Friday, April 22, 2011

In Defense of Oil Speculators

Whenever oil and gasoline prices go up, people start vaguely casting blame on "manipulation" and "speculation." Now I see that even Obama has gotten into the game, vowing to"root out any cases of fraud or manipulation" in gasoline prices, "and that includes the role of traders and speculators [big applause line]."

It's true: speculation in oil futures can drive today's price up (or down). And that's just what we should want it to do.

Because we shouldn't care just about today's price, but about tomorrow's price too. If we knew that demand would likely be higher in the future (for example because of seasonal effects), or that supply would be lower in the future (for example because of unrest in oil producing countries), then what we would want to do is take some oil off the market today and save it for later. This would of course drive up the price we pay today, but it would lower the price we'd pay later when the oil would be even more scarce.

This is exactly what "speculators" try to do. People who believe they are well informed about future oil market conditions bid up futures prices, which causes people to store oil, or just leave it in the ground, in anticipation of higher prices later on. If these people are right, then they make money (at the expense of the people who took the other side of the bet), and consumers are better off in the long run. Of course the speculation could prove wrong (that's why it's called "speculation"), but still it represents the aggregated best guess of the people who have studied the issue enough that they are willing to place large bets on the outcome. If they are wrong, they lose money.

Now let's look at some quotes from the story about Obama's announcement as reported in McClatchy Newspapers:
Despite turmoil in the Middle East, there has been no significant interruption of oil production, and supplies remain abundant.
Well, not yet. Futures prices are about preparing for the future. Or would you prefer we just forget about the future and just burn whatever oil we can get our hands on with no concern about what might happen later?
Obama is under political pressure to address gasoline prices that are nearing an average of $4 a gallon.
Of course, political pressure. Ignorant voters forget that oil is traded in a world market and the president has basically no power to affect the price. Perhaps they would prefer that the government take over the entire gasoline market; maybe we could even have gasoline riots, like they do in Iran.
Commodities markets rely on speculation. It's excessive speculation that regulators are trying to curb.
Great! I'm sure government bureaucrats will just gaze into their federally issued crystal balls and determine when speculation is "excessive," outguessing the investors who make their living by making these predictions.
Bart Chilton, a member of the Commodity Futures Trading Commission, has argued that speculation is excessive.
Then maybe he should use his special insight sell some oil futures and get rich. Good luck with that, Bart!
But he said that determining how much of the oil-price increase stems from speculators, rather than a "fear premium" rising from Middle East instability, isn't a simple calculation.
Um, aren't these the same thing? The "fear premium" is due to a reasonable "fear" that supply will be lower in the future. (Of course if the fears turn out to be unfounded, then all those "speculators" will lose money. But predictions are hard, especially about the future.)
Proving market manipulation isn't easy.
Right, so this will probably come to nothing. (In fact, I don't think there are any commodity traders remotely big enough to "manipulate" this giant world market.) Maybe that's what Obama thinks too...I like to think he's smarter than this.


  1. What about the elasticity argument?

  2. Not sure I understand your point. Yes, gasoline demand is fairly inelastic in the short run so prices will go up (or down) a lot even without any futures market. My point is that futures trading should tend to smooth out these changes in the long run, on average, even when if the effect is to raise prices today.