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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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I’m Speculating About The Speculation About Oil

Comments (13)

Having just finished reading George Soros’s latest book The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means my brain is now full of his theories around reflexivity.  I have always instinctively agreed with Soros’s philosophy even though I find it incredibly difficult and chewy to work my way through (but that’s true of all philosophy for me.)

I’m a great fan of the Heisenberg Uncertainty Principle which, according to my friend Wikipedia, "is the statement that locating a particle in a small region of space makes the velocity of the particle uncertain; and conversely, that measuring the velocity of a particle precisely makes the position uncertain."  Wikipedia suggests that this is often conflated with the Observer Effect (when you observe a phenomenon, you change it), but I think the intersection of the Heisenberg Uncertainty Principle and Soros’s Theory of Reflexivity reduce nicely in my brain to the Observer Effect. 

That leads me to the real point of this post, which is the great short article in the New Yorker by James Surowiecki titled Oily Speculations (thanks Amy.)  In the last month a new class of villain has emerged in the rapidly escalating price of oil – the "speculator."  Surowiecki calls bullshit on this (not on the involvement of the speculator, but why this is both irrelevant and why the speculator is not the villain.)

The key sentence in the article is "Speculation has been a favorite target of politicians looking to mollify anxious voters since the time of ancient Greece, when the orator Lysias protested that wheat traders had reduced Athens to a state of siege.” 

The conclusion, which Surowiecki bashes us (appropriately) over the head with is "The difficulty for Congress, of course, is that none of the problems that have driven up the price of oil lend themselves to a quick fix, and most, like the boom in global demand and the inaccessibility of certain oil fields, aren’t under our control at all. That’s what makes speculators a perfect target: by going after them, Congress can demonstrate to voters that it understands their pain, and at the same time avoid doing anything that might require real sacrifice from Americans. Our dependence on foreign oil, together with the fiscal fecklessness that has helped reduce the value of the dollar, means that there is no easy way out of where we are. But in an election year that’s hardly a message that anyone in Washington is going to deliver."

If you net it all out, it’s the Observer Effect writ large.

  • http://www.kidmercuryblog.com kid mercury

    the criminal federal reserve is the real problem here. they excessively expanded the money supply, this resulted in a devalued dollar (because of excess supply of them), and all the speculative bubbles we've seen since nasdaq (because speculative bubbles arise when there is too much money in the markets). of course, no candidate who plans on getting on television and getting fair media coverage will ever mention this.

    • Jeff

      I think your economic theory needs a little work: First of all, are you calling the price of oil a speculative bubble? I'm not saying that $130 barrel is here forever but calling it a bubble shows little grasp of market – either underlying or derivative.

      Secondly, How is it exactly that a devalued dollar caused a bubble in residential real estate but not in commercial real estate? Can you give me examples of other sectors of the economy which are or recently were in a speculative bubble due to a “devalued dollar”?

      BTW, the lowered value of the US Dollar has more to do with our ever increasing budget deficit far more than anything else.

      • http://www.feld.com Brad Feld

        Re: are you calling the price of oil a speculative bubble: Nope – quite the opposite.  I’m supporting Surowiecki’s assertion that the notion that it’s a speculative bubble is silliness!

        • Jeff

          Brad, I was referring to “Kid Mercury” in my reply – not your post!

          • http://www.feld.com Brad Feld

            Aha! 

  • Dave

    I might not be getting Reflexivity, but it seems more like the opposite of the Observer effect. The basic idea is that the movement of the markets affects the participants' behavior, right? This is a kind of classic second order effect, and isn't the same as the idea that finding out the price changes the price. Or looked at another way, reflexivity is the *failure* to understand WHY the market is moving – in other words, the *lack* of deep observation. Maybe you can fill in the gap here.

    • http://intensedebate.com/people/bfeld bfeld

      The movement of the markets affects the participants behavior AND the participants behavior affects the movement of the markets.

    • http://www.feld.com Brad Feld

      The movement of the markets affects the participants behavior AND the participants behavior affects the movement of the markets. It’s bidirectional.

      • Dave

        But that's not the observer effect. The observer effect is that the *observation itself* affects the status of what is observed. An example of this might be that, by asking about the price, you alert the seller that you are interested, thus affecting the price. This doesn't happen in liquid markets, especially those with freely available pricing. I and everyone else can track the price of oil all day, and it will have no impact.

        And, the fact that the market movements and participant behavior affect each other bidirectionally seems to me closer to the definition of a market than an indicator of anything special going on. Put another way, if the interactions weren't bidirectional, it wouldn't be a market.

        Reflexivity, the way I understand it, is more than just reaction to market movements, it's the creation of some sort of systematic bias in behavior due to a consistent pattern of movement. For example, markets have been going up so long that they're just bound to keep going up (like Texas real estate, right?) – this is how bubbles happen.

        Perhaps, then, your insight is that if market participants *wire their behavior* to market prices, this wiring is *consistent across many participants*, and it creates a *positive feedback loop*, then what looks (at a distance) like an observer effect occurs. These conditions are how it is different from markets operating normally, in which of course there is still observation and bidirectional influence. In normal markets, the wiring tends not to be very consistent across participants and also does not tend to have positive feedback effects (traders usually have sell and buy thresholds).

        Interestingly, venture capital is wired in this perverse way. The standard procedure for marking up valuations is to base them on the most recent financing round. If public markets and/or acquisition prices are going up, VCs start to pay higher valuations in financings; which increases the valuation of portfolios generally; which feeds back positively into both the LP capital raising process, entrepreneur valuation expectations, and other processes, even though the actual prospects of the individual companies haven't particularly changed, particularly considering that the long time horizons for VC funded companies likely take them to a different place in the acquisition/public market cycle.

        • http://www.feld.com Brad Feld

          Yeah – well – with all philosophy, none of it is particularly clear to me. I should probably realize that I can't interpret Soros correctly if I don't completely understand it! That said, I'd encourage you to read it as he strongly disagrees with the efficient market hypothesis and how it actually works – especially in the context of his theories of reflexivity. While the observer effect isn't bidirectional, reflexivity is, which as I (sort of) understand it is the thing that people often miss.

          Re: VC valuations – true, but not true. Under FAS 157, this is no longer the way it works. We now get to “subjectively” mark our valuations to market. Oh goody – as if introducing more subjective bias into the system will make the valuations more accurate. That said, your basic observation about the dynamics of VC pricing is definitely part of the the fuel for each up and down VC cycle.

  • Leo

    Here's a recent post on the same subject by Charles Hughes Smith: http://oftwominds.com/blogjuly08/speculation7-08….

    Charles Hughes Smith is a someone that William Safire and Spiro Agnew would likely refer to as one of those “nattering nabobs of negativity”, maybe even alarmist. Unfortunately, like a lot of the nabobs recently, he's been pretty much spot on about the housing crisis, the dollar and oil for over three years now. Well ahead of the wave and closer to the future economic conditions than most of us.

    You'll see a great Soros quote at the bottom of his page: “Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited.”

    I think what he's getting at is that, possibly because of the Heisenberg principle and/or the Observer Effect: even if there was a truth, we don't have access to all of it, and via language, only a very small percentage But we can sometimes approximate enough to at least see the wave coming. Similar to the idea (Gibson?) about the future being unevenly distributed.

    If you haven't already, check out “The Origin of Wealth” by Eric Beinhocker. Another brilliant and entertaining work on statistics, some game theory, stochastic waves, complexity economic, the behavior of markets, thermodynamics and innovation. My take away: Even if we could measure everything and found everything to be deterministic, we'd still have unpredictable chaotic patterns that would take longer to analyze than to let play out.

  • gregorylent

    speculators are a the target because the demand is the nearly the same as it was a year ago, but speculation that the demand would increase has lead to rising price.

    i find his argument an attempt to head off criticism for a circle of friends, avoid blame, and cya pr

  • cameron

    I wonder if we're overcomplicating the oil price bubble. Large amounts of money flow into the commodity futures markets thanks to new-fangled commodity index funds: http://www2.goldmansachs.com/services/securities/…into which large pension and endowment funds pour in hundreds of billions of dollars: (http://www.sacbee.com/103/story/1027383.html). Keep in mind that the size of these futures markets is tiny compared to equity markets (about 1.2 trillion market capitalization).

    This one-sided investment drives up futures contract prices because these funds are long-only and now comprise a large percentage of overall trading. Normally arbitrage keeps spot prices and futures price in check, but for Oil, which has little excess infrastructure, arbitrage is highly constrained, thus driving the spot price up to the futures price.

    So I'd say that speculation is not driving up oil prices per se (as in, there is no intent to manipulate the market), but it's an unintended consequence of hundreds of billions of dollars pouring into these commodity index funds.

  • http://intensedebate.com/people/kidmercury kidmercury

    the criminal federal reserve is the real problem here. they excessively expanded the money supply, this resulted in a devalued dollar (because of excess supply of them), and all the speculative bubbles we've seen since nasdaq (because speculative bubbles arise when there is too much money in the markets). of course, no candidate who plans on getting on television and getting fair media coverage will ever mention this.

  • Dave

    But that's not the observer effect. The observer effect is that the *observation itself* affects the status of what is observed. An example of this might be that, by asking about the price, you alert the seller that you are interested, thus affecting the price. This doesn't happen in liquid markets, especially those with freely available pricing. I and everyone else can track the price of oil all day, and it will have no impact.

    And, the fact that the market movements and participant behavior affect each other bidirectionally seems to me closer to the definition of a market than an indicator of anything special going on. Put another way, if the interactions weren't bidirectional, it wouldn't be a market.

    Reflexivity, the way I understand it, is more than just reaction to market movements, it's the creation of some sort of systematic bias in behavior due to a consistent pattern of movement. For example, markets have been going up so long that they're just bound to keep going up (like Texas real estate, right?) – this is how bubbles happen.

    Perhaps, then, your insight is that if market participants *wire their behavior* to market prices, this wiring is *consistent across many participants*, and it creates a *positive feedback loop*, then what looks (at a distance) like an observer effect occurs. These conditions are how it is different from markets operating normally, in which of course there is still observation and bidirectional influence. In normal markets, the wiring tends not to be very consistent across participants and also does not tend to have positive feedback effects (traders usually have sell and buy thresholds).

    Interestingly, venture capital is wired in this perverse way. The standard procedure for marking up valuations is to base them on the most recent financing round. If public markets and/or acquisition prices are going up, VCs start to pay higher valuations in financings; which increases the valuation of portfolios generally; which feeds back positively into both the LP capital raising process, entrepreneur valuation expectations, and other processes, even though the actual prospects of the individual companies haven't particularly changed, particularly considering that the long time horizons for VC funded companies likely take them to a different place in the acquisition/public market cycle.

  • http://intensedebate.com/people/Leo Leo

    Here's a recent post on the same subject by Charles Hughes Smith: http://oftwominds.com/blogjuly08/speculation7-08….

    Charles Hughes Smith is a someone that William Safire and Spiro Agnew would likely refer to as one of those "nattering nabobs of negativity", maybe even alarmist. Unfortunately, like a lot of the nabobs recently, he's been pretty much spot on about the housing crisis, the dollar and oil for over three years now. Well ahead of the wave and closer to the future economic conditions than most of us.

    You'll see a great Soros quote at the bottom of his page: "Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited."

    I think what he's getting at is that, possibly because of the Heisenberg principle and/or the Observer Effect: even if there was a truth, we don't have access to all of it, and via language, only a very small percentage But we can sometimes approximate enough to at least see the wave coming. Similar to the idea (Gibson?) about the future being unevenly distributed.

    If you haven't already, check out "The Origin of Wealth" by Eric Beinhocker. Another brilliant and entertaining work on statistics, some game theory, stochastic waves, complexity economic, the behavior of markets, thermodynamics and innovation. My take away: Even if we could measure everything and found everything to be deterministic, we'd still have unpredictable chaotic patterns that would take longer to analyze than to let play out.

  • http://intensedebate.com/people/bfeld bfeld

    The movement of the markets affects the participants behavior AND the participants behavior affects the movement of the markets. It’s bidirectional.

  • http://intensedebate.com/people/bfeld bfeld

    Re: are you calling the price of oil a speculative bubble: Nope – quite the opposite.  I’m supporting Surowiecki’s assertion that the notion that it’s a speculative bubble is silliness!

  • http://intensedebate.com/people/gregorylent gregorylent

    speculators are a the target because the demand is the nearly the same as it was a year ago, but speculation that the demand would increase has lead to rising price.

    i find his argument an attempt to head off criticism for a circle of friends, avoid blame, and cya pr

  • http://intensedebate.com/people/bfeld bfeld

    Yeah – well – with all philosophy, none of it is particularly clear to me. I should probably realize that I can't interpret Soros correctly if I don't completely understand it! That said, I'd encourage you to read it as he strongly disagrees with the efficient market hypothesis and how it actually works – especially in the context of his theories of reflexivity. While the observer effect isn't bidirectional, reflexivity is, which as I (sort of) understand it is the thing that people often miss.

    Re: VC valuations – true, but not true. Under FAS 157, this is no longer the way it works. We now get to "subjectively" mark our valuations to market. Oh goody – as if introducing more subjective bias into the system will make the valuations more accurate. That said, your basic observation about the dynamics of VC pricing is definitely part of the the fuel for each up and down VC cycle.

  • http://intensedebate.com/people/bfeld bfeld

    Aha! 

  • cameron

    I wonder if we're overcomplicating the oil price bubble. Large amounts of money flow into the commodity futures markets thanks to new-fangled commodity index funds: http://www2.goldmansachs.com/services/securities/…into which large pension and endowment funds pour in hundreds of billions of dollars: (http://www.sacbee.com/103/story/1027383.html). Keep in mind that the size of these futures markets is tiny compared to equity markets (about 1.2 trillion market capitalization).

    This one-sided investment drives up futures contract prices because these funds are long-only and now comprise a large percentage of overall trading. Normally arbitrage keeps spot prices and futures price in check, but for Oil, which has little excess infrastructure, arbitrage is highly constrained, thus driving the spot price up to the futures price.

    So I'd say that speculation is not driving up oil prices per se (as in, there is no intent to manipulate the market), but it's an unintended consequence of hundreds of billions of dollars pouring into these commodity index funds.

  • Jeff

    I think your economic theory needs a little work: First of all, are you calling the price of oil a speculative bubble? I'm not saying that $130 barrel is here forever but calling it a bubble shows little grasp of market – either underlying or derivative.

    Secondly, How is it exactly that a devalued dollar caused a bubble in residential real estate but not in commercial real estate? Can you give me examples of other sectors of the economy which are or recently were in a speculative bubble due to a "devalued dollar"?

    BTW, the lowered value of the US Dollar has more to do with our ever increasing budget deficit far more than anything else.

  • Jeff

    Brad, I was referring to "Kid Mercury" in my reply – not your post!

  • Dave

    I might not be getting Reflexivity, but it seems more like the opposite of the Observer effect. The basic idea is that the movement of the markets affects the participants' behavior, right? This is a kind of classic second order effect, and isn't the same as the idea that finding out the price changes the price. Or looked at another way, reflexivity is the *failure* to understand WHY the market is moving – in other words, the *lack* of deep observation. Maybe you can fill in the gap here.

    • http://intensedebate.com/people/bfeld bfeld

      The movement of the markets affects the participants behavior AND the participants behavior affects the movement of the markets.  It’s bidirectional.

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