Friday, June 27, 2008

Waldmann on Waldman

Krugman argues that speculation in oil futures can't have caused the current high price of oil because the future price is lower than the spot price.

Steven Waldman explains why this argument isn't rock solid. His argument is that oil demand isn't deterministic and, in the very short run, oil in different places can have very different prices. This means that the expected cost of having a tank full of oil isn't the storage cost plus interest, but the storage cost plus interest minus the "convenience yield".

What is this "convenience yield"? [snip+]

Oil is a "spiky" commodity. Every once in a while, someone really needs it, now, and will pay a premium for immediacy. The market for oil in Cushing, Oklahoma might be reasonably efficient, but what happens when someone in Peoria needs oil today? Opportunity! ... you build an oil tank in Peoria. Suppose that every month, there's a 10% chance a desperate client will offer a 5% premium for immediate delivery of all your oil, and that interest and storage cost you 0.2% per month. Then on average, you'd earn 0.5% (10% x 5%) each month from desperate clients, and pay 0.2% in expenses.


Actually I'm glad that Waldman isn't arguing with Krugman about the actual case of actual current oil prices, because I wouldn't want to disagree with another Waldman*.

He writes "I agree with Krugman that futures markets can't explain the recent skyrocketing oil prices." and "This is a disquisition, and ode, a homage and a tribute to the marvelous, mysterious, misunderstood and maligned convenience yield:"

The reason is that the convenience yield argument can reconcile one of Krugman's facts, the futures price is below the spot price, with the speculation hypothesis, but it can't explain the other -- inventories aren't growing.

In contrast, it is easy to explain the other -- the inventories in question are oil under the ground (although that should show up as a decline in production which I don't see but I only know monthly up to April). The point is that storing oil under the ground doesn't have a storage cost (you even save the interest on the cost of pumping it if you pump it later) but it does have an interest cost and it doesn't have a convenience yield.

Both facts together seem to make a solid case that the current price of oil is not due to futures speculators.

2 comments:

ddt said...

"the point is that storing oil under the ground doesn't have a storage cost (you even save the interest on the cost of pumping it if you pump it later) but it does have an interest cost and it doesn't have a convenience yield."

What if the interest cost is negative? ie you have a better chance of preserving value by keeping oil in the ground rather than exchanging it for dollars that yield a negative return after inflation.

If keeping oil in the ground has no storage cost, then whether the expected return on dollars is negative or positive would play a large role in determining whether or not it is in your best interest to keep oil in the ground.

The presence of negative real interest rates throughout the world would seem to provide a reason for keeping oil in the ground.

Also oil in the ground does have a small convenience yield. You just appealed to the convenience yield of leaving ANWR oil in the ground in your latest post.

Robert said...

The benefit from leaving oil in ANWR, which I mentioned, is not a convenience yield. It is noting that one plus the return is greater than zero, not claiming that one plus the return is greater than one.

Although I did not say so in the post cited by ddt, I happen to think that the return on unlocated oil in ANWR and off shore is likely to be much higher than zero. That is my guess of the speculative yield.

A convenience yield is a yield from having oil some *place* other than the place named in futures contracts. Given the way futures contracts are defined, I would guess that the convenince yield of oil in the ground in most fields is negative. I'm sure this is true of ANWR.

The correct comparison of the return on oil, given futures markets, is the nominal interest rate. If you insist on correcting for inflation, then you must subtract inflation from the future price of oil (it's a number of dollars) as well as from the nominal yield on bonds.

Inflation can make it wise to leave oil under ground *and* to pay a lot of dollars for a futures contract. It can't do one without doing the other even if people have different forecasts of inflation. If an oil pumper thinks inflation will be really high, he can do better by pumping and selling oil and buying oil futures which sell for fewer dollars than the oil. This would be a pure arbitrage gain with no risk yielding the same claim on future oil and some cash.