21 June 2008

How to Use LinkedIn

LinkedIn is a website used for access to people who can help with job searches. The object is to furnish a professional introduction online that will help you to put your best foot forward. LinkedIn is specifically designed for job searches and business connecting. It allows one to manage recommendations, an interactive résumé, and third-party connections.

It's actually fairly well-conceived. After being invited to join, one can accept and create a profile for oneself. The profile includes an online resume (you can select what is visible to whom); and a listing of your contacts. You can search for people you remember the names of, or you can look up the listings of members by employer, city, and industry. If they aren't already registered, you can invite them to join; actually editing their own page may occur much later.

LinkedIn follows a pattern that is becoming very standardized with sites such as YouTube, Flickr, and Facebook. Members have the option of carefully formatting their page and uploading content, but are under no obligation to do so. Registering allows one to access the content of invites or organize links to favorites (e.g., photos on Flickr, videos on YouTube). Amazon is moving towards full-fledged social networking, with the profile pages that link to friends or "interesting people" (meaning, you can link to them unilaterally). For years I've been posting reviews; now I can really go nuts with lists of books, and so on. I can also link to different social networking sites, including, naturally, this weblog.

Another fairly important feature of social web sites is that many can be linked together through iGoogle. The obvious example is the link between Digg and Facebook; when you Digg an article, a link to it appears in your Facebook minifeed (explained here).

Unfortunately, this doesn't really eliminate the business of contacting employers with customized cover letters that must arouse interest without aggravating. I find that sort of thing utterly dispiriting.

Guy Kawasaki, "Ten Ways to Use LinkedIn" How to Change the World (Jan 2007). Kawasaki makes several unsupported claims, and I'm not interested in trying to defend them. He mentions that one can use LinkedIn to increase one's Google page rank. This is especially effective, he argues, because the page ranking of LinkedIn is itself quite high.

Another point he makes is that "People with more than twenty connections are thirty-four times more likely to be approached with a job opportunity than people with less than five." This seems implausible to me; and there's no source for this claim. "Approached with a job opportunity" can include unwelcome spam to join an MLM, anyway.

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20 June 2008

The Social Laffer Curve

Click for larger image

This was borrowed and adapted from
Monissen (1999)

Click for image source

Wikipedia: Revised version of Martin Gardner's
Neo-Laffer curve.
The Laffer Curve was intended to illustrate a correlation between tax rates as a share of GDP and tax revenue. The x-axis is supposed to represent taxes as a share of GDP, and the y-axis is supposed to represent tax revenue. The problem with the Laffer curve is pretty severe: even as a thought experiment, it's impossible to map out an observable y-axis. Suppose we take a unitary government with a total overall tax rate of 0.75 of GDP (see upper figure). We surmise that the peak of the curve is at .55, and at 0.33, it's back down to whatever it was at x = .75. If that's true, then the effect of cutting taxes 26.3% is an increase in revenue to the state, and the effect of a halving taxes is to make revenue the same. This cannot be what Arthur Laffer meant, of course; surely some time is required before the tax cuts work their supply-side magic.

Ah, then in that case we have to say that the tax base is increasing now because the tax cut stimulated investment and labor. So what are we saying the y-axis measures? It must be tax revenue at some as-yet-unspecified future date.

I could be very generous and surmise that the Laffer Curve is based on the Ramsey-Cass-Koopmans model (which is pretty fundamental to modern economics), and that the values of y corresponding to each value of x are determined by the usual utility-maximizing objective function; at some point in the future the labor market reaches a new equilibrium of output at which point revenues reach their new equilibrium as well. But, in such a case, the derivative of the curve at each point is dependent on conditions under which taxes are cut or raised, and on expectations of future tax increases.1 This means that the derivative is entirely indeterminant, and hence the function that the Laffer Curve is supposed to represent has no fixed value. In other words, there's no sense in which the y-axis means anything at all.2

Even intuitively it is not much help because there's no consideration of what the government actually does with the money, which may be more important than the precise amount levied or raised. That's even assuming all the economic assumptions that orthodox economists make.

Aside from the trivial observation that tax rates of 0 or 100% of GDP will fetch zero revenues, while for rates between % and 100%, it'll be >$0, the Laffer Curve says nothing.

A Possible Analogy to the Laffer Curve
A modest proposal

Now, let's look at the Laffer Curve as a measure of social policy. We could say that the x-axis represents the rate of government spending on social welfare per person. We make some minor assumptions:

  1. social welfare spending mostly targets illiteracy, preventable diseases, and other obstacles to earning a living;
  2. social welfare spending has some marginal utility; it might not be perfect, and we assume there is some waste, but more spending in any given time period t­­i leads to greater income in period ti + 1.
In that case, it is reasonable to expect that if social welfare spending Gi is 0% of GDP, then total income will be low since poverty rates will be high and have dire consequences for civil order. If social welfare spending Gi is 100% of GDP, then the customary incentive effect is going to be bad, as everyone would expect: everyone is guaranteed everything that they could possibly have to consume, so productivity wastes away (albeit, probably not to nothing). For that matter, bureaucrats would probably be the worst offenders, so we'd never reach that point, but if we did, it's not controversial to claim that the economy would grind to a halt.

But in between there is going to be an optimal level of social welfare spending which might possibly be measured in terms of the total factor productivity (TFP), or perhaps an index that incorporates TFP and the human development index (HDI). Growth rate, in my opinion, is not really useful because so many things affect growth rates, such as saving (which can be distorted upward by the absence of a social welfare system, as it is in China, or distorted upward by the presence of one, as in Scandinavia or Japan).

So what about TFP? Why is this important?

It's not as important as the actual well-being or sense of connectedness that people in a [morally] good society feel towards their neighbors, but TFP may well be a good numerical surrogate. That's because TFP measures the effectiveness of utilization of economic inputs. In a society where crime rates are high, the GDP will be padded by spending on law enforcement, courts, and corrections. Since it is necessary, the money will be spent, but it will not contribute to productivity. Likewise, if the polity refuses to spend money on education for the ignorant masses, then productivity increases may occur, but they'll be mainly caused by the accumulation of capital (which is subtracted from productivity growth to get TFP). Also, extreme misery among the permanently poor and hopeless will require an immense wall around the squalid quarters where they live, wastage of money on armored Hummers for the affluent (to avoid getting carjacked and held for ransom), a less efficient transit system, a less efficient sewage and drainage system (with every house needing its own septic tank, whether the water table can sustain one or not), and so on.

When a social problem is not very intense, fighting it is comparatively cheap per victim.

Drug addiction is a good example. In the USA, there are reportedly six million users of cocaine, or 3% of the population aged 15-65. There are 3.6 million ATS users, some of whom also use cocaine. Possibly ten million Usonians use a class A drugs on a regular basis.3 Prevalence for class A drugs in the USA is usually several times what it is in Western European countries, especially for cocaine. The enormous number of users, particularly of ATS, has created a market for more pernicious drugs than were used in the past. While there are doubtless many explanations for the extraordinarily high US rates of class A drug use, one has to be the weak social model. During the period 1990-2000, drug use declined in the US (as did most types of crime) but it did so at a terrible cost: record-busting incarceration rates, a compromised judicial system, paramilitary policy forces, and ultimately, the loss of basic Usonian freedoms.4 In effect, the people of the United States paid very heavily for a reduction of crime to average OECD levels. Measuring this with TFP indices is unreliable, but clearly turning huge regions of modern cities into armed camps, and adopting the highest rates of incarceration in the world (mostlly for nonviolent drug offenders) had a dire impact on the productive deployment of labor, capital, and energy.

I am aware that the last sentence is obscene. Please accept my apologies; if you've read this far, you probably sense that I think the real cost is not in terms of output or measurable welfare, but in terms of human freedom and moral decency. But when one attempts to analyze the impact of a large number of heterogeneous policies on the large set of heterogeneous human activities known as an "economy," one has to use the language and methods of economics.)

Another compelling example is poverty itself. Poverty is closely tied to location; the poor are less mobile and usually can leave a depressed community only with difficulty. In many cases, a policy change of reducing welfare/food stamps causes a loss of jobs in retailing in the community; firms that were viable at the prior level of custom go out of business, and unemployment rises. The community will experience a multiplier effect, and finally settle at a much greater level of unemployment.While the initial policy might have supplied $1000/person per month on average, the new policy might supply $500/person per month; but there's twice as many aid recipients, and since poverty is more intense, the community where they live can no longer sustain schools or internet access. Poverty there has become virtually hopeless, and the surrounding community has to be defended from a desperate, sick, ignorant, and antagonistic enclave. Public libraries contrive ways of excluding the poor, denying them access to job opportunities. Private property, such as cars used for business or construction tools, are stolen or impounded (because the owner can't keep up the registration).

Even outside of blighted ghettos, the effect of reduced public spending below a certain point can sharply worsen the ability of people to be productive, and thereby make the usual business of government costlier.

For example, the US government is organized so that most social services are provided by state and local governments, while the federal government takes care of the military, foreign relations, some law enforcement, and some supplemental R&D for big corporations (Department of Energy, Department of Transportation, the BLS, etc.). During business cycles, the federal government not only continues to spend the same amount on soldiers, narcs, and gizmos, it actually increases spending during recessions. The states, cities, counties, and school districts are compelled to cut back. In fact, their budget typically decreases by much more than the local gross state product does, because tax revenues are volatile. When a recession hits, the proportion of governmental expenditures directed at things people actually need, like health care services, schools, local infrastructure, public transit, and law enforcement, declines; government spending actually shifts to things that are largely destructive and pointless, such as preparing for another optional war or rescuing the coal industry.

As a result, the Usonian educational system is subject to violent budgetary swings and enormous local variance in quality. Mathematically, education spending per student per year averages out to something quite high, but with programs like education, extra spending in boom years is mostly wasted; the bad years ruin the progress in building up a strong, committed cohort of educators. Police forces react to reduced funding by shifting energies to traffic tickets and impoundings. This, of course, negatively impacts safety and makes the worsened social problems costlier to deal with.


The Laffer Curve has towered over policy debate in the USA for almost 30 years now. While it is not helpful for describing the behavior of revenues in response to tax policy (except at the extreme points of 0 and 100%), it actually has some practical relevance for social spending. To wit, assuming that
  • social spending moves within reasonable limits (say, the levels encountered in OECD countries during the last forty years),
  • social spending is managed in good faith and does not vary greatly in efficiency over the relevant domain,
  • social spending is mostly directed at assisting the ability of people to become or remain productive,
then TFP is a curve that is concave downwards with respect to the horizontal axis. The peak value of TFP will correspond to "pre-emptive redress" of social problems like poverty, public health risks, education, infrastructure, and safety (G*). "Pre-emptive redress" implies that problems are redressed at a level of thoroughness such that they remain at a relatively low, manageable level; do not impinge on the general quality of life; and do not jeopardize the resource-base of the economy.

Levels of social spending in excess of G* will of course pose the expected problems posed by exorbitant taxes and hyperactive states. But at levels significantly below G*, social problems will grow in size so that maintaining them at a higher degree of severity (e.g., higher crime rates, worse poverty, more cases of tuberculosis) becomes more expensive, and government expenditures will have to rise at a later date just to contain them. The surprising inference is that attempting to reduce the cost of government by slashing social spending will likely lead to increased government spending in subsequent budget cycles, as routine governance gives way to putting out fires.

1 There is a Keynesian method of predicting the stimulus caused by a particular tax cut under particular circumstances, and there's a rational expectations (REH) method. The latter method requires that one know what the future fiscal balances will be after the cuts. The REH method incorporates (to some degree) the Ricardian Equivalence Hypothesis, in which taxpayers adjust their savings and investment strategies in expectation of future deficits (and a probable tax increase).

The short version of this is that, if the government slashes taxes without reducing spending, then taxpayers will anticipate the approximate size of the deficit and include a future tax increase in their personal financial planning. The effect, according to Robert Barro, was that the intended stimulus of deficit spending will be entirely thwarted. Instead of actually increasing aggregate demand, consumers will hoard wealth because they know they'll need it when the government has to balance the budget again.

How do households know when or how big the tax increase will be? They don't, but a very rough guess of both is surprisingly effective. The reason is that the longer the government waits to restore a balanced budget, the larger the tax hike will have to be. Economists assume that households value future income/spending less; so if the government waits a short time and raises taxes a little bit, then that little bit will have about as much effect as a long wait and big tax increase far in the future. Based on past experience and cultural expectations, households will tend to guess correctly what the most likely course of action will be.

For an introduction to this idea, see Douglas W. Elmendorf & N. Gregory Mankiw, "Government Debt" , originally an excerpt from Handbook of Macroeconomics Federal Reserve Board (1998), p.28.

2 A Mr. Hans G. Monissen wrote "Explorations of the Laffer Curve" (1999) in which in included a large number of assumptions to allow the Laffer Curve to "mean something." Specifically, a cut in taxes reduces the demand for leisure and consumption, and increases the willingness to work and to save. Investment increases the productivity of labor, and workers will accept longer hours (bidding down the price of labor). According to the Swan-Solow Classical Growth Theory, this stabilizes at a new GDP, which is definitely higher than the old one. Under certain assumptions one can calculate what that new GDP level will be; but it corresponds to a future date which has to be specified. In order for the Laffer Curve to work, however, workers will need to "know" that it will work, because if they assume that deficit spending will be followed by a comparably-sized surplus, they will not make the virtuous adjustments that a Keynesian would automatically expect them to, and that would lead to increased revenue. If they guess wrong, no stimulus will occur and deficits will in fact follow (as they expected), which means that they weren't wrong at all. Monissen's attempt to salvage some meaning for the Laffer Curve leads to a paradox in which there are actually infinitely many rational expectations with self-fulfilling prophesies.

3 United Nations Office on Drugs and Crime, World Drug Report 2008 , table 7, p.84; see also The Threat of Narco-Trafficking in the Americas, p.21. Please note that cocaine is not the only serious drug problem. See also the Global ATS Assessment, which mentions that amphetamine-type stimulants (ATS; includes methamphetamine, crystalline methamphetamine, and ecstasy) are much more prevalent than either heroin or cocaine. See p.11. Exact comparisons of different "habits" are difficult, but the prevalence of ATS in the USA is massively greater than in any other region. This, despite a near-halving of ATS usage since 2001. See p.14. Heroin usage is much larger outside of the Western Hemisphere than in it, but heroin is used by far fewer people in Europe than cocaine is by North Americans.

Class A drugs are ecstasy, LSD, heroin, cocaine, crack, magic mushrooms, amphetamines (if prepared for injection). The term is British but fits standard penal classification in other countries as well.

4 It is difficult to make a fair comparison between crime rates internationally, but see the International Crime Victimization Survey (ICVS), 1989-2000, ICVS International Working Group (United Nations 2006). The ICVS is the most thorough international study of crime; it is probably unique insofar as it consists of survey of many different national populations, directly, by a single organization. The Codebook is part of the data package that one downloads at the link above; it has a section called "Key Findings from the 2000 ICVS" which is an outstanding summary of the data. Most types of crime monitored by the ICVS declined in the USA (1990-2000; see the Codebook in the data download, "Findings"), but increased sharply through 1996 everywhere else. As a result, except for murder, the crime rates in the USA are no longer particularly high.

Incarceration rates: see Christopher Hartney, "US Rates of Incarceration: A Global Perspective" , National Council on Crime and Delinquency (Nov 2006); see chart, p.2. The rates of incarceration in the USA are about 5x that of the UK and Spain, which are (in turn) the highest rates in the rest of the industrialized democracies. France has one eighth the incarceration rate. In contrast, the Stalinist GULAG held only a slightly larger share of the Soviet population at its peak in 1950.

Compromised legal system: I am to blame for such a vaguely-worded rebuke, but one exceptionally good source (on DVD) is Frontline: the Plea, PBS (2004). Bearing in mind that the vast majority of criminal cases are resolved through plea bargaining, "plea bargaining" is almost synonymous with "criminal justice system." Hence, another excellent source is George Fisher, Plea Bargaining's Triumph: A History of Plea Bargaining in America, Stanford University Press (2004), especially III: "On-file Plea Bargaining and the Rise of Probation." Fisher is very restrained in making any sweeping editorial claims. Another, more plaintive work is Jonathan Simon, Governing Through Crime: How the War on Crime Transformed American Democracy and Created a Culture of Fear, Oxford University Press (2007).

Paramilitary policing: a widely-cited reference is "Botched Paramilitary Police Raids" and Radley Balko, "Overkill: the Rise of Paramilitary Police Raids in America" , both hosted by the Cato Institute (2006); see also Christian Parenti Lockdown America, Verso Press (2000), Chapter VI.

Loss of basic Usonian freedoms: technically, the Military Commissions Act of 2006 rendered the Bill of Rights null and void. Text of Act ; ACLU fact sheet; Amnesty International report. The Act does not include language that precludes US citizens or legal residents from being designated "illegal combatants" and held without charge. Since military commissions do not include a grand jury and are not subject to writs of habeas corpus, it is potentially irrelevant to them whether any US citizen/legal resident is plausibly engaged in any "combat," illegal or otherwise.

Additional Sources and Reading:

Barbara Sard & Jeff Lubell, "
The Value of Housing Subsidies to Welfare Reform Efforts," Center for Budget & Policy Priorities (2000)

Hans G. Monissen, "Explorations of the Laffer Curve" University of Wuerzburg, Germany (1999)


13 June 2008

The Optional Catastrophe

This is a question that's been tormenting me for a very long time: how can derivatives influence the spot price of the underlying item?

In order to answer this question, I've considered futures and call options. It just dawned on me that there was a scenario in which the options market could conceivably affect the price of an underlying commodity, which I have dubbed "the optional catastrophe" (OC). I'm going to use an example of West Texas Intermediate (WTI) crude, but it's important to understand that the OC would probably strike the other crude markets as well. For simplicity, I'll start by assuming everything is done in US dollars.

While the supply curve of the good has shifted to the left,
many buyers have options that allow them to pay P* for
Q*; this pushes the price for everyone else up to P***,
rather than the equilibrium price P**.

It's February 2008 and the price of WTI has just punctured $100/bbl. An investment banker known as Writer makes a huge gamble that the price of WTI will now back away from its "psychological barrier"; she takes the biggest risk of her career and writes a naked call option for 1 million bbls. of WTI at $101/bbl. The option sells at a small premium of $0.30/bbl, so that Writer gets $300,000 for something with no intrinsic value. We will call the buyer of this option "Secondary." At first it looks like Secondary has been played for a sucker, as the spot price of WTI falls to $98.57 the next day. But on Leap Day, WTI rises again to 101.79 and Writer's nerve gets a test drive. She is now $490K in the hole. It gets worse. On 13 March, WTI is 110.21, and Writer is on the hook for $8.91 million. The price sinks back to $100.92 by April Fools' Day, and Writer is feeling triumphant. But the ascent resumes, and by 11 April, Secondary decides to exercise when the spot is at $110.14. Writer must come up with 5 million barrels that she doesn't happen to have. Fortunately, her firm has deep pockets and can afford a 8.91 million loss; unfortunately, the sudden spike in demand (by Writer) drives the price to $119.17. The options mean that the demand-suppressing effect of soaring prices does not come into play (see figure).

Now, I should mention that there are many grades of crude, and if we had a huge number of cocky Writers cranking out naked options (that routinely stayed out of the money, racking up free premia), then a few interlocking blunders like this could push the price up quite a bit.

(UPDATE (26 July 201o): the technical term for what I have described above is a "short cover." For any method in which one can take a short position on a stock/commodity, there is a scenario in which the shorts can be caught flat-footed, and compelled to buy more of the underlying stock/commodity. This can make a surprise rally somewhat more pronounced than it would have been otherwise.)

Moreever, there are some flaws in my exposition. Given the vast range of different call options strike prices, each buyer would have a jagged (and unique) supply curve: jagged, because each one would have been accumulating options over time and exercising them to buy different "batches" of WTI crude at different prices. Conditions where different buyers pay different prices is known as discriminatory pricing, and when sellers can match prices to individual consumers, it's a powerful tool for maximizing monopoly rents. In this case, the discrimination would have been partly random and partly self-selecting; prices could be higher for those who could pay more, and lower for others. For those who did not dabble in options at all, the price would be immensely higher. There might not be much incentive to produce, however, since a select number of major buyers (Secondaries) would have enjoyed such huge discounts.

The influence of futures is somewhat hazier, and I'm obligated to rely on the testimony of George Soros (3 June 2008). My understanding is that, in the past, futures traded at a discount relative to cash; in other words, a bank could buy futures from a producer, and be (on average) guaranteed a profit. The cost to the bank, aside from the actual future itself, was the time that passed before the bank could cash out; and since banks can borrow money more cheaply than anyone else, banks were uniquely empowered to profit from doing so. For this reason, after the 1999 financial liberalizations, which allowed homologization of the financial sector, indexed commodity funds became popular.

An indexed fund is a portfolio of assets which corresponds to some prominent index, such as the S&P 500 index of US-based industrial firms. The object is to reduce systemic risk using a current indicator. Commodity indices became popular because they were known to offer low-risk interest arbitrage to banks (which were, in fact, lending money to the commodity producer). But, per Soros (p.3), as large numbers of fund customers bought into the commodity indices, this drove up the price of the futures. What would occur when the futures matured and prices were so high that there was a glut? The supplier of the commodity (again, say, petroleum) could agree to simply exchange the old future for a new one.

Endlessly distributing new contracts with maturation dates ever-further off into the future: and producers large enough to play this game would remain liquid by continuing to produce a dwindling volume of the underlying good. In this case, the object would be to treat the future price as a leading indicator of the appropriate price and cut output so that the futures themselves seldom ever had a price reduction. In that case, the real impact would be producer use of the derivatives market, rather than the real goods market, as the source of price signals.

10 June 2008

Speculation and Prices

With oil prices continuing to hover around $135/barrel (or €85/barrel), the speculation hypothesis has widespread support. That's the theory that high prices of commodities generally reflects illegitimate financial market activity. I'm trying to keep an open mind but none of the arguments I've seen are convincing.

To me, the big headache is establishing a mechanism by which either (a) high futures prices drive up oil spot prices, and (b) how high flows of money into the forward markets (futures & options) influence the strike price of the commodity.

(For an introduction to this topic, see my post "Commodity Prices and Speculators.")

To some readers, these may seem like very dumb questions. If a lot of people are trying to abandon US dollars as a store of value, then they will want to buy up large tranches of oil future contracts, or perhaps options. That naturally drives up the strike price. When producers see that the strike price is rising, they naturally want to withhold stocks from the market in anticipation of still higher prices. Refiners likewise respond to the high forward prices by hoarding it. This drives prices even higher.

There are two steps to this explanation: one explains how a lot of currency flowing into commodity forward markets can drive up the strike price, and the other explains how a rising strike price can push up the spot price. Both steps are problematic. First, options can be traded at any of a wide range of strike prices.1 At the time of this writing, Brent crude was trading at about €87 per barrel. Options must exist for €85- and €89-barrel Brent, and probable for a wide range of prices above and below that. Also, new options are written each day for spot ± €0.50/barrel, so that options are tradable from €57-89/bbl (reflecting, in other words, the range of prices over the previous six months). So it's possible for a lot of speculative money to flow into the options market at lower strike prices. Buying an option for 100 barrels of Brent that expires in 3 months with a strike price of €68/bbl means an outlay of about €1,900; should the price fall to €80/bbl, then your loss will be €700, or 36% of your initial investment. If the strike price is €89, then the option is "out of the money," and costs very little; but then you're betting that the price will rise above €90 and stay there long enough for you to cash out.

When the market for options is extremely brisk, naturally the money goes to the people writing them: in theory, suppliers of the underlying good, but also some daredevils who may write "naked options" on [say] shipments of crude they don't own. Options can absorb immense amounts of speculative money, since anyone can write them and most will expire as worthless scraps of paper. They provide no benefit to the person writing them other than the fee and favorable price movements. Basically, they are a hedge: if you are a supplier and you write a lot of call options at the current price, you are locking in the strike price as the most amount of money you will make, but if you understand the market well, then you can reap a handsome profit when your product's price falls well below the strike price. Conversely, you might be a refiner who buys a lot of crude at the current high price; you anticipate that the price will rise even more, so you write put options and sell them to suppliers in which you promise to buy crude at €90/barrel. If the price does indeed go to €100, it sucks to be you but at least you got the money from selling the options to cautious suppliers.

Nevertheless, it's hard to see how this can influence the actual price of the underlying commodity. Writing options does allow buyers and sellers to recoup a modest amount of money from unfavorable movements of the market; when money flows from the non-financial sector into options trading, the effect is to shield options "customers" from some of the consequences of unfavorable movements (giving them time to prepare for new business conditions), while partly compensating "writers" for losses incurred by unfavorable movements.

(See here for an exceptional scenario.)

Futures are a different matter. Taking crude oil (again) as our example, there's a global demand of about 83 million bbls. per day; supposing about 10 million bbls. are sold as future contracts well in advance. Normal derivatives traffic ensures minimal price risk to suppliers and refiners. Then, so to speak, Satan enters the garden in the form of hedge fund managers desperate to park $10 million per day of new money. The hedge fund buys a large number of futures, but it has no intention of taking delivery of all that oil; instead, when the futures near maturity, it sells them to a major (i.e., one of the large multinational, vertically-integrated oil companies). The problem is that the oil company can choose between buying the inflated future or a lower spot price.

David Kruse, President, CommStock Investments, wrote an editorial describing precisely this scenario:
Cash commodity markets however, run the risk of becoming the tail swung by price discovery of futures exchanges that are not based on commodity market fundamentals but on the capital investment flows in and out of the commodity sector. The connection between cash markets and respective futures markets differs between commodity markets....

When funds dominate the futures trade, a fundamental distortion can occur. We believe it has occurred in soybean prices this winter. U.S. soybean carryover was projected to reach 565 million bushels this year which eclipses the previous historical carryover record of 346 million bushels in 1998-99. Global soybean carryover is record. We could have a flat out soybean crop disaster in 2006 and not run out of soybeans next year. Why did the market call for so many more acres of soybeans when carryover was already at an all-time record? The market didn't, funds did. November new crop soybeans traded $1 above fundamental market values all winter, producing incentives for farmers to plant more soybeans which the USDA says they strongly responded to.
In this case, the mismatch produced a soybean glut (in 2006).

Over the years different Usonian commodity futures markets have adopted cash settlements. Prior to 1982, when a future expired, you either took delivery or else arranged a cash sale of the commodity to someone who wanted it. Then the Commodity Futures Trading Commission (CFTC) allowed indexed commodities and cash settlement.2 While CFTC regulations are designed to prevent destructive speculation, it is worth noting that massive futures trading could easily lead to suppliers learning to anticipate the market's preferences for cash settlements rather than tangible delivery; and lead to sales of contracts for several times the actual volume of goods being sold. Note that CFTC regulations are supposed to prevent this; however, the much-discussed InterContinental Exchange (ICE) based in Atlanta, Georgia, allows one to trade virtual commodities over the web in London and Dubai.

This was extremely important because futures are very highly leveraged instruments. Typically one pays about 5% of the value of the underlying commodity (so, for 100 bbl. of WTI, $675 plus premium)3; in theory, this allows one to claim very large pools of oil for very little money. A squeeze is a situation in which a trade goes long by an amount that exceeds the actual physical capacity that can be loaded during the month. Then the trader claims delivery, knowing that the supplying parties will not have sufficient supplies to meet their obligations. This drives up the price, but the effect is of very short duration (usually a couple of weeks, at most).
1 An option is similar to a future except that options are binding on only one party, while futures are binding on both buyer and seller. A [call/put] option is a tradable right to [buy/sell] a commodity at a fixed price on or before a given date in the future. For an explanation of options and how they work, see "Factors affecting Options...." For our purposes, "options" are understood to be American style, i.e., they can be exercised at any time prior to expiration.

2 Leo Chan, "Cash settlement and price discovery in futures markets," Quarterly Journal of Business and Economics (Summer 2001). The mechanism for cash settlement works like this: supposing the commodity price rose $10/unit over the period the investor held it. Rather than take delivery, the investor merely accepts a payment of $10 (minus some fee), and the supplier sells the product to another buyer for cash. Assuming the price falls by $10, the investor pays the supplier; in both cases, the transfer of money effectively cancels out the price change (as far as the supplier is concerned).

3 The premia on futures and options varies with the number of futures/options bought. Very large trades involve very small premia per contract/option. Different brokerages have very different schedules of forward premia.

Long: in finance, a "long position" in a security or commodity is a position where one benefits if the price goes up. This includes writing a naked put option, buying the underlying commodity, buying futures for delivery of that commodity, or buying call options for same commodity, are all examples of "going long" or "taking a long position."

Senate Committee on Comerce, Science, & Transportation: Hearings, 3 June 2008
"The Role of Market Speculation in Rising Oil And Gas Prices" (PDF), Permanent Subcommittee on Investigations, United States Senate (27 June 2006)

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