From the Fed to the Hill, and Back to Washington

With an eye on the big economic picture, Will Melick delves into the arcane world of options trading

In 1990, Iraqi troops swept into Kuwait and its seized its oil reserves. There was concern that the fallout from the Kuwait invasion might affect production in neighboring Saudi Arabia, the world's largest oil producer.

Some American officials worried that the possible loss of production would trigger a catastrophic rise in oil prices. The U.S. Energy Department predicted prices might hit $100 a barrel, a level that would send the world economy into a tailspin. Then Will Melick, a young Federal Reserve Board economist, took a second look at oil prices using a new economic forecasting tool he was helping to create.

Melick, now an associate professor of economics at Kenyon, focused on the arcane world of options trading. He thought options, used by savvy commodities traders to hedge against sharp swings in prices, might offer an accurate gauge of where oil prices were headed.

An option allows traders to lock in the price of a commodity for some future date. By looking at mounds of seemingly obscure options data, Melick determined that commodities traders didn't think the Middle East turmoil would drive oil prices all that high. The traders were right. Prices peaked at around $40 a barrel.

Melick joined Kenyon's faculty In 1998, after eleven years in the Federal Reserve system. At the College, he has continued his work with options pricing, traveling to the Federal Reserve Bank of Cleveland periodically to do research. He is a visiting scholar at the Cleveland Federal Reserve.

The theory behind his research is simple: options traders know what they're doing. If they didn't, they would lose their shirts. Thus, if they bid commodities prices up, it's a sign of some problem down the line such as a war-induced tightening of oil supplies. If options prices fall, it's a sign that oil supplies will likely be adequate.

Melick believes options pricing could emerge as a very important economic tool. "It's found a lot of use in the last ten years, especially in forecasting the direction of oil prices," he said. "It's key to setting economic policy to have an idea where oil prices are going, because energy is one of the fundamental components of the economy."

Melick also served as a senior economist on the President's Council of Economic Advisors during a one-year leave from Kenyon. Although the council tells the President what makes economic sense, the chief executive often takes another course. The council, for example, opposed the $180-billion farm bill, but the president signed it. Farmers, quite simply, constitute an important political force.

"These guys want to get reelected, so they often cater to special interests," said Melick, who grew up in the Columbus suburb of Worthington and originally planned to be a high-school social studies teacher. "That's true in any administration, whether it's Democratic or Republican."

Melick never actually met President George W. Bush while serving as one of the President's economic advisors. Only the council chairman meets regularly with the President. The senior economists, as a rule, meet the President only once, to have their pictures taken with him. Unfortunately, Melick was at a conference in Japan when the photos were scheduled.

But he improvised. Visit his Web site and you'll see a picture of Melick "enjoying a moment with President Bush on Pennsylvania Avenue." He's standing with a cardboard cutout.

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