As frequent readers know, we make a habit of posting the International Energy Agency's monthly snapshot of the oil markets. Though we don't otherwise spend a lot of time on individual commodities or other asset classes, we view oil as a special case because so much of what is happening on the economic front around the world is easily framed in petro-terms. When China is growing and demanding oil, prices go up. When growth in the US slows, or when the population shifts from SUVs to hybrids, prices go down. When oil spills happen and supplies lessen due to obvious short-term reasons compounded by longer-term regulatory effects, prices rise. On and on the examples can go, with the oil markets often serving as the perfect case study on both the supply and demand sides as well as the perfect foundation for many of the economic, international affairs, geopolitical and even war stories pundits try to weave.
A quick look at this month's report, released on the 15th, proves once again why oil is such a good subject for supply and demand discussions. Month over month, global demand was essentially unchanged while supply increased. In the simplest way of thinking about supply and demand curves, one would expect prices to remain flat, or even decline, but not to rise under this particular set of circumstances. However pure realtime supply/demand numbers are unfortunately far from the only data points that flow into the oil pricing equation. During the time in question, for example, real questions about future supply were being asked, but not answered, as revolution swept across the dry sands of northern Africa. Fears over military action (well founded as it turns out) had their impact as well.
In other words, supply and demand at a given point in time alone were not harmoniously interacting to set prices; people were looking further into the future than that day's numbers when determining what they were willing to pay for oil. All this might seem simple, or intuitive. However, despite the fact that many people understand the fact that information should play into market decisions, it does not always bear out that way. Though this is a simple lesson in a market where participants are very good at reacting to available information, many other markets are less inclined to follow good sense. The housing market, for one, comes to mind. These mistakes are not only contemporary ones, however. From internet bubbles back to tulip bulbs, people have acted irrationally in markets. In conclusion, the lesson is no less valid for its simplicity; information is as valuable a commodity as any of its subjects...use it wisely.
I agree that individuals do not act rational as the model of homo oeconomicus implies. The concept of bounded rationality is probably closer to the truth (http://en.wikipedia.org/wiki/Bounded_rationality).
ReplyDeleteI learned to see markets as aggregated individual behaviour according to the first principle of the Dow Theory ("The market discounts everything"). The aggregation of rational and irrational behaviour results in effective markets.
The irrational oil price, which seems to ignore the supply and demand dogma, is maybe a result of "commodity futures" traders who bet on prices to make money out of it. The price is heavily influenced by bets on falling or raising prices. And for those derivatives, there is no physical settlement in the end. As far as I know they do it cash settled, so they cause bubbles who are not backed by real commodities. This might contribute to irrational prices.
Do you agree, since you know a lot more about it?
Hi Christian, Josh here (having some trouble with signing in this morning).
ReplyDeleteThanks for the comment and interesting thoughts. However, I think that this situation provides a contrary example to bounded rationality and irrationality that you so often find in markets.
Here, we are talking about the spot price, which means that futures traders have been removed from the equation.
Therefore, the price, and its reflection of future events and uncertainty, are evidence that, at least in some markets, information is assimilated more quickly than in others. Pure real time supply and demand were not dictating the price, but that isn't evidence that those forces aren't working in this market, it is just evidence that other factors were being considered as well.
This is in contrast to, say housing markets where people (and Wall St. for that matter) ignored some pretty clear signals of future doom, let current supply and demand set prices, and got burned in the end.
Bounded rationality as I understand it would apply more to the housing example where signals were not seen or understood by home buyers, leading them to make decisions on one thing only; price. They didn't make logical decisions because they only used the limited information that seemed to be available, which led to, as it turns out, irrational choices.
JS
Why would the principle of bounded "rationality" not apply to oil prices, since investors are human in the end? Every investor's brain capacity and information is limited. Of course the oil price also reflects politial instability in oil producing countries as well as the probability of those states to fail.
ReplyDeleteThis also leads to the question what a fair price is according to the presumption "markets discount everything".
What does a fair price comprise? Does the aggregation of rational and irrational or "wrong" trading decisions result in a fair price? Do they "balance" each other? It is not a contradiction to "bounded rationality" which only applies to the individual trader, not to all traders who jointly are the "market".
And is market psychology, for example the assumed probability of certain future events, only part of a fair price when it's based on facts and not on emotions?
Josh, I really want to know more about it since I have no training in economics, thus no rhetorical questions intended ;) CS
ReplyDeleteThanks for the comments. I don't know if I am the best person to consult for all of these answers; there are many studies available on market psychology and herd behavior which could prove useful if that is how you would like to analyze this situation. So often in economics, it is how you analyze a situation, ie what tools you utilize, which makes it interesting.
ReplyDeleteWhat I would say is that, breaking this down very simply and purely to a supply and demand analysis, it would appear that oil traders in one month did a good job of incorporating more information than quantity supplied and demanded during that month. Here, that information was the possibility of future supply disruptions due to geopolitical concerns.
Meanwhile, in the contra example we have been throwing back and forth, people did NOT do a good job of incorporating information into their buying decisions when it came to the US housing market over the past few years. This assumes, of course, that information was available that they didn't use. I believe that this is the case.
I would argue that, although information is limitless and nearly impossible for every actor to assimilate at all times (bounded rationality) the actors in the oil market, who at least accounted for available information when collectively coming to the spot prices of the month did a better job of trying to be rational if that makes sense. Meanwhile, participants in the housing market acted as 'satisficers' who had information available to them, but didn't account for it in their buy-sell decisions. Therefore, they exhibited more of the problems implicated by the bounded rationality theory.
I agree with you that many other factors come into play, and that many more factors can never be known in any market. However, on a spectrum of doing a good job of at least taking advantage of what was available, the oil traders in our example at least receive a higher grade in my opinion.