Dumb Comments on Energy Prices and Manipulation

There are so many silly assertions and so little time!

One of our missions at "A Dash" is to identify strong sources of information and analysis.  Even the most intelligent reader needs some expertise to make the key distinctions.  Let us consider some examples.

Oil Demand and Price

The Statement:  One of the CNBC talking heads repeatedly stated that oil prices fell by 80% but demand did not drop that much.  To her, this was evidence of an inaccurate market.  None of the many CNBC panelists contradicted her.

The Reality:  Introductory Econ classes start with how markets clear, showing a supply function (a curve) and a demand function (also a curve).  The markets clear at the intersection of the two curves.  A lecture or two later there is a discussion of elasticity — how much demand (or supply) changes with a unit change in price.  There are examples of inelastic demand (insulin is a favorite) and more responsive demand.

The Conclusion:  It is not proportional or linear.  It is another case of pop economics intuition leading one astray.  Let us suppose that the oil market is near a tipping point.  A demand curve intersecting slightly above the production capacity leads to a price spike.  At a slightly lower point, producers may still want to generate some revenue.  It is all about the shape of the supply and demand curves.

Oil and Stock Correlation

The Statement:  An expert says that stocks are trading based upon oil.  There is a chart showing a correspondence between stock prices and energy prices.

The Reality:  The relationship between energy prices and stock prices is situationally dependent.  In general, high energy prices are a tax on the consumer.  There is no reason for higher oil prices to cause higher stock prices.

The Conclusion:  This is a classic case of a spurious relationship.  This is a technical statistics term meaning that Factor A (in this case perceptions about the economy) is driving the behavior of both Factors B and C.  The apparent relationship is not causal.  In addition, this would make sense only if stock traders thought that energy prices were a more accurate read of the economic prospects.

Rogue Trading and Energy Manipulation

The Statement:  There are some rogue energy traders who made drunken or mistaken trades.  These needed to be unwound.  This shows manipulation of the energy markets.

The Reality:  Mistakes are discovered and corrected.  It is not manipulation.

The Conclusion:  It has no lasting impact on prices, despite the media hype.

Speculation drives Energy Prices

The Statement:  Speculators have exacerbated price swings in energy.  Some government officials in several countries want to hold hearings and consider legislation to curb speculation.

The Reality:  Speculators are trying to make profits.  They add liquidity to the market, acting based upon many sources of information about all conditions.  Think "The Wisdom of Crowds."

The Conclusion:  There is very good evidence on this point, from some excellent sources.  Astute economist James Hamilton took a close look at this when energy prices spiked, and wrote as follows:

I personally do accept the view
that the "paper oil" speculation has made a contribution in recent
months to the increase in the price of physical oil. I believe that
this speculation has resulted in a slight decrease in the quantity
demanded that has required some modest supply reductions or
accumulation of inventory by producers. But I expect that producers
will find these changes not to be in their best interests as the demand
adjustments become more prominent, at which point the price must return
to that governed by the underlying physical fundamentals.

Ultimately, the price must be such that the quantity of physical oil
demanded at that price is equal to the quantity of physical oil
supplied. Any speculator who promises on paper to buy oil for more than
the physical stuff is actually selling for will find themselves at that
point with a big, fat paper loss.

Here is another take from noted investment advisor Dr. Stephen Leeb:

The real force at work behind last year’s run-up in prices, the
subsequent decline and the rebound that has followed is the market’s
invisible hand. In other words, good old fashioned supply and demand
was the culprit. Unprecedented synchronized global growth between 2005
and early 2008 caused demand to soar, yet producers were unable to meet
the call to increase production by anything more than a token amount.

Readers should check out his entire review of the history and his argument.  Government intervention to distort markets is the last thing we need.

Our Overall Take

There is an active market in conspiracies and manipulation.  It makes an ideal media story, whatever the reality.  Commentators also seem to have a bias toward the legitimacy of equity markets and against futures markets, often citing off-hours trading.  Perhaps those of us with more "Chicago" experience better appreciate the depth and liquidity of futures trading.

Those doing "pop economics" have a field day.  It takes careful analysis to sort out the reality.

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  • VennData July 10, 2009  

    The Statement: Bill Gross said he’d work for free
    The Reality: Bill Gross won’t even work.
    The Conclusion: There is no “New Normal,” it’s just marketing hype.

  • Mike C July 10, 2009  

    Excellent post, Dr. Jeff. It is absolutely flabbergasting to me the amount of misinformation I’ve heard in the MSM (just the other day a very highly rated talk show)
    The Conclusion: It is not proportional or linear. It is another case of pop economics intuition leading one astray. Let us suppose that the oil market is near a tipping point. A demand curve intersecting slightly above the production capacity leads to a price spike. At a slightly lower point, producers may still want to generate some revenue. It is all about the shape of the supply and demand curves.
    It is mind-boggling to me the amount of people, supposedly educated and understanding economics, who don’t understand the concept of elasticity of demand, and that changes in price and supply/demand do not have to be 1:1 linear. Good example of a mistaken heuristic?
    To change the subject, I’m curious what your thoughts/position are on this thesis of a very long drawn out deleveraging cycle. From a report:
    This is what former IMF Chief Economist Ken Rogoff (now at Harvard University) had to say to the USA Today on the matter: “The kind of deleveraging we need to see takes six or eight years … The retrenching of the U.S. consumer is a huge adjustment the whole world is going to have to absorb”
    Also, just curious if you have an opinion on the inflation/deflation issue. Buffett says:
    Well, I don’t worry about deflation at all. We won’t see deflation in any significant amount in your lifetime, which is more relevant than my lifetime. We’ve taken action in fighting the economic war that we face that certainly sows the seeds of substantial inflation down the road. Not in the next six months or year or two years, but we have done things that raise the probability of really high rates of inflation at some point. We’re flooding the system with dollars. We’re monitizing debt. We’re doing all the things that lead to that.
    Hussman says we’ll see a doubling of prices in the next 10 years.
    That said, I’ve read some extremely compelling/persuasive notes that deflation will reign because the amount and magnitude of credit contraction will overwhelm monetary and fiscal stimulus:
    Make Sure You Get This One Right
    Barry had an interesting post on this subject in his Think Tank:

  • RB July 10, 2009