesting theme running through a number of comments is different definitions of the “fundamentals.” I believe most economists would include macro variables like exchange rates as well as market specific variables like inventories, production, etc. I am not sure if non-economists are as expansive in their lists.

  25. stormin norman

    Professor Irwin why is it OK for the us gubbment to trick you and the futures market, but not hedge funds or hunt brothers? Futhermore, they are probably still tricking you, how would you really know? Have you been down into the vaults of fort knox and done your own empirical testing – its all based on faith and hope eh?
    Here is a link with some brief info – but if you will do further digging into the trading of silver during those years – you will find some interesting things – I say what is good for the goose is good for the gander.

  26. DB

    Did Scott Irwin participate in the crude oil run-up? Yes or no?
    Does Professor Irwin participate in the markets with his own money?
    How is he positioned today?
    Irwin has been asked these personal questions for which he has not provided a disclaimer.
    Where is the honesty in that?

  27. Scott Irwin

    “Did Scott Irwin participate in the crude oil run-up?”
    I have not ever had trading positions in any energy futures or derivatives contract, including crude oil.
    “Does Professor Irwin participate in the markets with his own money?”
    I do not have any of my own money invested in any type of futures or options market at the present time.
    “How is he positioned today?”
    My position today is the same as tens of millions of other consumers—long the gasoline my family and I will use in our cars in the future and the natural gas we will use in our furnace. In this sense, my consumption position could lead me to join the chorus of “its the index” funds in an effort to use regulation to burst a bubble in crude prices. But I take the opposite position, which I hope adds credibility to my arguments

  28. EnergyGuru

    Scott –
    What if a large WS Firm that ran a CIF, managed many FUNDS (clients) trades, and then performed their swaps and then sold them new contracts for their swaps….this firm traded all over the world, even held oil in shortage and monitored piplelines it leased, and issued “ANALYST REPORTS” that the WSJ and CNBC would trumpet vigorously the crazed hype that oil was going to go to $100, $120, $140, $200 within 8 months. And when the Reports are released and hyped as they were, the “WS HERD” starts heading to the NYMEX and buys more futures…and guess what? Yep, the price goes up and up and the writers of the reports look like financial gods….
    But, at some point the MYTH and Hype discoonect so much that the rising bubble burst! And, many FUNDS and CIF investors start getting really hurt and go out, etc. (look at the last 60 days).
    Well, somebody was holding the last round of futres contract – TRUE – and these funds have gotten burned….But, what happened to the firm that was holding the swaps and the CIF? Surely they got burned. Well, did they. Or, were they the ones who begin to reposition their holdings and they started shorting ahead of the market – like on or about June 15th…looking ahead to July 15th, when the market flipped – and that was the last settlement date that they ‘swapped’…Hmmm…They also stopped submitting the reports between JUne 15th and July 15th…They covered their butts and left thier cleints and many other of “the herd” hung out!!
    Sound funky…well, don’t forget this firm did basically the same thing with gasoline in the fall of 2007.

  29. miszkam

    The theory against speculation runs nicely apart from ignoring the bid-ask spread. If money comes into the market one-sidedly, from the demand side, consequetive offers will be knocked out and the price will spiral higher. It will take time for new large money to arrive from the sell-side to start knocking out bids and lower prices.
    And cash prices do get determined from the global futures market, because oil, unlike gas, is not traded under long-term contracts. Btw, when liquified gas get’s enough respect we will get a new global gas futures market with the corresponding speculative bubble.
    Price of oil now is fair. When it was $145/barrel it was unfair, taking into account the global economy down-side risks.

  30. Anonymous

    Scott – I asked you, way back yonder, whether sellers of oil set their prices by looking at the futures market? The answer I got was phrased in general terms – usually price discovery goes from futures to cash market but not always. I suppose that sellers would prefer to set prices by the futures market when the price is going up. This mechanism implies encouragement to speculation, when price is going up and sellers ratify the proposed higher price.
    But you say, a “wedge” sometimes appear and the cash market controls the price. The only wedge i can think of would be the refusal of buyers to pay the higher price. So good ole supply and demand enters the cash market.
    It would seem to me to be in the interests of both speculators and sellers to encourage price increases, as long as the demand remains.

  31. VOC

    Here is the wedge: Because commodity futures always have greater transparency than physical commodities and often have greater liquidity than physical commodities, some physical traders will price their commodities to reference futures prices. This provides clarity and convenience; however, clarity and convenience are all that it provides. In instances when the futures markets fail to provide price discovery, physical traders can find other reference prices. In those instances, physical markets that are tied to futures prices will freeze ups. In other words, if Masters et al. were right that speculators had driven futures prices to irrational levels relative to cash prices, that would cause physical traders to stop using the futures markets for price discovery. If the futures markets have not decoupled from the cash markets, then Masters’ argument must be wrong. On the other hand, if the futures markets have decoupled from the cash markets, then Masters’ argument must be wrong.

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