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Hurricanes and Hedge Funds: What the Season Can Teach Us About Economics

Friday, August 15, 2014

[UPDATED 02 OCTOBER 2015]

The eastern seaboard is battening up the hatches as Hurricane Joaquin spins up in the Atlantic.  Even if the storm does not make landfall, it portends massive amounts of rain.

The imagery right now, though, is not yet dominated by destroyed buildings or flooded communities, but by those ubiquitous maps that project the path and intensity of the storm out a few days into the future.

This is a great opportunity to learn something about hedge funds and the casino that the supposedly free market has become under the money printing enterprise of the Federal Reserve.

This is pretty arcane stuff, and if you've read other posts in this blog you know I like to tackle arcane stuff and try to make it a little easier for everyone - especially you jocks out there - to understand.  In this post I am going to try and swim against a strong current among conservatives like myself by trying to explain the arcane world of what is called 'Knowledge Management' (KM) or 'Data Mining' in information technology, and how it is used in commodities speculation - and how this grossly distorts our economy.  But first I'll explain how this thing called KM works in hurricane modeling.

Data, Information & Knowledge

First we have to back up and define some terms.  'Data' can be any single piece of data like temperature or relative humidity.  That data is collected from certain places at certain times.  (I do not claim the following example is how data for storm maps is handled; this just a descriptive example.)  You can think of the date/time, location from the center of the storm and the relative humidity as the three dimensions of a cube, as in this graphic. (The top squares have the yards away from the center at the bearing on the compass, so 0/0° is the storm's center.  1,000/90° would be 1,000 yards away due east.)

The RH percentage, the date/time and the position with respect to the storm's center are all individually pieces of data.  When they are brought together like this - "data-in-context-with-other-data" - it is called information.  And when you "assemble" a single three-piece data set like this into a logical 'cube' by capturing the progress of time and the progress of things like RH away from the storm's center, you build out more and more information.

And as you build out this information over time from more and more storms, you can apply statistical methods to the information to predict the path and intensity of the next storm - this is called knowledge in Knowledge Management.  (See here for a great article on a 2012 improvement to the data modeling for hurricane forecasting.)  And the more information you gather over time, the more accurate your predictions become.

Apologies are in order from the Geek Tower; the propeller on my beanie is really spinning.  I just hope I haven't made you dizzy to the point of losing your lunch.

But this blog post is not really about hurricanes; it's about hedge funds.  And they are doing exactly the same thing with price activity in the energy markets (which is just one of many commodity markets where you will see this sort of thing).  The 'spot price' of crude oil today, for example, is like the center of the storm.  (West Texas Intermediate, or WTI, is at $45.28 as of this writing.)  Current inventory, current refining capacity, current transport capacity, and many other such variables are like relative humidity, air temperature, sea temperature, barometric pressure, etc. in storm modeling.  Each individual measurement (price, inventory, refining capacity, transport capacity, tracked over date/time) are all pieces of data.  They are brought together into logical 'cubes' of information.  And from this information, it becomes possible to predict future price activity - knowledge.  If you have noticed how the models for hurricane forecasting have improved over the years, the exact same thing is happening in the modeling of price activity in commodities markets.


The Blackjack Table of the Energy Market

Now think about this for a moment: Blackjack is basically a game of supply and demand.  The dealer has the supply, and it is 'inelastic' - the term economists use for a fixed supply - there are only so many cards in a deck.  Demand is a function of the number of players at the table.  So if you're one of them, you can watch as the low and high value cards are removed from play by previous hands.  If you can keep close track of this, you can bet big when the counts are in your favor - or bet small when they are not.

And you will, of course, get kicked out of the casino if management thinks you are doing this sort of thing.  It is considered cheating.

Now let's take up the energy market.  I am a hedge fund manager (not really - just playing one on the blogosphere).  I have a sophisticated KM system which is getting better and better each year at predicting price activity in the crude oil market.  Today the 'spot price' is about $45/barrel.  My system is saying, however, it will be driven to $65/barrel as a number of tanker ships go into dry dock for maintenance.  Leasing a ship is going to get a bit more expensive shortly, so the price for delivery of crude is going to rise with it.  Since I have clients who have invested in my hedge fund, I have to make money for them, so this is what I do:

I use their money to 'back' a contract for 1,000 barrels of crude at today's spot price of $45/barrel.  But this is for purchase within 60 days.  What I am 'betting' on at this Blackjack table is that the price will be $65 before I have to execute the contract.

And if my KM system is right, when that happens, my contract will then represent a $20/barrel discount to the spot price.  And the contract is for 1,000 barrels, so the contract is worth $20,000!

And you, dear reader, run a refinery.  You need the crude, and will refine it into things like gasoline for the motoring public and kerosene for the widowed pensioner on a fixed income who needs to heat her home.  Your competition is 'paying at the pump', as it were, buying crude for $65 per.  I drop by your office with an offer.

"I have this contract for 1,000 barrels at $45 per," I start my pitch.  "Your competition is paying $65,000 for that amount of oil today.  My contract represents a $20,000 discount.  So let's you and I split it!  You pay me $10,000 and I'll assign the contract to you."

This means you will have spent a total of $55K ($10K to me for the rights under my contract and $45K executing the contract) to get what your competition has to pay $65K for.  And I just made $10K for doing nothing substantively different than card-counting at the Blackjack table of the energy market and betting when the count was in my favor.  After taking my 'management fee' what is left of the $10K goes to my clients as part of their return on investment.

One of many myths in finance is that this sort of thing is highly risky.  It used to be.  And it still is for the investor who does not have sophisticated Knowledge Management systems.  But for the hedge funds who have these systems, as more and more data is collected and put in context with other data (information) over time, the reliability of price activity predictions (knowledge) inexorably decreases the risks of making bets like these - because the 'cards' at the Blackjack table of the energy markets are being 'counted' ever more accurately.


Economics & Conscience

Now while some might charge me with being a self-righteous scold over noting the unseemly 'card-counting' of this sort of thing, that really isn't the problem here.  And for opposing this, some might also accuse me of trying to repeal the laws of supply and demand.  The problem here is not with supply and demand; it is with the difference between true demand and false demand.

You, my erstwhile business partner in this transaction, have a refinery.  That means you can actually use the commodity to produce something that others need and will buy in the economy.  Me? I am managing a hedge fund from my home office - in my pajamas, no less!  I have neither the intention nor the capability to use the commodity to produce something others will buy.  It is for this reason your purchase is true demand, and mine is false demand - a mere bet at the Blackjack table.

But as a matter of how the price of crude rises and falls, affecting the price of things like gasoline and kerosene, my contract to buy 1,000 barrels of oil is registered by the market as demand.  When speculators like me pile in and sign contracts for oil, the additional false demand pushes the price up higher and faster than it would have otherwise gone if the law of supply and demand had been left truly free to determine price discovery.

The problem here goes back, as I wrote recently, to the problem of the dollar not being tied to anything of real value like gold.  This allows banks to extend credit without any effective limits.  If you can borrow money from the Fed at something for 0-0.25% and turn around and make 20% on that money by speculating in oil, that return is just way too good to turn down.

So let's start with the creation of all this new money.  It eventually chases the same amount of economic output, pushing prices higher.  The lower-middle class (who do not own a home) and the poor are left to watch as the dollars they do have buy them less and less.  The upper-middle class (who do own their home) and the rich have things like homes and stock - which rise in value along with inflation - to offset this loss of purchasing power.

But it gets worse.  Money available essentially for free which can bring a return of 20% at the Blackjack table of the energy market only guarantees that more and more of this excess money goes into speculation instead of production.  This is why the economy is not growing - speculation does not improve anything or produce anything, therefore it does not create any real wealth.  It only takes more money away from production, reducing supply and creating stronger upward pressures on price.  The mirage of hedge-fund wealth is merely the loss of purchasing power among the poor and lower-middle class being transferred to the already wealthy; the false demand of this speculation pushes prices up even higher and faster -  compounding the distortion of the underlying inflation.

Or to simplify: Imagine I am stalking a young man with a 25 kilo bag of rice over his shoulder as he carries it home from the market.  I furtively slice open the bag and catch the rice as it falls out - for my shareholders, as it were.  He thought he bought 25 kilos of rice.  By the time he gets home he realizes his 'purchasing power' somehow went from 25 kilos to 23 kilos just during the walk home!

What am I?  A hedge fund manager?  A conservative champion of the free market?  Or just a very sophisticated thief?


Striking a Pose for the Supposedly Free Market

I have very little patience for politicians and other so-called 'experts' who strike or tweet their poses for their concern for the poor.  I got grief for calling Paul Krugman an idiot in a previous post for doing just this.  I stand by that call.  But I will also call out my own side of the aisle here for how we like to strike our conservative poses for what we want to pretend is a free market.

We have not had a free market for over 40 years.  That died when the dollar was taken off the gold standard.  We have progressively gone from a free market to our version of a centrally planned market; what the Fed now calls 'macroprudential policies' is just central planning under an Orwellian name.

And there is nothing 'free' about speculation in commodities futures, either.  This does not mean, mind you, that commodities futures contracts are bad things.  A supplier is guaranteed a buyer at a set price, and that buyer is guaranteed a needed commodity at that set price.  The buyer actually uses the commodity to produce something and passes the discount to the wholesale spot price along to the customer in the form of competitive retail prices.  When the speculator card-counts at the Blackjack table of the energy market and inserts the false demand of their bets, however, the market is no longer free to allow supply and true demand to determine normal price discovery.

Again, all of this drives down to a sound dollar.    The Federal Reserve and the Treasury Department claim to be looking out for Main Street.  The claim is an absolute joke - all you have to do is look at how much of the new money goes into speculation and how that speculation distorts price discovery to see this for what it really is.  The Federal Reserve has turned the temple of the free market into a den of thieves.

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