Thursday, March 26, 2009

Department of "Huh"?

Apologies to Brad DeLong for the title, but this op-ed in the Star had me scratching my head:

Control speculative trading in commodities
Making a Point - By Jagdev Singh Sidhu


"The price of crude oil has been kept from falling through a combination of planned supply cuts by oil-producing cartel Opec to meet an anticipated reduction in demand in 2009, and the hope of demand increasing as the global economy recovers...The argument is that too low a price will mean trouble for the energy markets as higher costs have already seeped into the business. Refining costs have gone up and so too have exploration and drilling costs over the past few years as oil companies venture off the deeper waters and harder-to-access places in search of the commodity."

This is an argument that the current highish oil price is being supported by a restriction in supply as well as a higher cost structure - an argument based on fundamentals.

This is then followed by:

"Plans to limit excessive speculative trading in commodities by hedge funds must be carried through and enforced. The world doesn’t need higher priced commodities raising inflation, hitting the public’s wallets and slowing any recovery in the economy."

This suggests that speculators are driving up the price of oil - an argument based on market manipulation. So which is it? Given the current deleveraging and risk aversion going on, does anybody have the stomach for "speculating" at all?


  1. In the current bearish environment of falling prices, the speculators and market manipulators are sidelined.

    There were strong suspicions of market manipulation when crude oil prices reached stratospheric heights although no one in any jurisdiction has been hauled up to-date.

    The columnist is probably alluding to the regulatory sentiment that some form of control be put in place to temper the volatility of crude oil prices.

    The questions may be:

    (1)When is a good time to put regulatory controls in place?

    (2) Are regulatory controls necessary?

    (3) Is it possible to create any regulation of this type (a'la securities manipulation regulations?) in any specific jurisdiction let alone global regulation?

    (4) Who are the culprits that manipulated crude oil prices (if any)?

  2. The thing is - it's all normative. How do you differentiate between 'normal' speculation (which is necessary for the price discovery process), and 'excessive' speculation? What happens if excessive price movements are 'fundamentally' driven?

    I generally agree about regulation of the hedge fund industry, mainly in terms of their use of leverage, but not necessarily to limit speculation. What is speculation after all but an "informed" view of the future, and then putting your money where your mouth is?

    The problem I have with the op-ed is that it conflates "excessive speculative trading" with "higher priced commodities" despite mentioning "planned supply cuts". That makes for a confused and confusing argument.

  3. I understand the point you are making and, I agree that there is a contradiction in the op-ed piece.

  4. I wonder whether the difference of normal speculation & excessive speculation lies on amount of leverage and amount of derivatives used.

    should amount of leverage and amount of derivatives used be regulated ?

  5. "should amount of leverage and amount of derivatives used be regulated ?"

    Bingo! It's the leverage used that makes for excessive betting, and incidentally makes financial institutions more fragile. I understand that US investment banks were allowed to raise their leverage from 12x (normal Basle I requirement) to 30x in 2004.

    Coincidence? Don't think so.

  6. I have a blog post abt OECD's report titled "The Current Financial Crisis – Causes and Policy Issues". The author shares your view. Year 2004 and leverage ratio.

    do you think Basel II forming process is "captured" by financial institutions ?

    Quite ironic. Basel II that supposed to improve on risk management contributes(?) to more risks to the systems.

  7. Investment banks (and merchant banks) differ from commercial banks in the sense that their funding is almost entirely on the wholesale level, i.e. from the money market rather than from customer deposits (retail funding). That means their balance sheets are far more sensitive to liquidity risk. Raising their maximum leverage does not make sense from the point of view of managing systemic risk, even with greater access to hedging instruments - as the saying goes, in a crisis all market correlations go to one.

    And that's why using risk models to manage capital ratios doesn't make sense either - capital requirements become pro-cyclical rather than counter-cyclical, which excaerbates financial fragility when things go wrong.