AskDong

Do you know that it’s illegal to trade Onion futures? I certainly didn’t, and they do make a fascinating study on the how futures trading might or might not affect commodity prices.

Onion prices have been fluctuating more wildly than even other food commodities. Many think this is because of the ban on the trading of Onion futures. The conventional wisdom today is that speculators in the future markets drive price volatility. A great deal of blame has been laid at the feet of oil speculators. However, a properly functioning futures market should do exactly the opposite. When properly used futures create price certainty that helps smooth volatility.

For example without oil futures, oil production companies are less likely to make infrastructure investments for future supply as they cannot guarantee the price at which they can sell the oil at a later date. By trading futures, an oil company can lock profits that can be put towards infrastructure. If oil prices end up moving lower, the oil company is in no worse financial shape. Without futures, the oil company might drilling oil that uneconomic to recover. If oil companies must bear all that risk then are likely to be more conservative in it’s infrastructure investments.

Of course many the proponent of additional regulation in futures market want only to restrict speculators who have no natural position in the commodity. An oil producer, and airlines have natural positions in the oil market. The oil company needs to sell future production while airlines need to purchase jet fuel for flights in the future. A financial participant has no such interest, but this is not to say they do not have a proper role in the market. Speculators should on the most part drive volatility down. Without speculators, the liquidity in the market would be less and lead to wider price variations.

A reader recently wrote,

Dong, Having stood in line at 7:30 a.m last Sunday for a wii I had to wonder if I was just being tooled with via Nintendo’s marketing department or whether or not there truly is a shortage.
-JC

I did JC one better and stood in line at 6 AM in the dead of winter. I’ve had the Wii for over a year now, and there are still shortages. Nintendo’s new “game”, Wii Fit is even harder to find. Recently, I was lucky enough to obtain Wii Fit despite the shortages. I didn’t get it through any effort of my own, but via a good friend who always has his finger on the pulse of the Internet. Circuit City online had the game in stock - for about ten minutes. It seems like all things Nintendo are hard to come by. It’s really quite amazing. The Nintendo ADRs haven’t been too shabby either.

Is the Shortage Real?

I think it is. Recent sales data consistently points to incredible sales of the console. However, that is not to say there isn’t anything going on. Nintendo has not increased production of the Wii as much as demand might warrant. Nintendo is intentionally playing it conservative. Some of this is related to how the company lost it’s mojo in the late 90s. Nintendo of course denies that it’s intentionally creating a shortage. Call me naive, but I believe that Nintendo did not set about creating a shortage when the launched the Wii nearly two years ago. This is not to say that I believe that Nintendo is not contributing to the shortage today. They may not be holding back on supply, but their conservative customer expectations are leading to the shortages. It’s in Nintendo’s interest to make sure as many consoles as possible are in the hand of consumers. Ultimately, Nintendo makes more money from game licenses than it does from hardware sales.

Wii Fit Shortage
Part of the reason for the shortages in the U.S. for Wii Fit, is the weak dollar. Nintendo has chosen to shop 4 times as many products to Europe instead of the U.S. The strong Euro makes it much more profitable to sale there than it does here. It’s still a profitable product in the U.S., and if Nintendo could it would be selling more here.

While shortages may drive demand in the short run by bestowing the “IT” factor on a product, in the long run shortages on a product that requires market penetration hurts console makers. Success breed success. You can have the best game system in the world, but if no one has it, no games will be made. Nintendo is not in this position as the Wii has sold better than the XBox 360 and Play Station 3, but there’s nothing such as excess market domination. The name of the game is to crush your enemies and hear the lamentations of their fanboys.

McCain and Bush are both calling for the lifting of the ban on off shore drilling. While I’m fundamentally opposed because of my green conscience, I’m also opposed because it’s a short term solution to a long term problem. Even then, it’s unclear if this short term solution will yield results quick enough to fix the immediate problem, high fuel prices over the next few months. There’s a great deal of belief that the current extreme oil prices are product of a speculative bubble. Like all bubbles, it should pop at some point,

Fundamentally, however, lifting the ban will not all of sudden make the U.S. energy independent. There are not enough reserves off the U.S. coast or in Alaska for that matter to power America. It’s oil companies that stand to benefit the most by the lifting of the ban, not U.S. consumers. The only long term solution to the looming energy crisis is conservation and finding sources of energy that are either renewable or not likely to be depleted anytime soon.

There’s no question that high fuel prices are putting a crimp in everyone’s pockets, but short term solutions like tapping into the strategic energy reserves or lifting the the offshore ban at best postpones the inevitable and at worst exacerbates the problem. If anything the current high oil price regime is driving innovation in renewable energy, and inducing conservation amongst consumers. The country is moving slowly to long term solution. In the short run that journey might be painful. If we were to return to an era of low fuel prices, we would likely be back to driving gas guzzling SUVs and at the same time shunning research and development into alternative energy sources.

I was hoping to pick up a copy of Wii Fit yesterday on it’s North American debut. I had no such luck. Wii Fit is generally sold out at most retailers to my great disappointment. It looks like I’ll be repeating my Wii hunt of 2007. I’m not hugely suprised by the shortage of Wii Fit, but I am more astounded there are still shortages of the Wii almost 20 months after the initial launch.

Wii Fit retails at $90, but if I were to buy it now from less savory sources I would have to pay as much as $250. I’m not paying that extra premium. While I’m certainly not supportive of people and companies somehow jumping the line and hoarding items only to resell them, I can’t blame people for pricing a product at which it’ll sell.

I’m biased by the nature of the industry I work in, and my study of economics. I’m a strong believer in price. Price is agnostic, and price is what ensures the markets work properly. If people are willing to pay $250 for Wii Fit, that gives Nintendo incentive to produce more. Pricing it at $250 also dissuades someone like myself from going and buying the product. The price balances the market.

The efficacy of price is the clearest in the commodity market such as oil, copper, and natural gas. By it’s nature a barrel of oil from one producer is indistinguishable from one produced by another. I’m fudging a bit because crude does have different grades, but for the purpose of pricing the basic commodity the variation between West Texas Intermediate (WTI) and Dubai are inconsequential. While Nintendo may not have a monopoly on video gaming, it does have a monopoly on the Wii and Wii Fit.

In the world of oil, the closest thing we have to a monopoly is OPEC, The Organization of Petroleum Producing Countries. While they have influence, it would be foolish to think they control the oil market. OPEC learned it’s lesson in 80s. Other countries start producing more oil, and consumers started consuming less. As much as it hurts the pocketbook, high oil prices are part of the solution. However this time around, I don’t believe Oil prices will fall to 1980 levels. Many non-OPEC countries are tapped out - the North Sea is about dried up, and other such as Russia are not so eager to see prices come down. Demand management, especially in Developed nations such as the U.S., will be critical lever to keep things in balance.

I’ve been following the rise of oil, personally and professionally.  Oil prices affect me a lot more professionally than they do me personally. I don’t drive enough that the price of gas makes a substantial impact on my budget.  The fact is that rising oil prices have been good for me professionally.  Yes, I’m in the “evil” energy business.  I’m one those “speculators” driving up oil prices.

That’s not quite true. I don’t trade oil, but oil does have a substantial but indirect impact on the electricity market that I’m in. I also don’t believe that rising oil prices can be squarely blamed on financial speculators.  This is not to say that traders do not affect or profit from rising oil prices. However, it’s simplistic to think traders can make oil go from $60 to $120 and keep it there all on their own.

When an oil trader bids up oil by buying oil futures in the “shadow” financial economy, there is still a day of reckoning in the real economy. There’s no question that a speculator can raise the price of futures by merely buying.  Futures are contracts to buy or sell at a future date.  If I sold a one year future contract for $100/barrel, I’m obligated in one year to deliver oil for $100/barrel.  For instance let’s say I wanted to raise oil prices, I could buy future contracts settling a year out for $200 when oil is only trading $100 today in the spot market.  The spot market is the real world actual time economy.  The spot market and the futures market however do move together.  If someone is willing to buy oil for $200 in year, but oil is only $100 today, there’s a clear profit opportunity. I can buy oil today, store it for something less than $100/barrel, and sell the future contract.  Instant profit of a $100.  As a result spot markets and futures markets tend to track.

However for the same reason that speculators can affect the real world spot market, the real world spot market has impact of the shadow economy.  If speculators are willing to buy $200 oil in on year’s time, but inherent supply and demand implies oil should be $100 today and tomorrow, then there should be other traders who would gladly take the other side of that trade.  That trader knows he or she should be able to procure oil for less than $200/barrel.  Ultimately what really prevents speculators from affecting actual prices in the long term is that for every deal there is someone just as canny on the other side.

I’m not naive enough to believer that speculators have not had an impact on oil prices. They have, and were the movement in oil prices short lived, I would put more blame on speculators. However, high oil prices have been sustained and for that I believe there have been actual supply and demand changes. Speculators can only keep prices high only for so long as it takes ever more capital to keep prices high.  For example let’s say I’ve brought $200 oil last year, I’m out $200 already, and if I were want to keep prices high I need to come up with more capital to buy more without raising capital by selling.  It certainly wouldn’t be the first time that speculators have tried to corner the market.

Sadly enough, rising oil prices if they persist are being caused by long term change.  Rising demand in developing nations such as China and diminishing supplies have fueled the rise in oil.  I don’t believe necessarily that we will run out of oil in the next decade, but it is a matter of time.  Oil and other fossil fuels are a limited resources.  It’s not a question if we’ll run out, but when.  In this regard, high prices are the answer to the long term problem. Higher prices will force us to rethink where we get our energy and how we use it.