Time series of prediction market prices for the Obama and McCain contracts

The idea of relying upon futures markets prices to forecast future events has an interesting history. Nearly 25 years ago, UCLA finance professor Richard Roll published a paper in the American Economic Review entitled “Orange Juice and Weather” which showed, among other things, that the futures market in orange juice concentrate is a better predictor of Florida weather than the National Weather Service. Since the only way one can earn excess profits in a speculative market is to gain an informational advantage over the competition, traders are strongly motivated to try to do just that. If markets are informationally efficient, it follows that market prices represent unbiased forecasts concerning future events. Technically, this means that on average, the market’s estimate of the average value of the event in question is likely to be quite accurate.

Consequently, I believe that political “futures” markets provide reliable indications of the odds that a political party or candidate will win an election. Intrade.com maintains an actively traded market for futures contracts which pay 100 points (where 1 point = $.10) in the event that a specific political event occurs and 0 points otherwise. Essentially, prices represent “risk neutral” event probabilities. With this in mind, it is interesting to note that as of today (Wednesday, July 30, 2008), the intrade.com market implies 1.7:1 odds in favor of Obama, since the Obama contract implies a 61.3% probability of winning the presidence, whereas the McCain contract implies a 35.9% probability. The following graph provides a time series for the Obama and McCain contracts dating back to January 2007. The obvious reason for the spike in the time series for the Obama contract earlier this year is that Hillary Clinton (his principal Democratic opponent) dropped out of the race. Furthermore, since the time series is updated daily by intrade, it will show “current” prices of these contracts going forward (more accurately, closing prices from the previous day of trading). 

So much for $4 per gallon gasoline prices

Today, the unleaded gasoline futures contract which trades on the New York Mercantile Exchange (NYMEX) closed at around $3.04 per gallon. Less than two weeks ago, this contract was trading north of $3.60 per gallon. The futures price essentially represents a wholesale price that excludes taxes, transportation fees, service-station markups and other costs. Nationwide, the markup from the NYMEX futures contract to actual prices at the pump has averaged around 62 cents per gallon since January 2000 (which is when AAA began tracking this information). Therefore, if there is reversion to the mean anytime soon, it is not unreasonable to expect prices at the pump to fall below $3.70 per gallon in the not-too-distant future. The graph below (obtained from ft.com) shows this dramatic change since 15 July:

Given this substantial (nearly 16%) drop in prices of gasoline futures contracts, current pump prices (averaging nationally more than $4 per gallon, and around $3.90-$3.95 in Texas) are not sustainable. Barring a high severity natural or man-made catastrophe, pump prices have nowhere to go but down. It will be interesting to see how long it takes for these lower prices to make their way through the supply chain.

The "Prevent Unfair Manipulation of Prices Act" takes junk science to a whole new level!

University of Houston finance professor Craig Pirrong understands well how energy futures markets function in the real world (see his Wall Street Journal essay entitled “Restricting Speculators Will Not Reduce Oil Prices”). While Congress’s “Prevent Unfair Manipulation of Prices Act” makes for some interesting political theater, it won’t put a dent in the energy crisis. Finally, “The Onion Ringer” provides a cautionary tale from some 50 years ago when Congress last tried to implement a similar strategy for dealing with an economic crisis (AKA the “onion crisis”).

Rebuttal of "An open letter to all airline customers"

I received an email recently from a major airline company entitled “An open letter to all airline customers“. This letter has as it signatories 12 Airline CEOs, and it lays the blame for the airline industry’s current financial problems at the feet of all those “evil” oil speculators who are buying and selling oil futures contracts. Of course, the timing of the letter coincides perfectly with recent efforts of the US Congress to turn oil speculators into scapegoats for the energy crisis rather than doing something which could actually make a difference, such as taking steps to increase supply and/or reduce demand for oil.

No wonder the US domestic airline industry is losing money hand over fist. The industry’s CEO’s apparently must not comprehend the most rudimentary economic principles which underlie global energy markets. I will be the first to admit that I am definitely not a particularly big fan of market volatility; e.g., I haven’t particularly enjoy watching my retirement assets go bungee jumping as they have been prone to do recently. I guess that I could blame all the evil short sellers for driving down the prices of my favorite stocks, but perhaps the real problem is that I am not that good of an investment analyst. I guess that I have been operating under the apparently mistaken impression for the better part of my adult life that the whole point of going long, going short, and/or implementing various trading strategies using derivative securities such as options and futures contracts is that innovations such as these facilitate price discovery and help ensure that markets allocate resources to their most highly valued uses. I think that the energy markets are telling these executives that their business models are broken and that they better start thinking of ways to restructure themselves so that they and their firms can live another day, week, month, year, decade or whatever. The worst thing we can do as a society is to continue to shield the airline industry from the consequences of continuing to pursue unsustainable business models.

I also find it very curious that the CEO for Southwest Airlines is one of the signatories on this “open letter”, since Southwest Airlines has been making money hand over fist from hedging their energy exposures in the futures markets (according to a July 1, 2008 Associated Press story entitled “Airlines try to hedge against soaring fuel costs”, hedging (e.g., by purchasing futures contracts) has saved Southwest $3.5 billion since 1999). I guess when an airline takes positions in energy-related derivative securities, that’s okay; it’s just wrong for you or me or some other so-called “oil speculator” to do the same.

Cross-Price Elasticity of Demand

During the course of the last three months, Greg Mankiw has collected an interesting assortment of anecdotal evidence concerning the effect of high energy prices on all sorts of different transactions, including the demand for online courses, bicycle sales, small car sales, scooter sales, home buying practices, the demand for mass transit, and even the demand for camels and mules!

John Coltrane Quartet – Afro Blue

Last night, my two sons (Chad and Erik) and I took in a performance by a wonderful trumpet player named Ephraim Owens. One of the tunes he covered was “Afro Blue”, by John Coltrane. Thanks to YouTube, a substantial archive of live Coltrane performances, including Afro Blue, are now available for everyone to enjoy. Here’s Coltrane’s performance of Afro Blue, with McCoy Tyner on piano, Jimmy Garrison on bass, and Elvin Jones on drums!

Adam Bender – plays baseball with only one leg

From http://www.heraldleaderphoto.com/2008/05/31/:

“Adam Bender, 8, is one of several kids who plays catcher in Southeastern’s rookie league at Veterans Park. What makes Adam stand out is that he plays one of the toughest positions on the field with only one leg. Because of cancer, he had his left leg amputated when he was one. Adam doesn’t use a prosthesis, and only uses crutches when he reaches base for the Astros.”

An economics tutorial on oil prices

In today’s Wall Street Journal, Martin Feldstein provides a simple economics tutorial on oil prices entitled “We Can Lower Oil Prices Now”. Once you read this, you’ll understand why “Any steps that can be taken now to increase the future supply of oil, or reduce the future demand for oil in the U.S. or elsewhere, can therefore lead both to lower prices and increased consumption today.”

Of course, Professor Feldstein’s conjecture directly contradicts claims made recently by certain members of the political class who simply assert (without benefit of any corroborative economic theory and/or evidence) that increased drilling cannot possibly have any such effects; e.g., see “Obama and The Don’t Drill Democrats To America: Don’t Drive. Just Shut Up and Sweat In Your Dark House.”