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Pope Francis, the Free Market & Commodities Speculation

Friday, December 13, 2013

We have had a couple weeks to digest Pope Francis unnecessarily controversial Apostolic Exhortation (1) about how the world's economies affect the poor.  His use of "trickle down" - a loaded term in our American political/economic lexicon - seemed to provoke the strongest reaction.  The Pope has been called everything from a Marxist to a fool.  There really is only one thing to say in response to the critics:

Forgive them, father, for they forgot to read.(2)

But before we go back and do what it seems so few have actually done - that is, actually read the Holy Father's Apostolic Exhortation - we have to make sure we understand exactly what it is.  When the Catholic Church promulgates doctrine considered to be binding on the faithful it does so in a number of different kinds of documents.  And while an Apostolic Exhortation is not to be taken lightly, it is not a 'legislative' document under canon law. (3)  As such, it is a mistake to think that Francis' reflection here on economics and poverty is the same as binding church teaching - as in on something otherwise controversial like contraception.

In light of this we have to come to terms with a couple things about Pope Francis.  First, he is a Jesuit priest who has spent his entire life ministering to the poor.  He has seen, first hand, how economics works itself out in real life among the poor.  Second, his is not an economist, and does not pretend to be one here.  What he has done here is bring a distinctly Christian conscience to the larger issues of macro-economics and the much more local and personal issues of poverty.  He is exhorting us - even those of us who do not consider ourselves Roman Catholic -  to attend to the formation of our conscience on these issues.

As an example, Francis calls us to reflect on new kinds of power: "We are in an age of knowledge and information, which has led to new and often anonymous kinds of power."

Of everything the Holy Father has said in his exhortation, this is probably the most insightful of his observations.  While I do not know if he intended the words "knowledge" and "information" in the technical sense I as an information technology professional would use them, in the IT discipline known as 'Knowledge Management' (KM) data is collected and brought into context with other data.  That collection of data-in-context-with-data is called information.  And as this information grows, it becomes possible to detect trends and discern statistical profiles such that one can predict something into the future.  To be able to make such predictions with high degrees of probability is called knowledge.

For those who have access to the necessary sources of data, computing power, and the expertise to bring those two things together, there is a tremendous amount of economic power available.  And that power reaches down to the poor in almost exclusively harmful ways, and does so with almost complete anonymity - unless you understand what is actually happening.

Let's take the oil market as an example.  If I have access to a large array of data about the energy market - something I would get not from 'Big Oil', but from 'Big Data' - I could bring that data together into a sophisticated IT system and begin to engage in this 'Knowledge Management'.  I would take the data, bring it into the proper context with other data (information) and derive predictions about price activity in the oil markets (knowledge).  If the spot price today is $80/bbl., and my system spits out a prediction 90 days into the future which shows a $100/bbl. price, I will hit the market and sign a 'futures contract' to buy, say, 1,000 bbl of oil at $80 per within the next 90 days.

But wait a minute... I am blogging from my home office in my pajamas...  I don't have a refinery.  What the hell am I doing signing a contract for 1,000 bbl of oil?

I am gambling, of course.  No, actually, I am card-counting at the Blackjack table of the energy market.  This is what my sophisticated KM system allows me to do.  Where this kind of commodities futures play used to be a highly risky proposition, my KM system increasingly reduces those risks as the probability of its predictions increases proportionally to the amount of data to which I have access.

But why would this be something I should subject to my conscience?

First, let's follow what is happening here.  If, as my KM system predicts, the spot price does hit $100/bbl within 90 days, my contract now represents a discount to that spot price.  My contract is for 1,000 bbl at $80 per.  If the spot price hits $100 per, that's a $20 discount on each barrel.  Multiply that by 1,000 and you have a contract which represents a $20,000 discount to the spot price.

So let's do a deal.  You have a refinery and need the oil.  I sell you the rights under my contract (I 'assign' the contract to you) for which you pay me $10K.  You then buy the oil for $80K.  You have just bought 1,000 bbl of oil for a total of $90K where your competition will have to spend $100K.  Basically, we have split the discount.  You win.  I win (albeit for doing nothing more than signing a contract).  Isn't this what the free market is all about?

Maybe, until you consider what happens down the line with the price of home heating oil in the winter - and to the pensioner who needs to buy it to stay warm.

This is where our conscience comes in to the picture.  If I do not have a refinery - if I am merely card counting at the Blackjack table - I have neither the ability nor the intention to make use of the oil.  That is to say to produce something with it that others need and will buy.  But the market registers my contract as demand just as it would if you - who actually can refine it into fuel products - were to contract for the oil.  My demand is thus false demand; I cannot actually take the commodity and produce something useful with it.  Your demand is true demand - you can and do produce a supply of something needed in the economy.

My false demand for oil - being added to your true demand - pushes the price up higher and faster than it would otherwise go without adding that false demand to the true demand of those who can produce something with the commodity.  This is not an argument against the law of supply and demand.  Supply and demand is working perfectly - to my advantage, of course.  But in an inner city neighborhood somewhere in the Midwestern United States, for example, an elderly retiree can no longer afford her home heating oil.  The price has gone up too high, too fast, and for almost entirely anonymous reasons.

This is the most compelling example of the "new and... anonymous kinds of power" about which the Holy Father warns us.

Now, lest someone mock me for suggesting we do away with commodities futures contracts, the problem is not with futures contracts, per se.  It is with speculation in commodities futures.  Southwest Airlines is rightly famous for how it hedged against aviation fuel inflation with futures contracts (4).  While its competitors were 'paying at the pump' in 2007 when prices spiked dramatically - prompting the start of those hated baggage and fuel surcharges - Southwest was buying its fuel against its contracts, in some cases at nearly half of what was being paid by their competition.  Ever wonder how it is that 'bags fly free'?  Here is your answer.

When a supplier of a commodity and a buyer - who can actually use the commodity to do something like fly you and me from here to there - enter into a contract like this it guarantees the supplier a buyer at a set price.  And it guarantees the buyer the availability of the needed commodity at a set price.  Both gain predictability to their income and expenses.  In this case, though, the flying public wins as well.  Southwest is not trying to profit by selling its discount to the spot price to a third party.  They are sending that discount on to their customers in the form of lower fares.  This is true demand, and represents the commodities futures market working perfectly.

The essential difference here between true demand and false demand is the ability to 'assign' the futures contract.  If I cannot 'assign' my rights to a third party - for that $10K fee, of course - there is no reason for me - without any intention or capability to produce something with the commodity - to sign the contract to begin with.  And this means my false demand is no longer combining with true demand to push against supply, causing prices to rise higher and faster than they otherwise would.

This same dynamic can be seen in any commodity for which futures contracts are created.  When Ethanol was the rage, speculators poured into the market to sign futures contracts for corn.  And the wife of the subsistence farmer in Central America - who only wanted to make tortillas for her family - panicked as she saw prices in her local market soar.  When Australia's rice harvest came up short one year, speculators piled into the market for rice futures.  Rice riots followed in the markets of Asia. (5)

What is happening here is the false demand of speculation is distorting the price signal on the commodity, reducing the purchasing power of the little money the poor have available to buy that commodity or the food produced from it.  The poorer the end consumer is, the greater the economic injury.  The solution, though, is amazingly simple: disallow assignment for commodities futures contracts.  Proper hedging will still be possible; the producer will still be able to guarantee a buyer at a given price and the buyer will still be able to guarantee a supply at that given price.  But, unable to 'assign' a futures contract, the speculator will no longer be able to insert false demand.  This, then, allows the free market to calibrate supply to true demand, sending a more reliable - and just -  price signal.

To attach an adjective like just to price discovery might sound odd coming from a conservative.  But it is coming from a conservative who is taking his background in information technology and combining it with a conscience formed by Christian tradition to respond to the Holy Father's observation about how today's technology forms "new and often anonymous kinds of power."  It is an attempt to attend to the formation of a Christian conscience on the issue of macro-economics.

This, I believe, is exactly what the Holy Father asks of us in his Apostolic Exhortation.

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1. Pope Francis, "Evangelii Gaudium"

2. In fairness I have to credit a certain Mr. Tyler Buchanan, a frequent commentator on Marketwatch.com articles, with that very concise - and hilarious - response.  See comments on Darrell Delamaide, "Pope Francis attacking greed, not capitalism"

3. See Helen Hull Hitchcock, "The Authority of Church Documents"

4. For a brief description, see Jeff Bailey, "Southwest Airlines gains advantage by hedging on long-term oil contracts" in NY Times.  For a more in-depth study, see Dave Carter, et. al. "Fuel Hedging in the Airline Industry: The Case of Southwest Airlines"

5. See Timothy A. Wise. “The Cost to Developing Countries of U.S. Corn Ethanol Expansion”  See also “Food speculation: 'People die from hunger while banks make a killing on food'” and a WikiPedia article on the “2007–08 world food price crisis”.

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