The Market Works Just in Time
The recent political controversies over record oil prices have underscored the sad truth that even nominal friends of the market don't understand how it really works.
Because they have only a superficial grasp of this complex "organism" and how it coordinates interactions among billions of Homo sapiens spread across the entire planet, they quickly denounce its operations whenever things depart from the ordinary. The market is apparently good enough to be allowed to work when things are monotonous, but (we are told by its fair-weather friends) the politicians need to take the wheel when the road gets bumpy.
In particular, what has happened is that because most commentators -- even some professional economists -- don't really have a good intertemporal mental construct of the market, they can't really fathom how prices would guide people to properly allocate scarce resources. FULL ARTICLE
Comments (37)
Very informative. Thanks! Those ignorant of the market process see speculators as leeches. But the reality is that they are insurance companies. They accept the risk that others don’t want to take, and they make a profit doing it. Imagine that!
Published: July 7, 2008 9:17 AM
"Right now, motorists are getting killed at the pump . . ."
Somehow, when I see all the large cars driving around town, I doubt we're at that stage yet.
Published: July 7, 2008 9:43 AM
While I am not in favor of banning institutional investors from the futures markets, I would apply the futures markets rules to all market participants. There are leverage restrictions that apply to all participants save index funds. This can create persistent imbalances of demand between active futures markets investors and passive (indexed) investors.
I agree with Mr. Murphy's explanation of the theoretical impact of institutional investors trimming their positions to maintain policy weights as the prices run up and adding to maintain policy weights as the prices decline. In practice, however, institutional investors are more likely than not to let their winners ride rather than implement their contrarian trimming and rounding procedures. The pension officer has to report to the CEO and the Board of Directors, and everyone involved has a personal reason to go with the herd rather than stand out from it. Expect to see lots of trimming after the commodity bubble has clearly burst.
Published: July 7, 2008 10:03 AM
Why is so little attention paid the the basic reality that rising prices, particularly oil prices, are also driven by falling value of fiat money -- perhaps more than by market demand.
And stopping the falling value of fiat money, while painful to those who could do it, is possible.
To do so would also reduce the need for futures speculation.
Published: July 7, 2008 10:30 AM
Bradford: "There are leverage restrictions that apply to all participants save index funds."
JD: "Why is so little attention paid the the basic reality that rising prices, particularly oil prices, are also driven by falling value of fiat money..."
I think JD offers a better solution to speculation than increased regulation. The best way to limit leverage in the futures market is quit printing money. Without the new money, speculators would be able to borrow less and leverage less. Machlup demonstrated way back in the 1930's that a large portion of new money from the Feds went into the stock market. Today it goes into the futures market.
Published: July 7, 2008 10:41 AM
i actually find masters' comments baffling. futures prices converge to spot as expiration approaches. spot prices are not determined by derivatives, quite the converse. futures can absorb what i'd call the "white noise" of trading, but the market's primary trend is always determined by the underlying (arbitrage opportunities make sure of this).
if you really want to boost the price of oil, you better have a fleet of empty supertankers off the coast, and very deep pockets. all else is idle chatter.
Published: July 7, 2008 10:53 AM
Yeah, it sure would be great if there were property rights in all scarce resources so that the market could sort things out.
Published: July 7, 2008 11:08 AM
Fundementalist.
Leverage in futures markets are not actual credit that we know. There is no need for a FED for traders to use margin trading in futures market. Traders can do this by themselves.
For example lets say we have 10.000 USD each. We can do a forex trade with USD/Euro.
I can sell you 1.000.000 dollars worth of dollars and buy Euros for the same amount, and you do the opposite at 1.5 Euro/USD.
Thats 100 to 1 leverage.
If Euro/USD goes up to 1.5150 I take your 10.000 dollars. If Euro/USD goes down to 1.4850 you take my 10.000 dollars.
We made a transaction worth 1.000.000 dollars with only 20.000 dollars. And we didnt need some third party to print and give us the whole amount.
So regulating leverage wouldnt do any good.
Quite the opposite.
Because of the leverage that investors are using, the volatility isn't as much as it could be.
Because of the stops and limits in the margin trading, sharp falls and sharp gains are balanced out.
Published: July 7, 2008 1:00 PM
Fundementalist.
Leverage in futures markets are not actual credit that we know. There is no need for a FED for traders to use margin trading in futures market. Traders can do this by themselves.
For example lets say we have 10.000 USD each. We can do a forex trade with USD/Euro.
I can sell you 1.000.000 dollars worth of dollars and buy Euros for the same amount, and you do the opposite at 1.5 Euro/USD.
Thats 100 to 1 leverage.
If Euro/USD goes up to 1.5150 I take your 10.000 dollars. If Euro/USD goes down to 1.4850 you take my 10.000 dollars.
We made a transaction worth 1.000.000 dollars with only 20.000 dollars. And we didnt need some third party to print and give us the whole amount.
So regulating leverage wouldnt do any good.
Quite the opposite.
Because of the leverage that investors are using, the volatility isn't as much as it could be.
Because of the stops and limits in the margin trading, sharp falls and sharp gains are balanced out.
Published: July 7, 2008 1:01 PM
The price for absolutely everything is 100% pure speculation. Not 99.9%. Not 10.37693%. Not some variable percentage between 0% and 100%. Always at every single moment in time ever 100% pure speculation. This is so by definition of subjective value.
Buying an oil futures contract is *exactly* as speculative as not buying an oil futures contract, and instead doing something else, including putting dollars in a bank vault. Buying an oil futures contract is exactly as speculative as buying Brand X chocolate ice cream rather than buying Brand Y vanilla ice cream, is exactly as speculative as manufacturing ice cream, is exactly as speculative as driving an ice cream truck, is exactly as speculative as an ice cream truck driver buying rainy day weather futures to hedge his sales, is as exactly as speculative as an ice cream truck driver that buys no weather futures whatsoever.
Every price, every value, every action, is based on 100% pure subjective speculation.
Published: July 7, 2008 1:35 PM
rtr: Yes, and substance is just an aberration in the void.
Hyper-reductionism: trivializing insights since before the fall of Rome.
Published: July 7, 2008 2:09 PM
When any action is based on news events and not sound financial data, everything that follows such action will lead to undesirable results for the majority.
Speculation is a tool. Just as a gun, a wrench or a keyboard is a tool. It is when it is used as a means of generating revenue for the few, based on hearsay and lies that it becomes a tool that inflicts harm on the economy.
In the span of just a few hours, oil prices can drop or increase several percentage points based solely on the words that are uttered from some crack-pot dictator’s or elected officials mouth, regardless of whether or not the individual actual means what is spilling out of his hole and regardless of whether or not any additional money was injected into the economy.
That ladies and gentleman is not a free market at work. That is an opportunist taking legal advantage of a scarce resource by gambling based on qualitative information, at the detriment of the majority. A free market is not free if it is held hostage by a few
Published: July 7, 2008 2:15 PM
ktibuk: "There is no need for a FED for traders to use margin trading in futures market."
That's a good point, but it doesn't eliminate the Fed's influence; it just moves it back several steps. The cost of a future's contract is a small percentage of the total cost of the commodity. Someone is loaning you the rest of the money. It could be the broker or the exchange. But the entity loaning you the difference between the cost of the contract and the cost of the commodity has to get money from somewhere and often they borrow it from a bank. So loose policy by the Fed encourages banks to loan money to exchanges or brokers to loan to you so you can buy the contract for less than the cost of the commodity. If you decide to take delivery of the commodity, all of the leverage provided by the broker will disappear.
Florida: "When any action is based on news events and not sound financial data, everything that follows such action will lead to undesirable results for the majority."
Since speculation is about the future, what "sound financial data" would you suggest speculators follow? No sound data about the future exists.
You ought to read Mises's description of entrepreneurs in "Human Action." You'll find a much more respectable view of their function. Speculators are pure entrepreneurs in that they take all of the risk in the futures market while protecting businesses against that risk.
Published: July 7, 2008 3:03 PM
Florida Economist, of course, news affect speculation. They are the basis of speculation. If for whatever reason, something leads you to believe that the city government is going to rebuild an old park that is currently populated with drug junkies, you are going to buy as many houses as you can all around. As you can imagine, price will move much more smooth than they otherwise would when people just found out the park has been restored. Furthermore, you reserve these factors for its most valuable uses. BUT if you make wrong predictions, and the city has no plans for that area, then you're going to suffer losses. So the market has its way to weed out bad speculators.
If in fact there are oil speculators and they are wrong about their predictions, you're going to get oil much cheaper than it was even before.
Published: July 7, 2008 3:08 PM
How does one "properly" allocate resources?
Published: July 7, 2008 3:24 PM
If you want to drive out the speculators and break them, flood the market with oil, it will drop the price dramatically over night and wash out those "evil" speculators who are long on oil.
Can't our government get it? It's all about potential supply verses potential demand! Let us drill for more oil and refine here in the states and the price will fall. Then the evil ones will go short and make a killing as well...but at least they won't be blamed for higher prices.
Published: July 7, 2008 3:49 PM
If I understand correctly (and I freely admit that I probably don't), wouldn't a speculator only buy (go long on) a futures contract if he or she expected prices on the underlying commodity to rise? Likewise, a buyer would only sell (go short on) a futures contract if they expected prices to rise higher than the futures price, right? In what way, then, could a futures contract cause prices to rise, particularly if they're not actually taking a quantity of the underlying commodity off the market?
What I'm trying to say is that it seems to me that futures don't influence prices, but that it's the other way around. If prices were expected to fall, there'd be no profit to be made in futures trading, as the buyer would be better off buying at the market price instead of the futures price. Or am I on crack? Do the rolls simply reverse when prices on a particular commodity are falling? Is the buyer then long on the contract, and the seller short? In this case, would speculation supposedly push prices down even faster?
Published: July 7, 2008 3:51 PM
Ron:
Even if "prices were expected to fall" nobody knows for sure if, when, and how much they will fall. What the speculator does, is as Fundamentalist said, he acts like an insurance company and takes the risk.
The futures buyer pays a premium so that he can get a fixed price today. Until events actually occur, anyone who thinks they know how the market will react may put their money on the horse they think will win. Others prefer not to gamble and so use futures to lock in prices.
I think the speculator is given a fair look in the book defending the undefendable.
Published: July 7, 2008 5:25 PM
fundamentalist wrote:
The cost of a future's contract is a small percentage of the total cost of the commodity. Someone is loaning you the rest of the money. It could be the broker or the exchange. But the entity loaning you the difference between the cost of the contract and the cost of the commodity has to get money from somewhere and often they borrow it from a bank.
This is not the way the NYMEX operates. Most contracts are settled in cash rather than physicals - very few contracts result in actual physical delivery. The ICE exchange settles in cash. A futures contract is a essentially a bet with a payoff. The exchange collects margin to make sure people honor their bets - nobody need to buy and sell 42,000 gallons of light crude to do this.
Check the first chapter of this book.
http://www.amazon.com/Futures-Game-Who-Wins-Loses/dp/0070647577/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1215470684&sr=8-1
Published: July 7, 2008 5:56 PM
Mike D. "This is not the way the NYMEX operates."
You're right. I owe ktibuk an apology. I was thinking of selling stocks short where the broker loans you the stocks. In futures a small premium can leverage a lot of money. You only have to pay the full amount if you take delivery. Ktibuk is right. You can leverage a lot without a bank on the futures exchange.
Published: July 7, 2008 6:54 PM
Ron:
You have it down. The rest is just noise trying to obscure the points you made. Speculators are simply speculating that the price is going north or south and buy futures accordingly.
"In what way, then, could a futures contract cause prices to rise, particularly if they're not actually taking a quantity of the underlying commodity off the market?"
Even speculators who do take a commodity off the market are only doing so because they believe that that future prices are going to be higher. This acts to save scarce resources from present consumption in order to be consumed later when it is thought that the commodity will be more scarce.
Published: July 7, 2008 7:06 PM
How does one "properly" allocate resources?
By applying them to whatever can be more profitable. That is the role of an entrepreneur. He or she finds opportunities and exploits them, allocating resources in the process to where they are most needed. For this to happen, there must be a price system, and a free market to power it. For example, if there is a major storm and a big blackout in the lower part of California, there will be an opportunity to sell a great quantity of gas-operated generators. When the demand of generators starts going up, sellers would be able to raise the price and still clear the market. That new price information would signal other entrepreneurs to bring new generators to the market, to take advantage of the profit potential.
Published: July 7, 2008 7:10 PM
You have it down. The rest is just noise trying to obscure the points you made. Speculators are simply speculating that the price is going north or south and buy futures accordingly.
Published: July 7, 2008 7:14 PM
Do we really have a free market when it comes to oil? Don't foreign governments such as Iran, Venezuela own the oil for their country, hence a controlled market?
Published: July 7, 2008 7:48 PM
mises writes ("on the manipulation of money and credit") that following german monetary reform and the economic crisis of 1873, there was widespread complaint over the declining commodity prices. governments sought expert advice about how best to combat this "evil" scourge.
plus ca change...
Published: July 7, 2008 11:26 PM
Vienna, you're talking of different markets. Globally, it doesn't matter if oil is being produced by socialist countries: they still need to operate like any other economic agent in the global market. Sure, you have the OPEC but, like any other cartel, it hasn't proven very successful.
Published: July 8, 2008 1:36 AM
Futures trading may have its place in the modern world, but we should remember that it is a form of gambling, and thus it does not necessarily bear much relationship with the things which are actually to be traded in the future.
The fact that the present price of mineral oil is absurd is seen by realizing that it would pay to convert the vast deposits of coal in the Earth to oil using the Fischer-Tropsch process at these prices! Not to mention all the tar-sand or shale deposits which can be economically extracted at 30 or 40 dollars a barrel.
So what is the real bet here? In reality, oil speculators are placing their bets on the prospect of the USA, or perhaps Israel, bombing Iran, then hoping that Iran is able to sink a number of American naval ships and lots of oil tankers, thus causing a real shortage of oil. In fact, an acute crisis of oil.
You might say that it is a free world, and anybody should be allowed to bet on anything they like. But even in the USA various forms of betting are restricted - and for good reason!
After all, if you place a bet, then you want to win. Therefore it stands to reason that it is in the vital interest of all those powerful players who are presently placing their bets that war does occur. Surely this is the explanation for the otherwise inexplicable drumbeating which we are experiencing. Huge amounts of money are now riding on the speculation that the world will enter a dreadful tragedy. And those who have placed their money on this speculation will do all they can to see that it does come to pass.
Published: July 8, 2008 6:22 AM
Just a couple of questions to the author of this article: Aren't the futures markets for commodities, and especially oil, really quite thin relative to the size of the physical markets? In addition, aren't there huge quantities of physicals which do not meet the specifications for trading on the exchange (e.g., too high in sulphur content)? Can't this lead to distortions and inefficiencies in the market? In addition, isn't it possible that the use of program trading systems may further distort the market? Please do not misunderstand, I believe commodity markets are very important and for exactly the reasons set forth in the article, but they are by no means perfect. Before we decide whether or not the markets are distorting the price of oil, I am suggesting that it might be useful to have a little more evidence than is currently available.
Published: July 8, 2008 9:19 AM
Just a couple of questions to the author of this article: Aren't the futures markets for commodities, and especially oil, really quite thin relative to the size of the physical markets? In addition, aren't there huge quantities of physicals which do not meet the specifications for trading on the exchange (e.g., too high in sulphur content)? Can't this lead to distortions and inefficiencies in the market? In addition, isn't it possible that the use of program trading systems may further distort the market? Please do not misunderstand, I believe commodity markets are very important and for exactly the reasons set forth in the article, but they are by no means perfect. Before we decide whether or not the markets are distorting the price of oil, I am suggesting that it might be useful to have a little more evidence than is currently available.
Published: July 8, 2008 9:20 AM
Just a couple of questions to the author of this article: Aren't the futures markets for commodities, and especially oil, really quite thin relative to the size of the physical markets? In addition, aren't there huge quantities of physicals which do not meet the specifications for trading on the exchange (e.g., too high in sulphur content)? Can't this lead to distortions and inefficiencies in the market? In addition, isn't it possible that the use of program trading systems may further distort the market? Please do not misunderstand, I believe commodity markets are very important and for exactly the reasons set forth in the article, but they are by no means perfect. Before we decide whether or not the markets are distorting the price of oil, I am suggesting that it might be useful to have a little more evidence than is currently available.
Published: July 8, 2008 9:20 AM
Just a couple of questions to the author of this article: Aren't the futures markets for commodities, and especially oil, really quite thin relative to the size of the physical markets? In addition, aren't there huge quantities of physicals which do not meet the specifications for trading on the exchange (e.g., too high in sulphur content)? Can't this lead to distortions and inefficiencies in the market? In addition, isn't it possible that the use of program trading systems may further distort the market? Please do not misunderstand, I believe commodity markets are very important and for exactly the reasons set forth in the article, but they are by no means perfect. Before we decide whether or not the markets are distorting the price of oil, I am suggesting that it might be useful to have a little more evidence than is currently available.
Published: July 8, 2008 9:22 AM
Just a couple of questions to the author of this article: Aren't the futures markets for commodities, and especially oil, really quite thin relative to the size of the physical markets? In addition, aren't there huge quantities of physicals which do not meet the specifications for trading on the exchange (e.g., too high in sulphur content)? Can't this lead to distortions and inefficiencies in the market? In addition, isn't it possible that the use of program trading systems may further distort the market? Please do not misunderstand, I believe commodity markets are very important and for exactly the reasons set forth in the article, but they are by no means perfect. Before we decide whether or not the markets are distorting the price of oil, I am suggesting that it might be useful to have a little more evidence than is currently available.
Published: July 8, 2008 9:23 AM
Just a couple of questions to the author of this article: Aren't the futures markets for commodities, and especially oil, really quite thin relative to the size of the physical markets? In addition, aren't there huge quantities of physicals which do not meet the specifications for trading on the exchange (e.g., too high in sulphur content)? Can't this lead to distortions and inefficiencies in the market? In addition, isn't it possible that the use of program trading systems may further distort the market? Please do not misunderstand, I believe commodity markets are very important and for exactly the reasons set forth in the article, but they are by no means perfect. Before we decide whether or not the markets are distorting the price of oil, I am suggesting that it might be useful to have a little more evidence than is currently available.
Published: July 8, 2008 9:25 AM
geoff says:
"Futures trading may have its place in the modern world, but we should remember that it is a form of gambling, and thus it does not necessarily bear much relationship with the things which are actually to be traded in the future."
not correct. futures trading's raison d'etre is hedging, ie shifting risk from commercials to speculators. the very real risk of future price fluctuations exists in nature.
gambling is a man-made risk, primary function being entertainment.
without futures, all commodity risk would merely shift to spot markets. (and speculators would be confined to spot).
Published: July 8, 2008 10:24 AM
In response to newson:
Mineral oil used to be supplied within longer term contracts, as I understand is still largely the case with natural gas. This gives both the buyer and the seller a greater degree of security than provided by the current system where we have seen a more than 1000% price increase over the past 10 years.
If you distinguish gambling as a particularly man-made risk, then that would seem to imply that speculation on the oil market is a "natural" activity, beyond the scope of mere human activity. Is economics a phenomenon of nature above and beyond human control? I don't think so. Without people there would be no economics. Therefore economics is man-made.
And of course I cannot share your view that the present level of gambling on the oil market is a form of entertainment!
Published: July 8, 2008 10:56 AM
Geoff, you do have a point with regard to oil prices and future war, but the problem is not people who bet on criminal actions, but the real criminals who carry the actions out - in this case the american and israeli govervnments and they hired murderers - the military.
Also, the article would make much more sense if there was a free-market for oil. Of course such a free-market doesn't exist and not only because of Venezuela...
So, given that 'speculators' are making money thanks to a corrupt system with minimal respect for individual rights, the article may be understood as an apology for 'greed' and the worst features of capitalism. I'm not saying that's the author's intent though, but it may look like as if it was...
Published: July 8, 2008 1:25 PM
to geoff:
gambling by definition refers to an artificial risk.
now some people may have such an unsystematic and emotional approach to futures trading as to resemble gambling, but they are merely speculating mindlessly, and the raison d'etre of futures is as a hedging mechanism. fools are quickly separated from their money in commodity trading, and their presence a liquidity boost.
whether one trades spot, futures or long-term trade contracts makes not one iota of difference in changing price direction, though arguably the more markets available, the greater the ease of entry and exit, and spot markets become less volatile.
Published: July 14, 2008 10:42 AM