Oil prices head the news. Crude oil jumped above 140US$/bbl. And as was to be expected ‘speculators’ are blamed for doing their virtual business disconnected from the honest productive efforts of firms on the ground. Only the latter are confronted directly with preference orderings and thus have a better incentive to allocate resources as to maximize consumer welfare. Speculators, however, are greedy money-makers who ruthlessly increase the prices of energy (and food) and thus push diligent middle-class families to the edge of poverty (and Africans to the edge of starvation).
Economists like Guillermo Calvo, Paul Krugman, and Arnold Kling attempt to bring some economic reasoning to the confused, normative and ill-tempered babble you can see on TV or read in newspapers. Calvo’s piece I consider to be the best; Kling has the great merit to bring the Hotelling principle into play. However, his post confuses ‘Cantango,’ i.e. the case where future prices are above expected future spot prices and thus fall in real time, with the shape of a normal futures curve, which implies that future prices exceed the spot price. ‘Normal backwardation,’ the case where future prices are below expected future spot prices suggesting an increase in Brent prices over time, is accordingly confused with an inverted futures curve; Krugman, in defending the role of speculators, makes exactly the same mistake as Kling while adding some more errors. First, he does not apply the Hotelling principle and thus his little model has not much to say. Second, if we want to discuss causalities, we have to state functional relationships within a general equilibrium setting. Only then and equipped with the ceteris paribus-clause and the caution it implies with respect to our results, are we able to engage in partial equilibrium analysis, trying to single out dominant causes of the time path of oil prices. (@weissgarnix: general equilibrium theory does not forbid real time dynamics; rather, it is a prerequisite that we get them right, derived from the correct decision space of every individual, determined by his or her place in the division of labour and shaped by the scarcity nexus interrelating choice to choice to choice.)
The most important peculiarity of oil is that it is exhaustible. The endowment is limited, a homogenous stock of oil “sitting in a storage tank or sitting under the Saudi sand” (Kling). This aggregate endowment is distributed among market participant and I assume for the sake of simplicity perfect competition (this is highly unrealistic, but does not harm the principles which guide allocation). The problem of the owner of exhaustible, non-perishable resources is how to distribute his supply over time. He could exploit his entire endowment as fast as he could (that is, as fast as he can dig out oil and supply the relevant market). He could postpone digging and supply nothing until a remote date in the far future. Or he can distribute his supply so as to provide a continuous stream of his endowment over time. How to sell along the futures curve?
Now, the Hotelling principle comes into play. The seller of the exhaustible resource wants to maximize the present value of his endowments, that is, he wants to realize the highest return, given the rate of interest and all other alternative rates of return. He can sell barrels on future markets or he can sell them on spot markets to realize funds which allow him to buy himself into other investments realizing higher returns than the expected yield from a rise in oil prices (cost assumed to be constant). Let us assume that the rate of return from investing funds realized by selling crude oil on spot markets is higher than the opportunity cost of selling on future markets (that is we have a positive rate of return over cost a la Fisher). The supply on spot markets increase, reducing the spot price. The relative scarcity of future supply increases and – with demand conditions unaltered – future prices rise. At the same time, the additional funds supplied to the preferred investment reduce its rate of return. With increasing future prices and falling returns on alternative investments, we tend to an optimal portfolio.
This is done in respect to all future dates. That is, if funds realized by selling on spot markets earn a positive rate of return on competing investments, equilibrium forward prices on one-year contracts must be less than half of the equilibrium future prices of two-year contracts. Thus, we have to allow for compounding. In equilibrium the expected rise in the price of exhaustible resource, its futures curve, is analogous to the discount curve, or the term structure of interest rates. This is the Hotelling principle.
What is the role of the speculator? On the supply side, he can make a profit by anticipating the future state of the market as far as the owner of the exhaustible resource is himself a better speculator. Above, it was stated that reducing the future supply of crude oil would increase prices – demand conditions remaining constant. But it is the speculator, who has to make up his mind about the demand and supply conditions as well as on the evolution of technology. If future prices of oil rise due to the increased supply of a limited resource on spot markets, it is only due to speculators who defend the demand position we want to make in the future. He is active today and can earn a profit to the extend that the future consumers and producers of crude oil do not become speculators themselves and ensure today a more or less organized income stream. Speculation is thus crucial and as real as is the production of steel in a factory. Only if we think that future needs are more virtual, more unreal than present needs are, we can blame speculator on the grounds we usually do. Of course, nobody speculates to make all of us better off. Speculators do so because they want to reap the highest profit. But as Adam Smith has taught us, it is the intended action guided by self-interest which ‘by an invisible hand’ has the unintended consequence of improving the welfare of society at large.
However, speculators - like the rest of us - have to rely on the price system to diffuse the relevant knowledge about relative scarcities. Our capacity to anticipate is limited. We seldom come up with a totally new idea about the way the economy at large is shaped in the relevant future. To anticipate change, we have to stand on known ground, being able to make a reasonable guess about the general developments which may alter the context in which the new investment opportunity will make its appearance. Thus, speculation needs a reliable price system to be useful. As shown above, the rate of interest is important in guiding the time distribution of the crude oil supply. And the Fed’s policy of lowering interest rates and holding them down has significant effects on the futures curve. It lowers the opportunity cost to sell oil on future markets! Thus, the relative supply of spot oil shrinks in favour of future oil supply. Ceteris paribus we face an increase in spot prices and a corresponding decrease in future prices. Additionally, we observe a shift in the oil futures curve. Indeed, the Hotelling principle tells us nothing about its level. The shift may be due to China and other new players on the demand side of the market, due to whatever increases in the absolute demand for oil. The increase of spot prices over time, at least, seems to suggest that we are in a state of normal backwardation, with the market correcting the spot price insofar as future prices are below the expected/future spot price. At the same time the output of spot supply is reduced in favour of future supply. Thus, we have rising oil prices in general with spot prices increasing faster than future prices.
But this still would be a change in relative prices, not yet a bubble. The additional demand spend on oil would be missing somewhere in the economy, indicating a reallocation of resources to supply more oil over time according to the needs of the markets. Of course, if the oil productivity does not increase while leaving total factor productivity at least constant, real incomes shrink (the rentier, of course, wins ground relative to others). Thus, speculators do not by themselves create bubbles that are the credit financed market fantasies of increasing prices over time and for various investments. They need the nominal income effect induced by a too low rate of interest (in respect to the various rates of return all tending to the same equilibrium rate and representing the adjustment of the production structure to the anticipated data of the system).
And here Calvo steps in. Affected by the easy-money stance of the Fed, foreign countries fixing their exchange rate to the US$ and thus are in need to accumulate vast reserves denominated in US$ (e.g. China) as well as countries which invest public funds simply to earn the highest return instead of supplying their societies with public goods (e.g. China), attempt to participate in the hype generated by the Fed. After the second boom-bust cycle on stock markets and the recent collapse of the housing boom, commodities still perform on money-driven price fantasies. Since alternatives are now missing the increasing investment funds concentrate on the market for commodities, thus accelerating oil prices. In turn, foreign central banks and especially sovereign wealth funds (SWFs; i.e., “special government asset management vehicles which invest public funds in a wide range of financial instruments”) shift their portfolios. They reduce US government bonds and purchase commodities (oil still being denominated in US$). Now, the fall in demand for T-bonds hikes up interest rates or would do so if the central bank would not counteract through open market operations. Thus, in buying up T-bonds the US monetary system creates more money in circulation and feeds a further increase in commodity prices, encouraging further shifts in SWF portfolios, etc.
This is why oil prices accelerate. It is a bubble, but speculators are the heroes, simply mislead by monetary policy, the latter being the true villain of the plot.
