Alan Reynolds - Scapegoating the Speculators

Alan Reynolds has written another interesting article on energy and pricing entitled "Scapegoating the Speculators." After the Democrats tried to claim that the price of oil had gone up greatly because the U.S. oil companies were responsible for manipulating the price and most of the public did not buy into their arguments, they and others, including John McCain, began focusing more and more on an explanation that the price of oil was higher due to speculators. Alan Reynolds offers some very interesting perspective on this claim.

But first before considering his argument further, why is this an important matter? If, as the Democrats are saying, speculators are driving up the cost of oil or even if they are not but are perceived to be doing so, then the Democrats can address the problem of high gas prices by passing a law to control the speculators. This gives them more power over the financial markets and will result in more campaign contributions from financial people who will want to get on their good side. What the Democrats and their occasional Republican ally (John McCain in part) will not then have to do is to allow U.S. oil companies to drill for more oil and gas. As environmentalist extremists and Global Warming Alarmists, these people do not want to allow more oil and gas to become available. They actually do want the price of oil and gas to go up even more, but they do not want to be seen as the responsible party for that price increase. This is all about perception in the eyes of the public. The Democrats do want to manipulate the supply of oil and gas to make the price go way up, but they do not always, especially with an election coming up, want to be perceived as having done so.

So, what does Reynolds say? Commodities speculators are just as happy to bet that oil prices will go down as to bet that they will go up. They are trying to anticipate the expected relationship of oil supply to oil demand. If next month's oil futures contract is for oil at a higher price, then producers may slow their sales on the spot market and try to wait a bit for the higher price. [This is usually a good thing, since it helps to level out prices by keeping supply and demand on a more even keel.] Refinery's are likely to buy more oil now rather than in the future if the future price is expected to be higher, thereby boosting the present price. But, if this combination of reactions to the higher future price occurs, then oil inventories will increase. At this time, U.S. oil inventories are modest, so this speculative boost to oil prices does not appear to be the case!

He notes that speculation that the price of oil would go up decreased after the price exceeded $100 per barrel. On 11 March, there were 113,307 long contracts (those expecting a future price increase) on the New York Mercantile Exchange. By 10 June, there were only 25,246 long contracts, meaning that there are nearly as many contracts going short (expecting a price decrease) as going long. Off the commodity exchange, one can bet on the future price of oil by investing in the US Oil Fund. Those betting short on this fund outnumber those betting long by a two to one ratio. These speculators are betting on the price of oil going down!

Reynolds says there is no mystery behind the rise in oil prices. There is booming demand for oil and products made from it in India, China, and the Middle East. The supply of oil from the U.S., Mexico, Venezuela, Nigeria, and Russia has fallen.

Back to my comments: U.S. oil production is falling because Congress and President Clinton have not allowed more exploration and drilling for oil in the U.S. Production continues to fall in Mexico because their nationalized oil company is run incompetently. Oil production in Venezuela is down because of the tyrannical reign and complete irrationality of Hugo Chavez. Nigeria's production is down due to internal unrest and sabotage. Russia's production is probably down because the oil companies there were taken over by ex-KGB thugs tied in with Putin.

Prices are always determined by supply and demand unless government sets the price. If government does set the price too low, then people stop producing and supplying that good or service. If we want to use oil at a reasonable price, then we have to allow the production of a goodly supply of oil. So, instead of wasting our time and money while we pay far too much for our gasoline, Congress needs to allow the exploration and production of oil on the federal lands in the contiguous 48 states, in Alaska, and in our coastal waters. This will increase supply and that will bring down the price of oil and its products, such as gasoline. Of course, with oil and gasoline as expensive as they are now, people will make greater efforts to conserve them as well. The magnitude of the world's demand increase is likely to run well ahead of conservation efforts alone, so both oil production increases and more efficient usage are the proper response.

Depression Lunacy

There is a great deal of talk in the media, broadcast and print, that we are heading into a depression, or at least a significant recession. We had a one-month drop in manufacturing followed by a rise the next month and we had a brief leap in unemployment, which has since leveled out. Housing starts are certainly down and energy and food costs are certainly up. Despite all of this, the economy has not been knocked to the ground. It seems determined to chug on. Many companies just announced first quarter earnings which beat expectations. Consequently, stocks went up last week. But, the Gloom and Doomers have great staying power, especially with a Presidential election coming up. So, let's see what economist Alan Reynolds has to say about the state of the economy.

On 11 April, before most companies announced their first quarter earnings, Reynolds had an article appear in the New York Post. He notes that the gloomy economic news is of a credit crisis or a financial crisis. He points out that since WWII, no U.S. financial crisis has become an economic disaster. The S&L crisis of 1986-1995 was the worst financial crisis since WWII, but the economy grew by an average 2.9% a year in that time. There was a recession in that time lasting 8 months and beginning with the invasion of Kuwait by Iraq when oil prices jumped 113%. By then, the S&L problems were healing.

So, what is going on now? The LA Times asked on 20 March if another Great Depression was just over the horizon. On 6 April, the NY Times claimed that the "focal point for the stock market's difficulties" is that "banks have been reluctant to lend money to one another, or to anyone else." Reynolds points out that this is nonsense since the six-month London Interbank Offered Rate (LIBOR) would not have fallen from 5.3% to 2.6% in the last year if this were so. Bank loans to "anyone else" have increased by 8% according to Federal Reserve Board data since last August. As a further anecdotal measure, numerous companies are calling me daily eager to loan my laboratory money to buy equipment!

So, where is the difficulty? Reynolds says, "It is in selling or valuing exotic securities." The IMF, the Washington Post reports, says the crisis will cost nearly $1 trillion. Well, that estimate was for the entire world, not the U.S. This is the accounting loss of 4.1% on all sorts of loans and securities. The IMF estimates losses of $115 billion on mortgages alone. But, these accounting losses are in many cases only temporary. In many cases the future cash flow produced by the mortgages will be much higher than implied by the accounting loss declared. Standard and Poors says these write-down losses may be as much as $285 million. Well, in comparison, the S&L losses were 3% of GDP, which would be $450 billion now! Reynolds notes that many of these potential losses will be to foreign banks now, rather than U.S. banks or S&Ls as they were in the S&L crisis.

The villain socialist Paul Krugman (remember the guy of a few posts ago who did not like BB&T giving money to universities to teach Ayn Rand's philosophy) told Fortune that we should expect $6 or 7 trillion in capital losses in housing. Reynolds notes that the Federal Reserve estimated the value of household real estate was $22.5 trillion in the 4th quarter of 2007. A 30% fall in house prices would generate a $6.8 trillion loss! A 30% decrease in value across the nation is unlikely. Furthermore, Reynolds points out that this household real estate is not just single family homes, but it is actually all commercial, farm, and rental property as well owned by households and nonprofit institutions!

Further, the often quoted S&P Case-Shiller index of house prices only covers single-family homes in 20 metropolitan areas. The extra-expensive LA, San Francisco, and San Diego areas are weighted heavily at more than 25% of the total loss of 10.7% for home values in this index. Data for the whole country show that single-family homes lost 3% in the year ending in January. Between the 4th quarters of 2006 and 2007, home values rose an average of 3.8% in 29 states not appearing in the S&P Case-Shiller index. Two states not included in the S&P index actually did see home values decrease, but it is clear that the home value losses are largely localized to metropolitan areas heavily overweighted in the S&P index.

Others have claimed similarities to the 2000-2002 tech-stock collapse. But, Reynolds notes that in 1999 to 2000, oil prices also nearly tripled and in late 2000, the Fed increased the fed-funds rate to 6.5% with industrial production falling. Then came 9/11. So, there were more shocks to the economy than just the tech-stock collapse.

Actually, the S&L and tech-stock crises were quite mild recessions. They were brought on by worse economic conditions than we have now, so it is insane to be drawing analogies to the Great Depression. It is a common practice for socialists and some contrarians to tend to exaggerate the problems of the U.S. market. The socialists do it to create an excuse to have more government controls put in place and to hit higher income taxpayers with higher taxes. The contrarians often do it because they underestimate the resilience and resourcefulness of American producers and investors. Others do it because a frightened public will pay more money for investment advice. The media does it because frightened people watch and read the news more. As a result, you have to carefully seek out those who know what they are talking about, like Alan Reynolds.