Look: I am eager to learn stuff I don't know--which requires actively courting and posting smart disagreement.

But as you will understand, I don't like to post things that mischaracterize and are aimed to mislead.

-- Brad Delong

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Thursday, May 19, 2011

No Speculation About Oil Prices

I think I can show that oil prices are not behaving in a completely supply-demand determined way.  We'll look at price activity, volatility, and an estimate of what rational pricing might be.

First, here is Brent Crude spot price activity since 1987, data from the U.S Energy Information Administration.  I've taken a weekly average of daily data, and plotted it as of each Friday (it was just a lot easier than trying to work their data table into a daily data plot.) Also included is a 55 week moving average.

As you can see, the price really took off after 2000.  Coincidentally, the Gramm–Leach–Bliley (Financial Services Modernization) Act of 1999, which undid portions of the Glass-Steagall of 1933, was signed into law on Nov 12 of that year, and the Commodities Futures Modernization Act of 2000 was signed into law on Dec 21 of that year.  These new laws allowed mega-consolidation in the finance industry and prohibted the regulation of certain speculative activities.

Here is the same data, separated into two graphs around the year 2000.  Also shown are the 55 week moving average, and an envelope one standard deviation above and below the average.  St Dev is based on the same 55 data points as the moving average.  The sections of the price line that extend above the {Avg + St Dev} line are highlighted.

The entire data set contains 1166 points.  Of these, 428, or 36.7%, lie more than 1 Standard deviation above the moving average.  For the segment through 1999, 156 of  574 points, or 27.18%, lie above the St Dev envelope.  For the segment 2000 on, 227 272 of 592 points, or 45.95%,  lie above the St Dev envelope.

For data normally distributed around the mean, about 1/3 of the data points should lie outside the 1 St Dev envelope, half above and half below.   I'm no statistician, but this is not a well behaved data set.  Clearly, there is a powerful high-side bias.  What could be the cause?  Here are some possibilities.

1) Supply-demand forces in a growing world economy are so skewed to the demand side that this is that natural result.
2) External forces, such as panic due to war and instability in the Middle-East, have irrationally raised prices.
3) Speculative forces with a strong long-side bias have skewed the market away from a supply-demand determined price level.
4) Withheld supply due to OPEC activities, contango (hoarding on leased tankers), and the disruption of Iraqi supply for the last decade have unnaturally skewed the supply component.

My view is that possibilities 2 - 4 are all operating to some degree.

I have no way of evaluating 2 and 4. However, 4 seems reasonable, in view of the classic description of inflation: too many dollars chasing too few goods.  This effect could also spill into into futures speculation, where the amount of oil traded is finite, but the amount of speculative money available appears not to be.

Update:  To be clear, I'm not talking about CPI inflation, I'm talking about commodity-specific inflation.   I believe that financial tail-chasing has not been limited to oil speculation.  There is enormouse wealth in the world, and to a large extent, it is not being devoted to legitimate investment.  It is being devoted to computer generated program tradign that skims tiny fractional percentage gains thousands of times per day to skim money away fro tose who use eschanges for valid purposes.

And maybe we can get a handle on speculation.  My hypothesis is that deregulation in the 1999-2000 time frame has enabled and encouraged speculative rent-seeking activities in the oil futures market, which has inflated the price of crude.  One way to go at it is to have a look at volatility.  We already have standard deviation in our hip pocket.  Let's see what we can do with it.

Here is standard deviation, based on 55 consecutive data points, divided by the average of those data points.  Just for kicks, included are a 55 point moving average of the St Dev in red  (for what it's worth -  not much, I'd say) and a best fit (least squares) trend line. 

Well - the trend line slopes up a bit, but that's not really a lot to go on.  On the other hand, the entire 90's lie below the trend line.  In fact, except for the 1990 price spike, most of the of the St Dev values prior to about 1999 lie below the trend line.  Let have a closer look.

Here, the data are divided into two segments,  up through 1999, and 2000 and beyond.   For the early segment, the St Dev/ Price line is in dark blue and the 55 week average is in red.  For the latter segment, the lines are light blue and yellow, respectively.  Now, the trend lines tell an interesting story.  For the early period, the trend line is essentially flat, with a slight downward slope.  For the latter period, the slope is clearly upward.  Despite the localized gyrations, we can see that prior to deregulation, volatility had no trend.  After deregulation the trend is up.

Up to 1999, St Dev / Price averaged 12.65% (exclusive of the 1990 spike, taken as August, 1990 through January, 1991 the value is 12.01% )  From 2000 until now, the St Dev / Price averaged 15.06%.

So, what we see is that since since deregulation, prices have gone up, volatility has gone up, and upside bias in the data set has gone up.  Let's resurrect possibility 1) and see if demand pressure can be the cause.  To get a handle on this, I took a closer look at my speculative idea from the previous post, and extrapolated prices forward from 1990, based on hypothetical constant growth rates.  Originally, I took a SWAG at the 1990 average price, and came up with $30 per barrel.  With a growth rate of 4% over 21 years, that would result in a current price of $68.36.  The 4% growth rate came from a generous estimate of World GDP growth over the period, assuming a direct, linear link between GDP growth and demand for petroleum.

Here is a graph based on the data instead of a SWAG.  It shows constant price increase rates of 3, 4 and 5% per year, based on the actual 1990 average price of $23.66.  The first thing to note is that my $30 SWAG was more than $6 too high.  The next thing to notice is that 1990 was the worst possible year to select, given the point I'm trying to make.  Due to the local spike, the 1990 average of $23.66 is almost $5 higher than the 1987 to 1993 average of $18.84.  So, if anything, my estimate of $68.36 is artificially high.

Still, I went with the 1990 average for this chart.  Extrapolations are based on growth rates of 3 (yellow), 4 (red) and 5(green)% from the 1990 average of $23.66.  This gives current price estimates as follows.

At 3%   $43.34
At 4%   $53.02
At 5%   $64.09

I'm not suggesting that this is a fool-proof method.  However, it is gratifying that it is more-or-less consistent with the oil industry estimation of a supply-demand determined price.  Further, these price growth estimates are quite generous, since estimates of petroleum demand growth are in the range of 1.6 to 2.3 %.

My conclusions:
1) The price of oil is far above rational, market-based pricing.
2) While other distortions and manipulations are likely to play a part in an inflated price, it's not clear how they could contribute to increased volatility.
3) Unregulated, excessive speculation, with a long side bias is indisputably taking place.  I believe this is a major contributor to excessive price inflation, and the sole contributor to excess volatility.

Do you have a better idea?  Let's hear it.


Stagflationary Mark said...

"For data normally distributed around the mean, about 1/3 of the data points should lie outside the 1 St Dev envelope, half above and half below. I'm no statistician, but this is not a well behaved data set. Clearly, there is a powerful high-side bias. What could be the cause?"

You are comparing the current price to the 55-week moving average. That means that you are comparing the current price to the average price set 27.5 weeks ago (the average price set over the last 55 weeks).

If prices are generally rising over time (due to inflation if nothing else), then one would expect to see high-side bias in the current price relative to the 55-week moving average.

For example, the consumer price index is almost always above its 12-month moving average. That's because the consumer price index almost always rises over time. Since 1960, the price index has been above its 12-month moving average 98.5% of the time.

Stagflationary Mark said...

I'm not trying to suggest that there is not oil speculation going on by the way.

I'm simply saying that I don't think we can see it by comparing the current price to the 55-week moving average without at least correcting for the generally upwardly rising prices (that would occur in theory even if no speculation was present).

Stagflationary Mark said...

One more thought.

I am a believer in your "standard deviation / price" chart. It is what I would expect to see as a society becomes more and more leveraged.

It reminds me of one of my favorite housing quotes.

April 7, 2005
Home foreclosure listings surged in March

"It may simply reflect our overleveraged society and the fact that people are carrying more debt on everything and it doesn't take a lot to affect a small percentage of them in terms of moving them from homeownership to not," Curran said.

That was intended to give us comfort. Just read what he said next!

Jazzbumpa said...

Mark -

If prices are generally rising over time (due to inflation if nothing else), then one would expect to see high-side bias in the current price relative to the 55-week moving average.

I agree. What's interesting, though, is that while there is high-side bias in the entire data set, it is much greater in the post 2000 period, while inflation has been much lower than in the previous period. What I'm chasing here is the difference before and after 2000.

In fact, when inflation was the highest, oil pricing was close to stagnant.

Gotta run. I'll check your link later.

Thanx for the comments,

Stagflationary Mark said...


It is my opinion that the oil speculation is due to real short-term interest rates being negative (like they were in the 1970s).

This is an unintended consequence of using QE to force inflation. That's certainly why I speculated on gold and silver from 2004 to 2006. Ben Bernanke cannot force wage inflation but he can force hard asset inflation. He wanted housing inflation. He got commodity inflation instead.

The difference in leverage between now and in the 1970s can be explained by the difference in nominal rates. If interest payments alone constricted the ability to borrow (they don't but they do to some degree), then we could borrow 10x more money to speculate at 1% interest rates than we can at 10% interest rates.

I'm about to do a post on this topic as a thought experiment.

Stagflationary Mark said...

Here's the post.

The Arthurian said...

Great post, Jazz! Some time you have to give me a lesson on figuring and using St Dev. And Mark can give me a lesson on evaluating it.

RE: Your last graph there, the "Price Rise Estimates" graph... Looks like the actual prices are *flatter* than the estimates until around 1999, and *steeper* after. Adds weight to the deregulation argument you presented so well.

BadTux said...

Specifically, too many *INVESTMENT* dollars chasing too few investment opportunities. And there are too few investment opportunities because consumption has collapsed because consumers have experienced real deflation in wages and asset values (remember, the primary asset of the consumer class is their *home*, which has collapsed in value).

We have a way of dealing with too many investment dollars and too few consumer dollars: Tax the investor class and redistribute the money to the consumer class via government purchases of goods and services since goods and services are provided by, err, the consumer class (otherwise known as the worker class), since the investor class wouldn't know how to stock a shelf or build a bridge if you tried to make them do it at gunpoint, they're basically parasites that just move money from point A to point B while sticking a bit of it to their fingers in the process.

Oh wait, I forget, we can't do that, even though it'd solve the problem, because it'd make Baby Jesus cry or somethin'. Alrighty, then!

- Badtux the Snarky Economics Penguin

Stagflationary Mark said...

The Arthurian,

You posted a comment on my blog and the SPAM detector caught it. I rescued it from Blogger's evil clutches and it is now visible to all.

Sorry about that!