Craig Pirrong has long been known as the academic who probably most closely follows, and is widely quoted, on the impact that trading is having on the price of oil. His expertise is at the nexus of speculation/fundamentals/financial conditions, and how that's driving the price of oil.
At a luncheon this week in Houston, the University of Houston economist told a small gathering that he believes that exchange rate movements between the US dollar and the Euro over the past week or so, "explains," or represents as much as 70% of the variation of the price of crude over the same time period.
And beyond that, Pirrong said that variations in the value of the dollar are responsible for as much as 35% of the increase in the price of oil over the past five years.
Speaking at a US Association of Energy Economists luncheon at the Federal Reserve Bank building in Houston last week, Pirrong said that it "boggles my mind when (Federal Reserve chairman Ben) Bernanke stands up and says the dollar has nothing to with commodity prices."
Pirrong noted that in the week in which the price of crude dropped considerably, the value of the Euro to the US dollar dropped from $1.49 to $1.41. In other words, he said, when the dollar strengthened, oil prices declined.
At the luncheon to speak on the "inevitable role" that speculation plays in price formation, Pirrong, professor of Finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business at U of H, said, said the best way to determine how speculation affects the spot price by looking at the difference between the spot price and forward prices. By doing so one gets a sense of the magnitude of speculation.
However, Pirrong also said that another way is to look at the risk premium, which he said is the difference between a forward price and an expected spot price. Traders consider the risk to their trade from many factors, such as a rising or declining value of the US dollar, the elimination of a major terrorist figure, and the impact on supplies from a rebellion in a major, or minor producing country.
Since these traders use derivatives to transfer risk, Pirrong says, the more precise term is really financial speculation. "These guys don't get there hands dirty with the physical product," he noted.
Pirrong told the lunch crowd that he initially looked at electricity markets in the late 1990's and the early 2000's and concluded that "as much as 40% of power prices was risk premia," at that time. He noted that what speculation does is it "affects the risk premium over the market price."
Detecting this is hard, he said, just as it is difficult to determine how inventory levels are higher when hedging is cheaper, as Phllip Verleger contended in a study he did in 2010.
Pirrong said that since prices guide the allocation of resources, if prices are distorted by speculation, then the quantities of a commodity should also be distorted. He pointed to a number of examples, such as with tin in the 1970's, silver in 1980, and US government price supports for dairy products in the mid-1980's. "Quantities are the best way to determine whether speculation has distorted prices," Pirrong said. "In particular, if speculators are artificially increasing prices, this should reduce consumption and increase production." And he added that in the classic cases of trying to corner a market there would be accumulation of stocks of the commodities in the hands of the speculator.
The US government's response to speculation tends to always be the same. "It is Claude Rains in the movie 'Casablanca' every time--round up the usual suspects." The policy response is also repetitive, he said: to put limits on the positions traders can take.
Pirrong said that the rhetoric surrounding such proposals is
almost always "over inclusive," with calls to stop another Hunt
brother-style attempt to corner the silver market, for example.
But Pirrong said position limits "will not eliminate many kinds
of distorting speculation, if it in fact exists, but they will
interfere with the efficient transfer of risk."
Asked if his position on the position limits called for under the Dodd-Frank legislation is one of "limiting the limits," Pirrong said, "absolutely not." It goes further. "I am adamantly opposed to limits generally and conceptually because it is a bad idea. And in the particular case of Dodd- Frank, the idea is very bad."
Following the lunch, Pirrong said he believes the Commodity Futures Trading Commission is underfunded and essentially "underorganized" to meet the tasks of imposing and policing limits. And if all the rules are set in place and they go ahead with the task, he believes the trading markets could be badly hurt. "The potential for unintended consequences are huge," he said following the luncheon. In fact, he said, "The possibility for a train wreck is bad."
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