Posted by: bmeverett | June 19, 2008

Myth: Speculators are responsible for high oil prices


One of the key principles of contemporary politics is:  If you can’t fix the problem, at least find someone to blame.  Nowhere is this approach more evident than in the oil market.  According to Senator Byron Dorgan (D-ND) and many of his Democratic colleagues, “There is an orgy of speculation in the energy futures market, which is driving up the cost of oil and the price of gasoline.”

This all sounds good, but it’s wrong.

In American culture, speculators are a kind of folk villain, who profit without doing any actual work or making any real economic calculation.   Blaming speculators for economic problems has been going on for hundreds of years.  But what exactly is speculation?

Let’s say you are a farmer who plants wheat in the spring to be harvested in the fall.  You know what planting costs, but you don’t know what the price of wheat will be when you sell.  A drought in some other area could force wheat prices up, giving you a windfall.  Alternatively, a bumper crop could drive the price down, leaving you with a net loss, bankruptcy and foreclosure.  For millennia, farmers had no choice but to take this risk.  Today, a farmer can hedge his risks by selling some of his wheat in the spring for delivery later in the year.  In this way, he gives up the chance for a windfall in return for avoiding the risk of disaster.  The farmer may find this type of transaction, called a forward sale, not only helpful but essential.  The buyer could be a customer, such as a bakery, but what if all the customers declined to take the risk?  The farmer can still sell to a trader (the infamous speculator) who makes money by buying and selling risk.  If the speculator bets on a price increase that never materializes, he’s out of luck.  Nobody else suffers.  The ability to hedge risk in commodity markets, like the availability of homeowners or business insurance, is not just convenient, it’s essential.  Everyone is better off from this transaction.

The downside of speculation has always been the fear of market manipulation, particularly a situation known as cornering the market. In a corner, a trader buys up enough of the available supply of some commodity that he in effect becomes a monopoly. By offering or withholding supply, he can control the price. In 1980, Herbert and Nelson Bunker Hunt tried to corner the silver market, by buying roughly one-third of the world’s silver supply. Ultimately, however, the Hunt brothers were unable to pay the high cost of holding this position and ended up selling off much of the silver. On March 27, 1980, known as “Silver Thursday,” the price dropped 50%. The Hunt brothers were nearly wiped out as a result.

In 2006, BP was accused by the US Government of attempting to corner the Northeastern propane market. Propane is delivered largely by a few pipelines of limited capacity, and, according to the complaint, BP is alleged to have deliberately bought up a controlling share of the available supplies in order to drive the price up.

Attempts at cornering markets have occurred throughout history, but it’s very difficult and risky. Above all, cornering requires accumulating physical supplies of the commodity, which artificially increases demand and reduces supply.

Today’s crude oil market is very different. Crude oil speculators don’t buy oil, they buy a piece of paper that entitles them to buy oil one month, two months or some other specified time in the future at a set price. Such a contract requires two parties. The other signatory to this contract promises to deliver oil at the agreed time and price. This is simply a bet between two people. One will win and the other will lose, but there will be no impact on oil supplies or demand unless speculators actually buy and physically hold significant amounts of crude oil.

In 1979, at the time of the second world oil shock, global oil demand was about 65 million barrels per day (a barrel contains 42 gallons). For the next ten years, world oil consumption hardly increased at all, and OPEC restricted supply in order to keep prices from falling. Worldwide oil demand, however, has been growing very fast in recent years, particularly with the impressive economic growth enjoyed by China and India. The current world oil market is about 85 million barrels per day (a barrel contains 42 gallons) or about 31 billion barrels per year. Today, almost every OPEC country is producing as much oil as it can every day. Some of the Middle East countries could produce more over time, but only with substantial new investments. In other words, demand has finally caught up with supply.

At any given time, somewhere around 3-4 billion barrels of oil are held in inventory around the world with a total value at today’s prices of $400-500 billion. This oil is owned by hundreds of different companies at crude oil production points, in ships, at refineries, at terminals and in service stations. Total oil inventory in the US is about 1.7 billion barrels, about the same level as we had in the 1990s. You’d have to buy a lot of oil to influence the price, and there is no evidence that speculators are buying and holding physical volumes of petroleum. In fact, most people who trade oil are simply hedging their business risks as oil suppliers and consumers.

Why then the uproar over speculation? Easy. The supply demand balance cannot be influenced in the short term, and the decisions that would actually influence oil prices in the longer term are too politically difficult to make. Congress, particularly the Democrats, have been unwilling to open up new areas for exploration in the US, preferring instead to blame the oil companies and speculators. Even the oil industry itself beats the speculation drum.  According to the London Times, Peter Voser, Finance Director of Shell, said,  “We find it hard to explain oil at $100 a barrel. I don’t see anyone queuing for fuel and nor are there any physical shortages.” This statement shows an embarrassing ignorance of economics. Prices do not increase as a result of physical shortages. Suppliers take subtle cues from the marketplace regarding inventory levels and consumer behavior. Market prices are reset to equilibrium on a continuous basis, not as a result of shocks.

Blaming speculators for our problems is simply scapegoating. If we are going to address our energy problems, our public officials need to act more like doctors and less like used car salesmen.

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Responses

  1. Being in the business of speculation, I agree with the essence of this. I do sometimes wonder, however, if there are any restrictions on speculation by those few people who could affect the price of oil (or other futures) in the short term, especially in times of tight supply. For instance, could a Saudi prince buy futures contracts before an OPEC announcement cutting production? There’s still risk in the purchase, of course, but it is mitigated? Or (more farfetched probably) a MEND rebel leader buying front month contracts and then blowing up a 300K bpd pipeline? Or a labor union representative privy to knowledge of an impending dockworkers’ strike at Le Havre buying Med Aframax freight forwards?


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