31 May 2008

Bundles and Bundling

In economics, a "bundle" is a group of goods that are associated in some way. The most common context is in welfare economics, in the sense of an indifference curve. Each point on the indifference curve represents a different bundle of goods A and B; each point, that is, represents different quantities of each. Naturally, if one doesn't need to draw a diagram, one could use the same equations to solve problems involving bundles of many commodities; although technically, 10 different goods in a bundle means a 10-dimensional "indifference surface."

Commodity bundles are an important topic of interest for determining the true rate of inflation, the true purchasing power parity of currencies, or the actual rate of poverty in different times and places. Since inflation affects different commodities to different degrees, the difficulty lies in deciding how much weight to assign to each good.

A more interesting context for the idea of bundles is in analyzing the economics of goods that are really a group, or bundle, of simpler goods. An example of this is the financial services sector, which spent several centuries developing the concept of a merchant banking account, and then suddenly decided that what customers really wanted was all of these services sold separately:
The reason that growth has continued despite adversity, or perhaps because of it, is that these new financial instruments are an increasingly important vehicle for unbundling risks. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it. This unbundling improves the ability of the market to engender a set of product and asset prices far more calibrated to the value preferences of consumers than was possible before derivative markets were developed. The product and asset price signals enable entrepreneurs to finely allocate real capital facilities to produce those goods and services most valued by consumers,...
Alan Greenspan, remarks, 19 March 1999 (PDF)
Customers are expected to buy all of the separate features of a bank account separately, possibly from different vendors, and most likely as computer-generated securities. It bears noting that consumers may neither want to, nor be able to, supplant the expertise of an actual bank manager. Nevertheless, the fact that banking services have indeed been unbundled—i.e., detached from each other and sold separately—has allowed banks to establish what customers are actually prepared to pay for.


29 May 2008

Tradable Streams

Every time the topic of high commodity prices comes up, there's a lot of talk about Enron. Can speculation drive up the prices of traded commodities? Of course, Enron proves it. That's the commonsense answer, and I think it would be a good idea to address this in a dedicated post on the subject.

The Story of Enron

Enron was a very large energy company created by a flurry of mergers and acquisitions in the early 1980's. The core firm was InterNorth, a holding company created in 1979 to provide an additional layer of protection from the risks of a rapidly expanding subsidiary, Northern Natural Gas Company. The purpose of Northern Natural Gas was to build and operate 103,000 Km of PNG pipeline connecting Texas and the Great Lakes region. InterNorth acquired a natural gas supplier, Houston Natural Gas, and changed its name to Enron (1985). The following year Ken Lay, took over at the company, and relocated it to Houston.1

Enron remained almost exclusively a PNG supplier and pipeline operator until 1998. That year it attempted to diversify into water; they acquired Wessex Water, turned it into Azurix, and lost about $2 billion trying to turn water into a lucrative business.2 Enron then turned to broadband, partnering with Sun Microsystems to dive into the internet bubble. That, too, was a hugely costly failure that was not wrapped up until November 2001. But Enron's real business was trading in streams.

Streams Explained

A stream (in this sense) is a supply of a benefit that has to be continuous through time. An example of this is electricity. Electricity, for the end user, is something that has to be available at all times. Hence, when streams are commoditized and traded, they are fundamentally different from other commodities. First, there is no possibility of an inventory; electricity cannot be stored. It has to be continuously available to be useful. This means that, as a tradable thing, streams must necessarily incorporate a period during which they are supplied.

Someone might point out that the things I refer to as "flows," viz., crude oil, iron ore, gold, pork bellies, rolled steel, and the like, have active futures markets. Futures contracts specify not only the amount and quality of the commodity to be delivered, but also the date of delivery. But those are derivatives, not the underlying good. Second, a future contract to deliver a load of a particular commodity on a particular day is not comparable to a contract to deliver a stream of service over a period of time. The exact time period of the service is an inherent and permanent feature of the thing being sold.

Examples of Streams

The most obvious examples of tradable streams are
  • pressurized natural gas (PNG);
  • electricity;
other very common examples include
  • water/wastewater;
  • broadband internet connectivity;
  • long distance telephone service;
  • insurance.
The last one is actually the earliest stream to be traded: Lloyds of London introduced the concept of securitizing risk and trading it. Natural gas can only be stored or reshipped with difficulty; usually it is consumed fairly close to the source, although Enron's precursor, Houston Natural Gas, created a complex network of PNG lines spanning thousands of kilometers.

Problems with Trading Streams

As we shall see, this makes trade in streams inherently much more complicated than trade in flows.

The first reason is that packaging a stream (as opposed to an item like an ingot of steel) is likely to sharply impinge on the value or character of that stream. For example, for industrial applications, a kilowatt-hour is not a generic thing at all; often major commercial consumers of electric power require a premium vendor who can ensure no spikes, extra support, and so on. While it's possible to specify different grades of stream, or even unbundle those services and trade them as separate steams, this defeats the point of premium service since the consumer has to essentially replicate the administrative abilities of the premium supplier.

Second, markets don't clear in the same way when the commodity is time-specific. Let me explain again: other commodities can be traded as future contracts, for delivery of a specific amount, quantity, and quality by a specific point in time; a stream is for something that exists only during a period of time, namely, the period during which it is actually used.

The market price of a thing represents the opportunity cost to the supplier of actually supplying that good to the person paying the price. In other words, commodities have prices because they are scarce, which is to say that there are alternative uses for them. Our market economy uses prices to ration commodities to those who can pay the most for them. However, as the time approaches when the stream bid upon is to be delivered, the price can become highly volatile.3 The total number of buyers and sellers shrinks very fast, which tends to make any "equilibrium price" very unstable. Essentially, basic economic theory gives way to the arcana of game theory and multiple equilibria. The result, at best, is a much more demanding regulatory environment; at worst, unacceptable disruptions in the system of energy supply; and in between, a permanently higher cost (if not price!) of the stream itself.

Part of the problem, naturally, is that both buyer and seller have a gun to the other's head. Trading in streams, in practice, typically involves transactions that take place literally minutes before delivery of the stream for the relevant time period. Since it's not really practical for smaller players to engage in games of "chicken," this restricts stream trading to very large customers.

This doesn't mean the concept is a failure. It does mean that the system only works when it's tightly controlled, as in Western Europe.

1 Enron does have an extremely interesting history, especially since it consisted of a merger of several older firms. Bryce (2002, see below) emphasizes Houston Natural Gas (HNG) Co. as the core firm, as well as the peculiarities of Houston's business culture. However, Enron appears to have always been something of a bungling conspiracy of its components, rather than an organically unified entity.

2 When Bryce wrote Pipe Dreams, Enron had tried and failed to displace Vivendi (Compagnie Générale des Eaux) and Suez, the two French companies that dominate the market worldwide. As Bryce's book came out, it depicted Vivendi as the seasoned victor of its clash with Enron, which it was in 2000, when Azurix imploded. Nevertheless, Vivendi suffered a financial meltdown at the time of publication, as a result of Jean-Marie Messier's spectacular joyride at the helm (Time). Vivendi's water business is now Veolia Environment.

Suez is still in business; it dates back to the 1850's, although it had taken its current name in 1999 after a merger; its water operations are named "Ondeo," which makes for a much easier Google search. Suez is about to be acquired by Gaz de France (Forbes).

3 An exception to this is Nord Pool, where the balance from the spot market is maintained until the actual, physical delivery takes place under the regulating power market in Norway. Denmark, Sweden, Finland, and Germany are also members of Nord Pool. Another energy trading regime exists in the UK.

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22 May 2008

Commodity Prices and Speculators

Figure 1

Source: International Monetary Fund WEO, Chapter 5
Figure 2

Since the summer of 2007, the world has experienced an extremely rapid increase in the price of many commodities (figure 1); the most obvious is oil, which has recently reached $135 per barrel. The recent climb in oil prices can be said to have begun in January '07 when the 12-month price change reached a cyclical trough and began to rise, becoming positive in March and began to rise (figure 2). Not only have oil prices been rising; the first derivative of oil prices (i.e., the rate at which oil prices have been increasing) has also increased, with the most recent quotes suggesting a 94% increase over the price 12 months ago.

This post will deal with the question of whether or not speculative activity has played a role in the recent run-up of the price of oil. The null hypothesis* is that recent conditions are nothing more nefarious than the adjustment of prices to increasing demand. Rejecting the null hypothesis means we need to acknowledge that speculative activity on commodities markets has led to the recent increases (or contributed somewhat to the size).


I'm going to need to introduce some technical terms for explanation.
  • pools: an asset for which the total tradable supply is either permanently limited (e.g., paintings by dead artists, real estate) or represents a share of the total (e.g., equities).
  • flows: an asset that is produced and consumed at fairly high rates, such as oil, copper, wheat, or steel.
  • tradable streams: an exotic type of tradable that includes electricity and pressurized natural gas (PNG). Markets in tradable streams are, at best, not mature and I won't be discussing them here.
  • null hypothesis: In statistics, the negation of the idea one wants to test. When statistics is used to establish a particular finding of fact, there must be an explicit statement of fact that one is seeking to prove (the test hypothesis) and an explicit contradictory hypothesis (the null hypothesis) that one seeks to prove false.
  • inventories: US inventories of crude oil are counted in two ways: commercial and commercial plus strategic petroleum reserves (SPR). The Department of Energy usually supplies statistics on both, but it's commercial inventories that get reported. The SPR is under Congressional control; usually Congress has an incentive to add to the SPR, rather than release reserves, so it should come as no surprise that the SPR is huge: almost 650 million bbls, or twice the commercial inventory. Recently, as prices hit staggering highs, Congress took the momentous decision to desist from further expansion of the SPR.

    The Coleman-Levin report features a chart on p.19 that reveals the oscillation of private inventories (commercial US less SPR); inventories are shown mainly oscillating between 290 and 330 million bbl (i.e, over a range equal to 4 days worth of imports to the USA).
  • strike price; guaranteed price of a commodity at date that futures contract matures. Hence, a future contract for 100 bbl of WTI oil at $150/bbl for 6 months in the future (23 Nov '08), which is currently $18 above the price this exact minute.
  • spot price is the actual quoted price of the commodity
"Pools" and tradable "streams" can be subject to price manipulations; the one through corners, and the other through shorts and derivatives. In fact, the 2000-2001 energy crisis in California was largely the result of intentional manipulation of TS markets by Enron and Reliant Energy Systems.

Figure 3
Figure 4
But "flows" are very difficult to manipulate. Basically, you have to hoard the supply in some way; long-run price controls are really hard to do unless you're the government of a major country and can permanently interfere in the supply. At least, this is orthodox economic theory as I learned it in college. In figure 3, when the demand curve slides to the right, the equilibrium price (p* to p**) will rise, as will the equilibrium flow rate (Q* to Q**). All that that has happened is that the increase in alternate uses for each unit of each commodity (or "an increase in demand") has resulted in a new equilibrium price.

But let's now introduce financial speculators. Suppose they know the demand curve is actually concave with respect to the origin (Figure 4). If one really big investor could carry it off, he could buy a huge amount of the stuff, hoard it somewhere, and then sell it. The price would go up a lot, which would make profit α, while the loss incurred selling the inventory on the world market would be the smaller amount β.

More realistically, speculators don't buy current flows, but future ones: say, oil in six months time. Now, there's no huge tank farms with sequestered inventory, but rather, a bubble in the price of oil to be delivered in December '08. The problem, of course, is that this is always possible; and as the price gets more and more out of line, demand shrivels. But producers of either refined gasoline products, or products that require energy to produce, aren't in a position to know that. So they plan based on the forwards market rather than the spot (or current) price. When Dec '08 arrives, other commodities have gone up in price because production of them really has gone down, in response to the soaring costs of inputs. Of course, the oil producers (Kuwait, Venezuela, etc.) have to adjust production of oil downward in response to the pancaking demand.


In theory, speculators who buy commodities future or options (the forward markets) are betting against producers on the price at the time of delivery. Gordon Gecko thinks West Texas Intermediate Crude will be $200/barrel in December; Ellis Wyatt thinks it will be $150. By agreeing to pay Wyatt $175/barrel for oil delivered then, Gecko allows Wyatt to ramp up production to where marginal cost of recovery and shipping is $175/bbl. And if Gecko is right, he walks away with an enormous profit. If he's wrong, and oil is less than $175, then he's already paid for Wyatt's capital expansion; the losses would come out of previous successful bets he's made. The speculator, in theory, absorbs the risk of major short-run fluctuations in price.

But what the speculator can't do, at least in theory, is influence the outcome. Gecko can buy all the options in the world, bidding up the forward price to something astronomical: on the actual commodities markets, the flow of commodities into port facilities all over the world has to match the flow out of them, and the flow out will stop if processors and refiners can't afford them. Several news outlets have suggested that speculators contribute to the high price of petroleum, although without offering details as to how this is possible.

(Examples include Financial Times "Commodity prices part speculative - IMF"; Los Angeles Times, "Are commodity traders bidding up food, fuel prices?")

However, I had heard references to a US Senate Report entitled "The Role of Market Speculation in Rising Oil And Gas Prices" (link below), which alleged that the most plausible price for oil was well below $60/bbl.
Since late 2004, the amount of stored oil in the United States has been increasing. Oil inventories recently reached 347 million barrels – an eight-year high and the largest U.S. inventory since 1998, when oil was $15 per barrel. Similarly, oil inventories in Organisation for Economic Co-operation and Development (OECD) countries recently reached a 20-year high. As the report explains, the traditional factors of "supply and demand" do not tell the whole story on oil and gas prices.

What is new, according to the Levin-Coleman report, is that over the past few years market speculators have poured tens of billions of dollars into the energy commodity markets. For example, the International Monetary Fund reports that over the past three years approximately $100-$120 billion has been invested in energy markets worldwide. Over this same period about $60 billion has been invested in oil futures on the NYMEX.
Bear in mind that that report was published in late 2006, when $60 billion was comparable to about one quarter's worth of US crude oil consumption. Since that report was published, crude oil inventories in the USA have declined somewhat to 320 million bbls. Inventories did indeed reach a high at the end of '06, but Department of Energy statistics show both US and OECD inventories have hovered around 2400-2700 million bbls since 1994 (EIA). And they've fallen off considerably since the late-'06 spike.

One major issue for Congressional investigators was the popularity of commodity indexed funds, which allowed small investors to buy stakes in the movements of commodities. As speculators bought futures in (say) WTI oil for delivery in December, the strike price would presumably soar (this ignores the fact that a booming futures market can include contracts with any strike price, and indeed does: complete listings include the prices for futures at many different prices, including above and below the spot price. Another consideration, though, is the impact of derivatives markets on inventories of the traded commodity: basically, if an index fund is pegged to the price of WTI oil, then the firm offering the fund is presumably obligated to own tangible inventories of the commodity equal to the amount notionally owned by investors buying into the fund.

(I am not aware that this is essential; a fund could instead invest in instruments intended to beat the judgment of amateur investors in no-load funds; in most quarters, the short-run liabilities for the fund would be smaller than quarterly net increases in asset values, and there would be no need to literally match what the investors actually did. So if I offer a fund whose value is indexed to WTI oil, then all I need to do is own financial instruments that match or exceed the growth in value of WTI oil. If there are many other funds offered by my firm, then the risk that I'll fail to do this is greatly mitigated by the fact that in quarters like this one, the losses from the WTI fund will be offset by net gains from the other funds.)

While the Senate report includes a lot of hyperventilating claims about speculation, there's surprisingly little (for a 60-page report) on actual mechanisms for "disconnecting" market equilibria and the price of petroleum. Essentially, everything is riding on a brief spike in oil inventories, and a rather smallish one at that.

There does exist a nontrivial question of volatility, in which refiners are left trying to make decisions about stocks and blends in the face of wildly oscillating futures prices. More precisely, some of the price of retail gasoline at the pump may constitute a premium for uncertainty. But even my Senate report was uncertain if commodity speculation was to blame for volatility.

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