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A very murky crystal ball.

by Colman Fri May 19th, 2006 at 10:04:30 AM EST

A lot of people seem to think that oil futures give a good indication of future oil prices, apparently believing in the "wisdom of crowds". Menzie Chinn (who is a real economist) on Econbrowser looked at that idea:

A relevant question is whether futures are actually good predictors of future spot oil prices. The answer is not obvious -- for instance, for currencies futures aren't good predictors. In a paper assessing energy futures, coauthored with Olivier Coibion and Michael LeBlanc, I assessed whether the gap between the futures rate and current spot rate predicts the actual change in the spot oil price. Over the 1990-2004 period, we find that at 3 month, 6 month and one year horizons, regression of actual change on predicted yields coefficients of 1.2, 0.8 and 0.9, respectively. In no case can the null hypothesis of unbiasedness be rejected.
So they're not very good at predicting prices. In fact, he goes on to say that they're not much better than a random walk would be.
One caveat to this conclusion is that our results only apply to horizons of up to one year. The markets further out on the maturity spectrum are very thin, and the characteristics of these futures are unknown.


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So let me get this right.

A bunch of greedy barrow-boys on the make seem to be very good at buying and selling a commodity in such away that whatever happens, they rake in tons of money for themselves and their pimps.

However, their cultural inability to shift out of "what is good for me  now, today ?" means that they have proved to be effectively ignorant of geo-political trends that don't help them at this time.

Their job is to be reactive, not pro-active. So, sadly, they are not well-placed to predict what happens tomorrow. In a well-ordered system, that'd be somebody else's job.

keep to the Fen Causeway

by Helen (lareinagal at yahoo dot co dot uk) on Fri May 19th, 2006 at 10:26:53 AM EST
the front end of the market is much as you describe.  The traders play the ebb and flow on a second by second basis.

In the longer term area people do think about how they want to hold the risk.  There isn't always 2 sides to the market down the curve 5-10 years.  Small oil producers need to hedge to satisfy their bankers.  Consumers, even airlines, rarely hedge more than a few years out, if at all.

means that they have proved to be effectively ignorant of geo-political trends that don't help them at this time.

bit harsh.  are you a buyer or seller of 2011 Brent based on your geopolitical worldview??  If you think peak oil and Mid East in flames you're a buyer.  If you think, oh shit, major recession looming, how much do you want to own or are you short?

by HiD on Fri May 19th, 2006 at 04:50:36 PM EST
[ Parent ]
One of the things about futures contracts is that most people lose money on them. For stocks the rate at which they are exercised is less than 10%.

I assume that real buyers of commodity futures use them as a way to control raw material costs in an orderly way. I used to watch silver when Kodak was using a lot, prices were usually rational except for the time the Hunt brothers tried to corner the silver market.

Speculators, on the other hand, aren't interested in future commodity costs, they treat the contracts like bets on horse races. So they spend more time studying the psychology of markets than economic forces.

Only the poor can afford to gamble. The rich invest.


Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Fri May 19th, 2006 at 10:32:31 AM EST
Futures contracts are a way of insuring yourself against future price movements (hedging). Speculators provide the insurance. Insurance costs money. On average, speculators make money on the futures market, and hedgers lose money. This is because the price risk has been transferred from the hedgers to the speculators, and risk has a price. Because the speculators are taking the risk, just because they make money on average doesn't mean many of them don't get badly burnt.

At least that's the theory.

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman

by Migeru (migeru at eurotrib dot com) on Fri May 19th, 2006 at 10:37:36 AM EST
[ Parent ]
How much of this model is based on statistically significant research, and how much is 'Everyone knows that...'?

And how does this work in practice? Do speculators formally quantify risk from data points and a distribution curve and only bet if the peak probability suggests they're more likely to win than lose? Or do they stick a finger in the air and guess a lot?

If it's the latter then the concept of risk becomes very fuzzy, because it's really just guesswork and opinion, and presumably becomes more of a sales exercise than a quantifiable process.

If - as Colman's study suggests - no one really knows anything, then what is it that people are really betting on?

by ThatBritGuy (thatbritguy (at) googlemail.com) on Fri May 19th, 2006 at 12:22:31 PM EST
[ Parent ]
Being a contractor for the IT of a leading bank in derivative equities, I can assure you that some traders go into great length of calculations before taking a positions, involving lots of historical data, mathematical models, and Monte-Carlo simulations. They happen to make a lot of money, for the 10th year straight. Could be coincidence. Of course, it helps that other players on the market do stick a finger in the air, and engage in risky deals with those who really know what the risk premium should be. This works well with derivatives, which depend on well installed trends like some class of stock being more volatile than others or having correlations between them, and not too far away in the future (36 month option contracts are a finger in the air).

Pierre
by Pierre on Fri May 19th, 2006 at 12:38:28 PM EST
[ Parent ]
yep.  we had some the brightest mathematicians you'll ever meet.  And at least one I know of made partner level at GS coming from the oil group.

A lot of it still involved sticking your finger up though unless the game was designing ultra complex derivs to pimp the client.  some of that going on too.

by HiD on Fri May 19th, 2006 at 04:59:14 PM EST
[ Parent ]
Of course, it helps that other players on the market do stick a finger in the air, and engage in risky deals with those who really know what the risk premium should be.

You do realize, don't you, this observation destroys Neo-Classical Economics?

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sat May 20th, 2006 at 02:15:23 AM EST
[ Parent ]
The article Colman links points to this paper on "for currencies futures aren't good predictors". From the abstract:
For most, but not all, of these instruments, we find that we can reject the hypothesis that the forward or futures rates are rational expectations of actual future prices. It is well known that foreign exchange forward rates give less accurate forecasts than a random walk, but we show that this is also true for some interest rate futures and forward rates. We conclude that forward and futures prices are not generally pure measures of market expectations: they are also heavily affected by the market price of risk.
The article Colman quotes says this:
It turns out that in a horse race against a random walk and a simple time series (ARIMA) model, futures do not have the smallest mean error.

...

On the other hand, futures do have the smallest mean squared errors. Hence, one could do worse than using futures to assess prospects for oil prices. (See also Wu and McCallum, 2005.) On the other hand, the differences aren't too great between the futures and a random walk (at 3 month horizon) and an ARIMA(1,1,1) -- close to a random walk -- at the 6 month and one year horizons, thus consistent with this post by James Hamilton on the time series characteristics of oil prices.

I need to chew on this some. As for statistical tests of whether speculators make money, let me get home to my copu of Hull and I'll get back to you.

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman
by Migeru (migeru at eurotrib dot com) on Fri May 19th, 2006 at 12:42:39 PM EST
[ Parent ]
The really good speculators make money most of the time as a team.  But it's not monolithic.  I've seen dozens of small players blow up and disappear.  Also entire groups at Oilcos blow it really big and get sacked (Neste c. 1995).  I've also seen investment bank groups make a huge mess and get killed (some war stories there too).

The dentist in des moines (generic tiny speculator) is rarely more than a source of commissions for retail brokers.  I don't think many of them make money over time.

Individual traders at the big boys can look like a genius one year and idiots the next.  Part of that is what the trade calls the trader's option.  If you bet like crazy and win, you get a big bonus.  If you bet like crazy and get killed, you get a new job because you have a reputation as a big swinging dick.  That works once or twice.  If you blow up a couple times running......

The real trick is to become the clearing house which is where Morgan and GS excel.  They are where the interesting business clears so they always get a nice flow on which they can make a bid/ask spread and speculate based on the extra info they have from seeing more of the market's intentions.  Those guys ALWAYS make money.  They keep the wild eyed punters under control so that they can't sink the whole desk.

by HiD on Fri May 19th, 2006 at 05:17:02 PM EST
[ Parent ]
re the horse race analogy.

we put a lot of effort into trying to figure out supply/demand issues.   It's not rank speculation.  What the lay person can't see though is that far down the curve is a very different game than up front.  

Historically it was all sellers out there with the pros trying to figure out how to lay off the risk.  Now you have hedge funds playing the curve and much less pressure on the producers to sell forward (I'd suspect)

by HiD on Fri May 19th, 2006 at 04:56:05 PM EST
[ Parent ]
I follow oil prices via MRCI, who show WTI and Brent futures one year ahead. Based on price movements I saw there, my comment is: well duh!

The quoted graph shows a similar-looking pattern that moved up a dozen dollars (and whose leg got less steep), e.g. futures prices following spot prices with some damping, and I saw the same happen on a daily basis.

*Lunatic*, n.
One whose delusions are out of fashion.

by DoDo on Fri May 19th, 2006 at 01:29:18 PM EST
Futures are the opinion of the market as to where prices will be in the more or less distant future. Usually, there are fairly precise bets for the first year or two, and then it drifts towards what is seen as the long term expectation.

For twenty years, that long term expectation was extraordinarily stable. It is just as remarkable how quickly that long term expectation has changed in the past 3 years. This is truly the market absorbing new information.

That curve alone tells us that the markets know that something major has changed in the oil market, and that it will not go back to the "good ol' days". The markets are saying thay prices will not go down - not for long anyway.

And people are betting serious money on that, never forget it.

Countdown to $100 oil (24) - What markets are telling us about future energy prices

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Fri May 19th, 2006 at 02:55:15 PM EST
keep in mind what may have changed is the character of the market.

to repeat myself,  in that long flat period, small producers were often forced to sell future production to satisfy banking covenants.  There were few, if any, real buyers 5+years out.  Only Wall Street making a market.  Most projects had to make money with $15-20 crude or they couldnt get financed, and there was surplus of production so there was no upward pressure on the back end.

Now the hedge funds are big, big players.  Buffett/Munger was on the phone daily to the guy sitting across from me back in 1996.  (Ditto Tiger.)  Buffett was an early adopter.  Many, many more are involved in commods now and there is much more money in hedge funds overall.  

So now you have a more realistic market.  That overlays the obvious supply/demand tightening.

by HiD on Fri May 19th, 2006 at 05:22:54 PM EST
[ Parent ]
Trying to extrapolate any real meaning from the differentials between spot market and futures prices on oil is entirely speculative.  The futures market can do little more than take present-day numbers for supply, demand, global economic growth projections, etc., and attempt to discern where that might lead.  But this is remarkably ill-equipped to deal with major external events that may have a far greater impact on the spot market price, such as:
  • major weather events such as Katrina;
  • civil unrest in an oil-producing region (e.g., Nigeria) that takes a significant volume of production capacity offline;
  • embargoes against countries or voluntary withdrawal of capacity for political purposes (think Venezuela, Iran, etc.)
When anything like these occur, the traders get spooked, and the spot prices jump around.  And in their wake, the futures prices shift accordingly.
by The Maven on Fri May 19th, 2006 at 02:57:34 PM EST
that is painfully true.  political events are what give traders ulcers.
by HiD on Fri May 19th, 2006 at 05:23:59 PM EST
[ Parent ]
It's been patently obvious since the early 90's the oil market was going to hit the wall of declining production and rising demand.  

It's been patently obvious since 2001 the US money supply has been 'managed' by the Major Money Center Banks driving a semi-tractor/trailer truck up to the FED and filling it with peachy-greenbacks.  For god's sakes, for 2 years the FED was paying MCBs - through a net negative interest rate - to haul the stuff away.

So there is lots & lots of US bucks, as a commodity, bidding against a declining net supply versus demand.  So the price, in those dollars, went up.  (Duh)

Nobody in their right mind, in 2000, would have thought the President of the US would invade Iraq.  But he did.  So there be lots & lots of US bucks, as a commodity, bidding against a declining net supply versus demand plus IdiotStick further reduces the total oil supply by playing at Alexander the Great.  

So the price, in dollars, goes up even more.  

And the money the FED is throwing into the economy is sending house prices ever upward and those houses are being constructed ever further in the boonies resulting in people driving 300 kilometers a day to get to their wage-slave stupid job so they can pay the mortgage, consumer debt, and car payment so the people who work in the construction industry, at the bank, the WorthlessCrap-R-Us Shopping "Experience," or car dealerships who are also driving 300 kilometers a day to their wage-slave stupid job ... can keep their job.  And all of this results in greater demand for oil and the price goes up.  

Again.

And economists come upon the TV and speak punditly about people making rational economic decisions?

Just kill me now.

</rant>

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sat May 20th, 2006 at 03:04:48 AM EST


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