A brief word about speculation in oil
The front page of today’s business section of the New York Times features an article by Joe Nocera that correctly questions Washington’s preoccupation with speculators as the source of our oil crisis. It seems the witch hunt in Washington D.C. is underway again where the fingers are out pointing, looking for someone to blame for the bout of inflation now roiling the global economy.
The truth is always a shade of gray, never black and white. There is a fundamentally sound argument to be made that oil prices have risen in response to a tightening of supply and demand. Oil demand is inelastic, meaning that as supply becomes constrained and excess capacity becomes marginal, prices will rise in parabolic fashion. This is what has happened to date.
Yet, there is ample evidence that excess global liquidity is increasingly being thrown into the commodities markets into long-only funds, which drive up the price of these commodities above what the free market would dictate.
The leading proponent of [the “London loophole”] theory is a portfolio manager based in the Virgin Islands named Michael W. Masters. When I caught up with him on Thursday afternoon, after his week of testimony, he said that the problem was that institutional investors had stopped seeing energy as a commodity the world relies on and instead saw it as an “asset class” for their portfolios. “I am opposed to thinking about commodities as an asset class,” he said.
Several years ago, he continued, he began to notice that increasing cash flows were moving into commodities index funds. This was, he said, “long-only money” — meaning that it was a pure bet that prices would go up. By now, he told me, there is $240 billion in commodity index funds, up from $13 billon five years ago. As he also noted in his testimony before Congress, “the prices of the 25 commodities that compose these indices have risen by an average of 183 percent in those five years!” He claims that energy prices will fall by 50 percent if the speculators can only be driven out of the futures market.
While I find this evidence compelling at the margins, Nocera goes on to question its validity.
There are so many holes in this argument I scarcely know where to start. The C.F.T.C. says that some $5 trillion worth of futures and options transaction trades take place every day; can an influx of $240 billion, spread over five years, really propel prices upward to the extent that he and others claim? Then there’s the fact that the commodities markets don’t work like equity markets, where a small amount of trading can lift every share of a company’s stock. In commodities trading, every contract has a buyer and a seller, meaning that for every bet that prices are going up, somebody else is betting they are going down. Why doesn’t that short interest depress prices?
And what about all those commodities, like coal or barley or sulfur, that don’t trade on any futures market but have risen as fast as or faster than oil? Or how about the recent decline in cash flows into many commodity funds — why have prices kept going up if the money has stopped pouring into those funds? My speculator friends tell me that in the last two weeks, trading volumes have been cut in half. Indeed, what I hear is that much of the speculative money that remains in the market is betting against higher oil prices.
As for the London and Enron loopholes, I can pretty much guarantee they will be closed soon. There are some eight bills aimed at curbing speculation, and virtually every one of them calls for an end to the loopholes. That is probably a good thing — but I’d lay odds the price will not drop as a result. The loopholes are not the reason prices are going up.
In fact, I’d be willing to go a step further. Even if you eliminated speculation entirely, the price of oil wouldn’t fall. Thankfully, no one is proposing to go that far (though Senator Lieberman was toying with the idea), because even members of Congress understand that futures markets serve a crucial purpose. They help companies hedge their oil prices, and they help energy companies manage their risk, for starters.
The energy speculators I spoke to say that Congress has it exactly backward: the futures market is actually taking its cues from the physical market, where the buyers and sellers of oil do their business. Last week, the Saudis promised to produce an extra 200,000 barrels a day. But it is pricing that oil so high that oil companies are balking at paying for it. The Saudis didn’t arrive at their price by looking to the futures market — but if they get that price, it will certainly affect the futures market.
Both speculators and oilmen say that supply and demand is the real culprit. “Our supply is pathetic,” said Gary Ross, the chief executive of the PIRA Energy Group, and a well-known energy consultant. “Look at the data,” he continued. “The world economy is growing by 3.9 percent a year. World oil demand should grow by 2.3 percent just to keep pace. That’s an extra two million barrels a day. We don’t have it! It’s obvious.”
And this is the problem regarding the debate about oil prices. It is much like the debate about the Technology and Telecom bubble in the 1990s and the Housing bubble this past decade. In both cases, there was a fundamentally sound argument as to why prices should rise at a fairly heady pace. However, at some point these markets took on a life of their own and the intoxication of asset appreciation created a euphoria that ended up in a bubble. The existence of a bubble does not negate the fundamental argument for the initial price appreciation just as the fundamental argument cannot wave away the truth that speculation and euphoria created unsustainable highs in prices. Elements of both are evident.
Speculation and boom busts are endemic to the capitalist system founded on fiat currencies, central banking and a fractional reserve banking system. The underlying mechanism for boom and bust is always at its core about credit. And to the degree our central bankers are the ultimate source of credit control,it is their responsibility to monitor these events in order to prevent the boom bust cycle from having an undue impact on the real economy.
The Fed, in particular, has failed spectacularly in this endeavor as it has allowed ever increasing levels of credit and bubble creation in the United States. However, this does not create an opening for politicians and bureaucrats to step in and over-regulate in a way that is detrimental to the laws of supply and demand. When boom turns to bust, politicians, in their fealty to the whims of popular sentiment turn to look for scapegoats. Nocera ends his story thus:
“Speculators have always been an easy target,” said Leo Melamed, the man who founded the futures markets. As Ron Chernow, the great business historian put it, “At times in history when you have vast and impersonal forces wreaking havoc in markets, there is always a temptation to villainize someone.” Centuries ago, it was Shylock; now it’s the speculator and the short-seller.
In his book “The House of Morgan,” Mr. Chernow has a description of Herbert Hoover, “moody and isolated,” convinced that short-sellers were behind the market’s horrendous downturn in 1929. “He came to believe in a Democratic conspiracy to drive down stocks by selling them short,” Mr. Chernow writes, adding that Hoover “began to compile lists of people in the bear cabal and even claimed to know they met every Sunday afternoon to plot the week’s destruction!”
I wonder whethe
r [our present congressional regulator-in-chief] Dingell has heard about them.
Congress will only end up making this problem worse and needs to stay out of this debate. But, in an election year, with the electorate looking for someone to blame, that’s not likely to happen.
Easy Target, but Not the Right One, Joe Nocera, The New York Times, 28 Jun 2008