Thursday, February 3, 2011

Those Darn Speculators

After casting around for a villain, it appears congress has settled on "speculators" as the scapegoat to blame for high oil prices. Having tried out "evil oil companies" and "Bush's war in Iraq", the bipartisan consensus seems to be that somehow evil speculators have managed to drive up the global price of oil.

Let us just look at the market without the specter of sinister speculators and ask if maybe there is something there that could explain higher oil prices. Well, China and India are rapidly industrializing, and demanding massive quantities of oil. And there was a little war in the middle east which disrupted oil production in Iraq. And the US refuses to open up new regions inside the US, allowing foreign oil cartels to control large percentages of the market. Mexico's socialized oil company is showing its age with slowing production and rampant corruption. And Socialists just took over Venezuelan oil as well, which, though not immediately harmful raises the specter of declining returns there as well.

But none of those can be controlled by congress for the purpose of gathering votes. Gutting the futures market on the other hand is well within the power of congress. And so we get the demonization of speculators.

So, what do speculators do? They buy a good they expect to rise in price, then SELL it to make a profit. That second part is what gets lost in the congressional debate. They somehow think oil speculators just keep buying oil and raising prices and never sell. But then how do they make money? Speculators who just buy and hoard tend to go bankrupt, which means they don't remain speculators for long. And when they do sell, then prices drop. Which means there is no way speculators could both make money and continually raise prices. It is simply not possible to do through speculation alone.

I explained it elsewhere, but speculation does not raise prices, or does not exclusively do so. What speculation tends to do is level prices. It raises them when they are going up and lowers them when they near the peak. In other words, speculation serves to soften price shocks at both ends, when prices rise or fall too much, then speculation causes those rises and falls to be more gentle.

But congress,  being economically illiterate will blame speculators for rising prices (never crediting them for falling prices when they sell), and probably pass all sorts of useless regulations to restrict futures sales. Of course, the end result will be more dramatic swings in price, but no overall drop in prices. Mainly because speculation is reactive, it responds to price changes, it does not create them.

But it feels good to blame speculators rather than face the truth that increased demand and decreased supply leads to increased prices.  The hard facts of economics don't come with dramatic villains against which to fight, and since they aren't good theater, don't expect to hear those words from any politician.

POSTSCRIPT

Some will argue that sufficiently large investors CAN drive world markets and so are not just responsive. However, that is an absurd overestimation of trading houses and underestimation of the world oil market. If anyone thinks someone, or even some cabal, is driving world oil prices, then explain the fate of the Hunt brothers. They had more resources and were trying to corner a much smaller market, yet failed. I am afraid myths of brokerages moving markets in that way is just absurd. The speculators are in oil because it is moving, they are not making it move.

UPDATE

While I did not mention it in the main essay, clearly the government can help reduce oil prices, but only by removing restrictions on drilling and exploration. There is nothing else that will have any lasting impact on the price of oil. Releases form the strategic reserve are simply a one time fix, which probably will not even briefly lower the price.

NOTE

I recently wrote much more about this on my other blog, Random Notes. If you are interested, read any of the following articles:

In Defense of Speculators
Authoritarian Oil Talk
Stop Big Porcelain Now!
A Shortcoming of Conspiracy Theories

They do a good job of elaborating on the points I made here.

UPDATE


I also covered a similar complaint, that "the market isn't working" on my other blog, under the title "Absurdities on Oil"


Originally Published in Nation of Whiners on 2008/07/22.

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