“The cost of living in this country must not be a football to be kicked about by gamblers."--President Harry S. Truman
More than a year ago, reporter David Kocieniewski wrote a piece for The New York Times that took on an eye-catching headline, Academics Who Defend Wall St. Reap Reward. The article presumes a pet thesis of Kocieniewski’s, that speculation in futures drives up the price of the underlying. To this it added an auxiliary thesis, that anyone who questions that view is so obviously wrong that the contrarian must be corrupt.
The story was a hit piece aimed at Craig Pirrong and Scott H. Irwin. Pirrong in particular was said to have been tainted by work he has done as a consultant for nasty speculators, including Trafigura, a commodities trader based in Switzerland and founded by a veteran of Marc Rich & Co. That is enough to make him a hireling of “Wall Street”, [presumably the headline writer was using that term metaphorically] and to give Pirrong a corrupting interest in covering up the badness of speculators, those engines of price inflation.
The charge was a flimsy, false, and arguably dishonest thesis from the start. Now, though, there is new evidence that bears on the question: is it even coherent?
Profiting from Price Decline
Trafigura has done quite well from the decline in crude oil prices in recent months. In the six month period that ended March 31, its profits rose 40%, getting to above $650 million.
So: Pirrong was supposedly shilling for Trafigura so it could continue driving up the prices of the commodity whose fall would make Trafigura record profits? Sound sensible to everyone? Um, no.
This record profit figure rather dramatically confirms some of the points Pirrong made at the time of CK’s attack: that Trafigura and other companies in a like position don’t have an interest in rising prices.
Indeed, Pirrong, in an amusing new blog entry in Streetwise Professor, has spelt it out for us, and for Mr. Kocieniewski. If anything, the bias of a physical commodities broker (one which, as in this instance, uses derivatives chiefly for hedging) will generally be for lower rather than higher prices of the commodities in which it deals, because “(1) low process reduce working capital needs … and (2) low price environments often create trading opportunities, in particular storage/contango plays that can be very profitable for those with access to storage assets.”
In the recent price fall-off in crude, one of the trading opportunities that Trafigura successfully exploited involved a set of short-term prepay deals with Rosneft, the oil company majority-owned by the government of Russia. These deals have left Trafigura as one of the most important channels by which Russia’s crude gets to the rest of the world. Again: it doesn’t need (and hasn’t employed) the sort of speculation that Kocieniewski has warned about in order to get to this point, and it hasn’t had the supposed benefit of price increases in doing so.
Some History
Controversy about the consequences of speculation on underlying commodity prices has a long history. It forms, for example, the gist of Chapter 16 of Henry Hazlitt’s famous book, Economics in one Lesson. Hazlitt was writing in another time, and speculators were more likely to be blamed then for driving prices down than for driving them up: the farm lobby in particular demanded that the commodities in which it was interested should be shored up against the influence of the speculators trading on the basis of short-term supply and demand.
In our own day, sentimentality about Ma and Pa farmer has dissipated: along with Ma & Pa farms. At any rate, the commodities-pricing issue is more often debated in the context of minerals than of crops. And the ugly memory of 1970s inflation levels has left the general public with a greater fear of ever-rising prices than of their collapse. Such changes in context paved the way for a thesis memorably advanced by Michael Masters in 2008, that index buying had amplified the historical significance of futures, played a critical role in the run-up of commodity process, and produced the financial crisis of 2007-08.
Index funds don’t speculate: that is rather the point of their existence. Still, they are long-only, and arguably that is in itself a sort of ‘speculation’ with scare quotes.
The enduring suspicion here is that expressed by President Truman, in the observation quoted above. But if we take the metaphor literally, we’ll ask ourselves: what share of the football movement in the world is actually effectuated by gamblers? Aren’t gamblers the people who bet each other on how well another set of people can move a football?