Wednesday, July 21, 2004

Dept. of Delays: Apartment Search and Moving

Sorry folks, will be moving the next few days, and today at least there will be no oldman posts. I'm working on some posts regarding interpreting Greenspan's testimony where it seems like he's trying to have it both ways. I'm also working on writing that exposes why the housing market is not a free market - government price supports and subsidies via Freddie Mac and Fannie Mae - and why this has contributed to the slow decline of the asset/savings side of the American economy as our consumer asset base declines. Once again, I state my mantra that I would support free markets given that someone could find major examples that were governed truly by free market principles. I am a free market supporter. I just don't believe in blinding myself to the fact that there are very few free markets.

I have a nice one bedroom lined up that I have to make a call and confirm, and in addition the oldman is looking into several income supplementals and has an idea about what to do for his next career move. If things work out by this time next year the oldman could be moving to Houston, Texas. More details will be forthcoming.

One note however, there has been a new poster the last few days. Mr. Johnston seems an earnest sort, and far be it for the oldman to chase away one of his readers who care enough to post something.

Mr. Johnston did claim however that I had no evidence that government regulation was not 'efficient' besides my dogma. Well I wouldn't call it my dogma, that would be a little bit presumptuous. You see it's just the definition of what market efficiency and markets are, something usually discussed in Econ 101.

A market is a group pricing mechanism where prices are determined by many market participants sharing information as they buy and sell titles of possession. I put it that way for instance to distinguish it from blind auctions or low-bidding or any number of other sale mechanisms where information is not shared. Market efficiency is an economic hypothesis that states that given a market without any systematic biases and transactions of ownership titles are conducted using rational processes, then markets will determine the "best" or optimum price given supply and demand considerations among the market participants. The hypothesis is more broadly known as market efficiency.

Such a market for instance is the oil market. Here is a site entirely devoted for instance in tutoring people about oil market basics. It has a lot of interesting facts and observations such as this one: (with a nice graphic you should look at too)

The core refining process is simple distillation, illustrated in a stylized fashion at the right. Because crude oil is made up of a mixture of hydrocarbons, this first and basic refining process is aimed at separating the crude oil into its "fractions," the broad categories of its component hydrocarbons. Crude oil is heated and put into a still -- a distillation column -- and different products boil off and can be recovered at different temperatures. The lighter products -- liquid petroleum gases (LPG), naphtha, and so-called "straight run" gasoline -- are recovered at the lowest temperatures. Middle distillates -- jet fuel, kerosene, distillates (such as home heating oil and diesel fuel) -- come next. Finally, the heaviest products (residuum or residual fuel oil) are recovered, sometimes at temperatures over 1000 degrees F. The simplest refineries stop at this point. Most in the United States, however, reprocess the heavier fractions into lighter products to maximize the output of the most desirable products, as shown schematically in the illustration, and as discussed below.

Understanding this process is important to understanding pricing in the oil market. That way it'll make sense when you read stuff like this:
The IEA forecast that growth of world demand for oil would slow down to 1.8 million barrels per day next year from a high point for growth of 2.5 million bpd this year.

The reason, the IEA said, was that the pace of growth of the world economy would slow.

Most of the extra demand for oil would continue to come from countries outside the 30 industrialised members of the Organisation for Economic Cooperation and Development.

However, the IEA said that it had revised upwards its estimates for OECD demand with the result that forecast global demand would be 81.4 million bpd this year and 83.2 million bpd next year.

Supplies of oil from countries not belonging to Opec would grow by 1.2 million barrels per day next year, the same growth rate as was expected this year.

Countries of the former Soviet Union would underpin this growth, adding 585 000 barrels per day in 2005.

Now if you do the math, you can see that if the demand is 1.8 million bpd then the combined production is sufficient to meet that need and stabilize the price of oil. If you look at the high point demand however you can see that 2.5 million bpd is a shortfall of 700,000 bpd roughly. Furthermore if you understand the oil market, you'll understand that different regions produce different qualities (sulfur low or sulfur high is one distinction) that may be in different degrees of demand given differences such as sulfur emission restrictions like those in the USA that may drive the prices of certain subsets of the oil market differently. Finally you have to understand the stocking or hoarding mechanism where oil is a crucial energy resource commodity so people need to stockpile it, and this stockpiling demand can alter the supply-demand dynamic. When terrorism happens in sensitive oil-production areas, the price of oil rises because people are purchasing a higher forward supply guarentee of oil either against supply disruption, to lock in costs before prices rise higher, or against future speculation by other market participants. The latter demand component can be measured through the proxies of oil market volatility and liquidity.

The point is that oil is not a free market in any sense of the world, it is a managed market. OPEC is clear evidence of that. Nonetheless within the dynamic of that management it is a mostly free market and therefore while it has less than unity in its market efficiency of pricing you can see that it is at least partially market efficient.

The most crude (pardon the pun) form of price control would be a fiat of price levels. Clearly this would be an interruption of the market pricing process of many participants sharing information as they buy and sell back and forth. So by definition any outright coercive or regulatory interference that interrupted the pricing of supply and demand through market participants would not be market efficient.

So therefore by definition government price controls and regulatory intervention, except where to establish market rules conducive to market pricing such eliminating fraud, are not market efficient. Whenever a government acts to promote a market's sound functioning, that is market efficient. Whenever a government acts to interfere in market pricing, that is market inefficient. It's just a matter of definitions from Econ 101. In the real world you will rarely see a large-scale free market, where market efficiency approaches unity. Typically the markets have some sort of participant bias, a systematic regulatory bias, information barriers, government intervention, etc. So most of the world's markets are managed markets. Understanding the inherent biases of markets and being able to estimate their market efficiency is crucial to making money in them.

This is important because according to economic theory, a rationally systematic and perfectly efficient market should only be capable of a random walk deviation from the supply-demand solutions. That would mean that it would be impossible to make money from them except by selling high and buying low on supply-demand information and your profit would be limited by all the other market participants with the same information. In the real world, most markets are managed and it is possible to make money from them systematically simply because they are not efficient. The key however is that most of the patterns within the market are transient. Meaning you generally can't lock onto a single winning strategy, you have to be able to identify and capitalize quickly on emerging trends and then get out before they are overexploited by all the other people looking to arbitrage them into non-existence.

A well managed market is approximately efficient or approaches efficiency. Stupid moves like changing the ownership title rights of futures to options would be a bonehead way to guarentee a market bubble - which is just a pricing abberation created by a systematic market inefficiency. The market participants eventually adjust to this reality with a new equilibrium, but that's hardly stating that this new equilbrium must have market efficiency approaching unity just that markets of many participants tend to optimize efficiency given their boundary conditions over time - usually with a solution appreciably less than unity.

Perhaps later the oldman can give an amusing anecdote and discussion about the local supply-demand dyanmic of searching for one bedroom apartments in the Midwest in a college town.


Post a Comment

<< Home