|August 24, 2006
Economic Scene/New York TIMES
The Rapidly Changing Signs at the Gas Station Show Markets at Work
By HAL R. VARIAN
THE recent gyrations in oil prices offer a textbook illustration of
how financial markets and commodity markets interact.
Oil prices are notoriously volatile, particularly when times are tense
in oil-producing countries — just about all the time these days. So
when BP announced this month that it might have to suspend as much as
8 percent of the nation's oil production because of corrosion in pipes
on the North Slope of Alaska, the price of crude oil immediately shot
up by 3 percent and wholesale gasoline prices simultaneously increased
by about 2 percent.
But why? Even if it will cost more to produce gasoline in the future,
gasoline being sold today was made with cheaper oil. This must be a
Actually, no. The reason behind the quick price change is a phenomenon
known as storage arbitrage.
[or "speculation" or "hoarding"; academic economists like Varian love
obscure jargon! -- JD]
To spell out the argument, imagine that you own a storage tank full of
gasoline that is currently worth $2 a gallon at wholesale prices. It
is widely believed, however, that the price of gasoline will be $2.10
You would be crazy to sell your gasoline now: just wait a few days and
the higher price will be yours. But if everyone waits a few days,
there is no gasoline to be sold now and the resulting shortage pushes
the price of gasoline up.
How high does it have to go? The answer is $2.10 a gallon [or rather,
slightly less, because selling gasoline now rather than later rewards
one with interest on the revenues]. That is the price necessary to
induce those who have gasoline to sell it now rather than to wait till
This argument does not depend on whether you think the gasoline market
is a paragon of perfect competition or an evil oligopoly. [I thought
economists knew nowadays that perfect competition can be "evil."] All
it requires is that you believe that people who own gasoline, like
just about everybody with something to sell, prefer to receive a
higher price rather than a lower price.
Even if the price of gasoline were set by a perfectly benevolent
conservationist, we would expect to see the same pattern of price
movements. If oil will be scarcer in the future because of the BP
pipeline shutdown, we would want to conserve [or hoard] the
already-produced gasoline that we have now. That means that the price
of gasoline has to rise right away to prevent hoarding and to
Storage arbitrage arguments were featured in a recent article in the
Sunday Business section of The New York Times with the headline "Is a
Futures Stampede Keeping Oil Prices High?" The article described a
provocative report written by Ben P. Dell, an analyst at Sanford C.
Bernstein & Company, that blamed speculation [i.e., "storange
arbitrage"] in oil futures markets for high oil prices.
Mr. Dell's argument was that inexperienced institutional investors had
been investing in contracts for future delivery of oil, driving up
futures prices. If the price of oil to be delivered in the future goes
up, it has to pull the current spot price up as well.
[Varian's real argument is with the "inexperienced institutional
investors" bit, not the speculation bit, since "storage arbitrage" is
a form of speculation.]
There is no risk [sic! -- no asset holding is totally risk-free except
perhaps US T-bills] associated with holding the oil in storage since
owners can sell futures contracts, collecting a payment now to deliver
the oil later. If you don't happen to have a tank of oil in your
backyard, that is not a problem: just go out and buy some on the
market. The article pointed out that on Aug. 4 it was possible to "buy
heating oil in New York Harbor at $2 a gallon and store it and sell a
future to deliver it in December for $2.24."
Perhaps Mr. Dell is right that speculation in the oil futures market
is driving up spot prices. But we should not expect that to be the
normal situation. As long ago as 1953, Milton Friedman argued that
speculation normally helps to stabilize prices rather than destabilize
[and what assumptions did he make? why should we believe him?
speculative bubbles _never_ happen?]
Mr. Friedman's argument was applied to currency trading, but the same
[unsupported] reasoning works here. If speculative trading tends to
push prices higher when they are already high and lower when they are
already low, then traders must be buying high and selling low.
That would mean that traders have to lose money on average — which
does not seem very likely. [why not? it happened to the US stock
market circa 2000. Paper gains in wealth need not be realized.] To the
contrary, speculative traders try to buy low and sell high, activities
that by their nature tend to push prices up when they are too low and
down when they are too high.
Since Mr. Friedman's 1953 article several papers have been published,
both supporting and attacking this argument. But the general principle
seems quite robust.
Mr. Dell's report specifically cited the rush of new and inexperienced
traders into commodities markets as the cause of the current problems.
Mr. Friedman's argument was a long-run argument: speculators who
bought high and sold low would be driven out of business.
[it's also an argument based on an ahistorical view of the world, with
no path-dependence and no fundamental uncertainty. In any event, after
the inexperienced losers are driven out of the market, new ones enter,
so that there will be a new supply of losers. Further, there's no
reason why there can't be innocent by-standers driven out of the
market because they're not liquid enough (rather than because they bet
wrong). So the bubble's burst can lead to downward over-shooting. ]
But there is no reason speculators cannot lose money in the short run,
particularly if they are inexperienced. Mr. Dell says that storage
facilities are now close to capacity, which will make it more
difficult to play the arbitrage game in the future. Indeed, crude oil
prices have declined nearly 8 percent in the last two weeks.
[we can't make _any_ conclusions from a mere two-week trend. That's a
pretty basic mistake, Hal.]
If speculators start to worry that the price of oil could soon be
significantly lower, some of that stored oil would come back on the
market, pushing spot prices down, and offering welcome relief to
Hal R. Varian is a professor of business, economics and information
management at the University of California, Berkeley.