Facts on Oil Speculation

Gas prices have returned to about the level they were in 2008 before the economy went into recession. As with every other time gas prices get high, politicians and similarly misinformed people are blaming speculators in the oil markets. Such statements have risen to the top of government, with Barak Obama saying:

“We can't afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage and driving prices higher, only to flip the oil for a quick profit.”

More ignorantly, Joseph Kennedy suggested baring speculators from the markets outright:

“They should be banned from the world’s commodity exchanges, which could drive down the price of oil by as much as 40 percent and the price of gasoline by as much as $1 a gallon.”

Saying ignorant statements for political expedience is no excuse; many people end up believing it. And from their passion for the topic, I suspect these politicians truly do believe it. This is despite the fact that a economics refutes their claims, or at the very least offers no evidence at all to back them.

Here are some facts about speculation:

1. The increased number of speculators in oil markets does not necessarily increase prices.

2. When a speculator buys a futures contract for oil, it means there is also a seller. If purchasing a futures contract increases the price of oil, selling the contract would reduce the price.

3. However, if the market expects the price of oil to rise, the price of futures contracts will rise. This will create an incentive for suppliers to take some oil off the market today to sell at the higher future price. But this is merely the smoothing of a price shift due to a change in supply/demand equilibria.  

4. If speculators were artificially driving prices significantly higher than their supply/demand equilibrium, it would reduce demand, causing producers to reduce supply. In the short term inventories of oil would build up due to a lag in the reduction of supply, which isn't happening.

5. No economic study has found that either the number or positions of speculators have increased average prices of oil.

If you would like the details…

1. The number of speculators in a market does not necessarily have an effect on prices. The number of speculators has increased in both the oil and natural gas markets. Oil prices have gone up whereas natural gas prices have dropped. This merely means that more people are placing bets on which way prices will go. Additionally, the greater the number of market participants, the less proportional influence on the market of any one speculator. This would make the market more competitive, and make price collusion harder.

2. In an oil futures contract, a buyer agrees to pay a certain price today for the right to take delivery of a certain amount of oil in the future. Speculators have no interest in taking delivery of the oil; instead they try to sell the contract for a better price than they bought it. Most of the time, the buying and selling takes less than a day. So if there is any increase in prices now due to the purchase of a contract (and that’s still an IF) then selling at the end of the day would have an equal opposite effect on prices. It is hard to understand how, if the speculator never takes possession of the oil (but merely buys a contract and sells it before the oil is delivered) they could be increasing prices on a sustained basis.

3. However, if the market collectively expects oil prices to rise in the future, more speculators will want to buy futures contracts at today’s prices. Meaning there will be more people who want to buy than sell, so the price of futures contracts will increase until there are equal buyers and sellers. This creates an incentive for suppliers of oil to wait to sell some of their oil at the higher future price, or enter into a forward contract (agree to sell the oil at a certain price and future time). If the market is wrong, and prices don’t increase they lose a lot of money. If the market is right, they will have smoothed out a price shift due to a change in supply/demand and not speculation. The result is that the supply of oil today is reduced, and prices increased, to increase the supply of oil in the future, and decrease future prices. Basically, in these cases speculation helps shift resources to the point in time they are most needed, and causes price swings to be less sudden and severe.

4. I’m no expert on the oil industry, but economist Severin Borenstein, of the Haas School of Business, is. He recently argued, on NPR’s “On Point”, that if speculators were able to conspired to create significantly higher prices (which they can’t, see point 1) this would dampen demand. To keep at their most profitable, oil companies would sell less oil, resulting in increased inventories since it is difficult to immediately reduce production. But inventories of unsold oil are very low, and supply has been increasing due to high world demand (the real reason for high prices). Therefore significant price collusion cannot be happening.

To combat a problem that doesn’t exist, Barak Obama has suggested spending more money on the Commodity Futures Trading Commission to investigate speculators for price fixing. This is wasteful. It’s not to say markets are perfect and don’t need regulation, but one must remember there is an opportunity cost to spending money for political reasons on a non-issue. If you need further convincing, let these economists do it. Basically,

5. “We find that the existing evidence is not supportive of an important role of speculation in driving the spot price of oil after 2003. Instead, there is strong evidence that the co-movement between spot and futures prices reflects common economic fundamentals.”