December 24, 2008
Links for 12-24-08
Today I outsource to a couple of links I found interesting:
Dave Cohen on oil prices.
Stephen Gordon on economists' fatal flaw.
James Morley on the need for a new Fed-Treasury accord.
Posted by James Hamilton at December 24, 2008 10:44 AMdigg this | reddit
Thanks for David Cohen piece. Interesting.
Posted by: algernon at December 25, 2008 08:13 PM
Boy, David is one frustrated bull.
Markets try to anticipate events and they are made up of humans trying to anticipate events.
One possible explanation of some of his frustration. Before Katrina, the crude market was not very focused on hurricane damage so it did a poor job of anticipating hurricane effects and thus rallied significantly after the event. After Katrina and before Ike, with Katrina fresh on the mind, the market did a good job of anticipating hurricane effects and thus did not rally after the storm.
Markets are made up of many people trying to see into the future. Some themes resonate more at different times. Storm effects. Chinese demand. 1930s style Depression. Etc.
These themes capture the imagination of the participants (and attract new participants captivated by those themes) and there is usually some truth to them but then it gets overdone and some of the new participants get burned and never return and everyone remembers but then goes on to the next idea.
If technical analysis works, it works because markets are made up of people and technical analysis can be used to pattern match historical human behavior to be predictive of future human behavior.
Peak Oil folks are so earnest and they may even be right about the supply side of the equation (though I would not rule out technological breakthroughs such as the rise of shale natural gas in throwing a kink in that) but they fail to consider that the demand side of the equation is driven by humans who can anticipate and adapt and have proven the ability to do so, time and time again.
There is a reason we aren't talking about peak whale oil or food shortages anymore. We moved on.
p.s. real traders watch the spreads not flat price anyway.
Posted by: Bill at December 26, 2008 07:18 AM
Cohen misses the role of liquidity in oil future commodity markets or any market for that matter. Watching investment banks disappear while oil suddenly crashed should provide some clues!
Posted by: ron at December 27, 2008 03:00 PM
Cohen should start by recognizing the pro-cyclical nature of many prices and then ask why some of those pro-cyclical prices are more volatile than others. Might also help broaden his perspective if he spent some time studying other commodity prices like base metal prices.
Viewing markets as a coordination game might also help. Come to think of it, he could probably use an advanced degree in economics though that might spoil his ability to actually make money in the markets.
Posted by: GNP at December 27, 2008 08:30 PM
Re: the "pro-cyclical" nature of prices
Hamilton found that the historical oil price looks like a "random walk without drift". How does that support commodity cycles?
Re: the role role of liquidity, watching investment banks disappear
The role of liquidity & speculation has been vigorously debated for months now, with mainstream economists like Hamilton or Krugman demonstrating that markets are self-correcting -- speculative injections make no difference in relevant time frames -- and others like Michael Masters saying these injections distort price. Masters is right if you're talking about driving short-term price movements that take advantage of the very low demand elasticity of gasoline and other oil products. "Thus to a first approximation, the spot price would move by exactly the same amount as the near-term futures price" -- see Hamilton's Oil Bubble (May 17, 2008)
Speculative bets go on when the price is rising or the price is falling. It should be market manipulation that is our proper concern when the exchange rules are skirted or not enforced.
Re: "one frustrated bull"
The mere fact that oil prices are $25 below marginal production costs for new oil should send alarm bells ringing everywhere. My article concerned the long-term pricing of oil. Day traders engaged in "chart gazing" are blind to oil's long-term value. Thus the market is inept, a viewpoint that goes against the usual religious view. Oil necessarily is treated as if it were soybeans or iron ore (the examples I used) and not a precious finite resource.
Re: they fail to consider that the demand side of the equation is driven by humans who can anticipate and adapt and have proven the ability to do so, time and time again
You would be amazed how much time I devote to studying the viability of plug-in hybrids, cellulosic ethanol and other potential substitutes for liquid fuels. I have less faith in humans than you do. I believe it will take 20 years to make a truly significant dent in our oil demand and overcome our 100-year investment in the current infrastructure. We don't have 20 years. It won't happen in any case if the price is not right, which was my point.
Posted by: Dave Cohen at December 28, 2008 06:26 AM
It is quite likely that oil had a speculative bubble this summer and went way too high, with now a crash that has way overshot on the low side. However, there are some other factors in here. One is the widely reported excess buying by the Chinese prior to the Olympics and then stopping afterwards. Oil has historically been quite volative to small shifts in the market, especially when inventories are tight.
And the other, despite JDH's finding of no cyclical effects, is the extreme decline we seem to be in now in the global economy and the related decline in global aggregate demand, possibly the worst such decline since the 1930s.
Which brings me back to the 1930s. The largest decline in percentage terms in oil price we have ever seen was in 1930, from about $1 per barrel to about 5 cents per barrel six months later. A similar decline today from July's peak would send the price down to about $7 per barrel. Of course, that super steep decline was aggravated not only by the declining global aggregate demand, but the discovery of the East Texas oil pool, a biggie. On this part the peak oil folks are right. There is probably not anything like that out there to pop up at this time.
Posted by: Barkley Rosser at December 28, 2008 11:08 AM
JDH gives the peak-oil crackpots way too much time of day.
Posted by: bartman at December 29, 2008 06:28 AM
re: oil prices $25 below marginal production costs
Only in the front of the curve. July 2010 crude is $70, well above marginal production costs for unconventional sources such as the oil sands. One of the reasons, that time spreads get so much attention from professional traders in commodities. The market is saying that we do not need additional production now but that we will need more by next year. $70 crude prices are there for producers to hedge against if they wish.
re: time studying demand
One person, no matter how diligent and well-intentioned, is very unlikely to do a better job of finding the best, most efficient solution to a problem with an almost infinite variety of inputs and outputs such as worldwide supply and demand for crude. This is why command and control economies have lagged market oriented ones.
I'll stipulate that we have not yet grown crude production significantly (though natural gas is quite a different story) and thus the peak oil theme is not dead. There is some reasonable chance that crude oil production will begin an irreversible decline in the very near future. However, there is also a reasonable chance of an unanticipated supply breakthrough similar to the one natural gas is undergoing.
Even if the decline is irreversible, there are a number of reasonable outcomes where demand for crude is reduced significantly.
The price of crude on an inflation adjusted basis has not really risen that significantly thus there has been little incentive to invest in efficiency. The flurry of activity in efficiency and alternative energy that $100 crude set off is indicative that there is most probably some low hanging fruit in short term efficiency gains to be squeezed from the current system (smart metering for electricity, mpg gains from ditching SUVs, etc).
Bigger gains in crude demand destruction will have to come from replacement technologies over a longer time frame. I don't pretend to know if the answer is an unconventional new source of hydrocarbons (i.e. methane hydrates) or better battery technology or whatever.
If we cannot significantly grow crude production there will probably be a period of technological change/upcertainty but given that oil prices have only been a "problem" or on the radar of most people for about 4 years, I am highly doubtful that the best outcome/way forward can yet be determined.
Twenty years is a very long time to forecast anything related to human activity
Of course, the market is available to anybody that has a clear view of the future.
If you believe in peak oil and are fairly certain that any demand response will be limited then your trade/investment is out there from the "inept" market.
Posted by: Bill at December 29, 2008 11:04 AM
Dave Cohen writes: Re: the "pro-cyclical" nature of prices
Hamilton found that the historical oil price looks like a "random walk without drift". How does that support commodity cycles?
GNP responds: Some macroeconomists have concluded that most major macroeconomic time series behave like random walks (with drift). Does that mean that one should avoid assigning any kind of causality? Or that different data perspectives may furnish different indicators of possible causal relationships?
Hamilton has also ignored how ME colonial politics have contributed to keep significant barrels of light sweet crude oil in the ground. That doesn't necessarily mean that western resource ambitions are not an important short- and medium-term pricing variable despite the glaring measurement issues.
I would add to Barkley Rosser's observation with respect to early 2008 Chinese buying that US purchases of high-grade CL for strategic reserves may have further aggravated an already tight market.
FWIW, I agree that over the longer horizon inexpensive CL is running out. I also lament the largely engineering-driven, technological-fix approach to solving the problem. It is the equivalent of focusing solutions to obesity on pills and liposuction.
Posted by: GNP at December 30, 2008 05:07 AM
Recently production has stalled probably due to high prices. As Krugman noted (I believe back in 2001), oil likely has multiple equalibria. Greenspan, in Age of Turbulance, also lamented Venezuela's neglect of it's production capability due to high prices. Given what we also know about Russia and it's state of afairs... I doubt Venezuela is atypical.
Posted by: aaron at December 30, 2008 07:38 AM
We aren't getting MPG gains from ditching SUVs. Actually the opposite is happening. Since 2005 MPG has been declining. People don't react well to excessive penalties. They ditched trucks and SUV and bought Prii to an extent that was far beyond rational.
Here's my prediction of what we'll see this Winter. We'll see decreased driving due to the economy and weather. We'll see decreased prices due less driving because of the economy and weather. We'll see a large deline in fuel efficiency. The media will finally notice that fuel efficiency is declining and note that "fuel efficiency decline with falling gas prices", ignoring that fuel efficiency has been declining for years and we're having an especially harsh winter (fuel efficiency always declines in the winter).
Posted by: aaron at December 30, 2008 08:17 AM
Here's a graph of Vehicle Miles Travelled / Finished Motor Gasoline Supplied since 1970. It's monthly data, I don't know why excel assigned the 15th as the date for each month.
Posted by: aaron at December 30, 2008 08:49 AM
Speak of the Devil... Megan McArdle just posted on the trouble that Russia Gazprom is in.
Posted by: aaron at December 30, 2008 09:27 AM
aaron: Wouldn't high prices stall demand growth? (As opposed to supply.)
If you are implying a satisficing argument as to how high prices slowed supply growth in Venezuela, I believe that you are incorrect.
Domestic rent seeking appears to have slowed potential supply growth in Venezuela and similar developing countries.
That process should not be confused with resource policies that seek to maximize social rents by slowing extraction rates through a variety of barriers such as high royalty rates, water tariffs, and environmental regulations.
Posted by: GNP at December 30, 2008 09:51 AM