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Tuesday, May 15, 2012

The Demons of Volatility

Do speculators increase market volatility?  Our president claims to think that:
"President Barack Obama on Tuesday asked Congress for $52 million in new federal funding to boost oversight of oil markets, increase penalties for price manipulators and raise margin requirements to reduce market volatility."
On the other hand, many economists claim the volatility is not increased by speculation.  Here is one example:
"And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings."
I've been doing the speculating thing for decades now and I'm certain that  both Obama and the economists are confused, misleading and/or just plain wrong.

Speculators absolutely increase price volatility but that volatility is an important feature of the speculator's function in the market that ultimately, over time, benefits the consumer.

Speculators' trades push the price up and down in a given market.  That's inherent in the whole concept of trading.  Activity moves prices.  No activity implies stable/stagnant prices.

So how is the price movement beneficial?  Many price movements either are proxies of actual information or beget real information that can and should cause changes in economic activities and allocations.  There are myriad mechanisms for this, but I'll describe one of them.

Actually, I'll let our president describe the first one:
"The problem is ... speculators and people make various bets, and they say, you know what, we think that maybe there's a 20 percent chance that something might happen in the Middle East that might disrupt oil supply, so we're going to bet that oil is going to go up real high. And that spikes up prices significantly."
Obama is a pretty confident guy and is probably certain that his brilliant and flawless foreign policy will prevent any middle eastern oil supply disruptions.  But let's say, just hypothetically of course, that instead of a perfect and all-powerful United States government under a president who can slow the rise of the oceans and heal the planet and apparently keep the oil flowing, we lived in a world where there really was a chance of a supply disruption.

In that case, the price increases and extra volatility due to speculators and people making "various bets" can be quite beneficial.  First, if the supply disruption occurs, we will already be partially adapted to the higher prices that will result from the disruption.  Second, the oil is still currently being extracted and the higher prices mean that more is being currently stored, so if a disruption happens, there will be more stored oil available.  Third, because demand is already lower and storage is higher, when the disruption of middle eastern oil occurs, the ensuing gap between supply and demand will not be as large and the smaller gap will attenuate the price spike and/or shortages and therefore reduce the negative impact on the rest of the economy.  Fourth, current higher spot and future prices of oil stimulates more drilling and reserves all over the world, which, as they come on line, mitigate the future impact of any disruption of the middle eastern oil supply.

Yet Obama is absolutely correct in that the speculators' activities are spiking "up prices significantly", at least in the short term, and perhaps needlessly should a supply disruption never occur.

If a supply disruption never materializes, what happens?  Most likely, the price will drop substantially over time.  After all, new supply has been stimulated, storage has been increased, and demand has been reduced.  All of these typically lead to lower prices.  Assuming that the price drops substantially, the speculators lose a ton of money.  The speculators, as a group, only make money if the price goes higher.
But if the price does go higher because of a disruption, instead of thanking them for blunting the effect of the disruption, we become even angrier at them because they're making tons of money while we're feeling pain at the pump.  It's far less pain than we would've felt without the activity of the speculators, but we won't know and/or understand that as the gasoline purchase drains our wallets.

In my personal experience and observing other speculators, significant money is only made on about one in ten trades.  The rest of the trades either lose money or more or less break even.  Each of those trades adds volatility to the price action.  The losing ones add unnecessary volatility but the benefit from the winning trades makes the entire economy better off in the long run by anticipating and blunting the negative effects of future events.

Speculators are very important for the economy, but they're damned if the prices rise and screwed if the prices fall and demonized in either case.


Jeff Shattuck said...

This post gets to the heart of why Obama is wrong for America. He believes that in virtually every subject he knows better or knows someone who does. He's wrong, of course, but then... he knows better, so good luck convincing him of his errors. Besides, who knows what he really thinks? He's going for votes and his strategy is to target the masses. Sadly, it will work. Even more sad, the Repubs can't field an opponent with a real shot. Depressing.

Bret said...

Are you saying, "Too many demons, not enough saints" in Obama's America. :-)

(I was just listening to that song of yours this morning - maybe that's what inspired the post title).

erp said...

It's called speculating, so you'd think that alone would give away the game.