Is Regulating Oil Speculation a Good Idea?

Oil prices have behaved erratically over the past two years, you may have noticed. After increasing steadily for most of the decade, prices rose dramatically in 2007, and then really dramatically in 2008. The 2008 spike could have been due to a speculative bubble, or it might have signalled a move past a critical point in the market, at which supply suddenly became more inelastic. Then the recession arrived and global demand collapsed; so, too, did oil prices. While the global economy continued to shrink, however, prices began rising again; as of last month, oil was more than twice as costly as at its recession low.

What was behind that move? Could have been expectations of imminent recovery for the economy and renewed demand. Could have been expectations of rigid supply, given the collapse in investment and exploration that accompanied the recession. Could have been a reaction to low interest rates, which made storage of oil attractive (contango!). Could have been speculation. Paul Krugman writes:

Last year I was skeptical about claims that speculation was central to the price rise, because what I considered the essential signature of a speculative price rise — physical withholding of oil from the market, in the form of high inventories — just wasn’t showing.

This time, however, oil inventories are bulging, with huge amounts held in offshore tankers as well as in conventional storage. So this time there’s no question: speculation has been driving prices up.

Now, “speculation” isn’t a synonym for “bad”. If the underlying assumptions that seem to have been driving oil markets were right — namely, that a vigorous recovery is just around the corner, and demand will shoot up soon — then it would be perfectly reasonable to accumulate oil inventories right now. But those assumptions are looking less reasonable by the day.

This is all the more interesting as the Commodity Futures Trading Commission is signalling its intent to rein in speculative trading by establishing volume limits on energy futures trading by "purely financial investors", keeping tabs on hedge funds, and potentially introducing other "speculative limits" on trading.

Is this a good idea? Ordinarily, we'd consider speculation in markets a good thing. Speculative traders are either introducing good information into markets or creating profit opportunities for those with good information. And as Mr Krugman says, prices driven higher by speculative forces aren't necessarily a bad thing.

There are two key questions. One is whether targeting speculation is the best way to target bubbles. If low interest rates or inflation concerns are driving investors into commodities, that may make resulting price movements look bubbly, but limiting speculative trades in oil will only send money elsewhere.

Perhaps a gold bubble is less damaging than an oil bubble, but as with the housing boom, the bubble may be signalling more significant problems than speculation. Not long ago, Kevin Drum quoted John Hempton's dictum that banks intermediate the trade deficit, and argued that economic imbalances meant that a bubble was bound to form somewhere. Regulations to limit speculative trading, then, are merely palliative; slowing oil price growth isn't really "solving" any problem.

The other question is whether limiting speculation is the best way to reduce volatility. Another way of looking at this issue is, why do we care about big swings in oil prices? We care, of course, because oil is a key economic input, and volatility is extremely damaging (and self-perpetuating, as volatility makes long-term investment unattractive). In a post on this subject, Justin Fox quotes Milton Friedman saying that the only stable exchange rate regimes are free floating and fixed. If free floating oil prices are undermining economic activity, then perhaps a price intervention is warranted. In particular, a floor would protect a minimum level of investment in exploration and production.

A number of commentators have recommended a petrol price floor as a means to reduce price volatility (and raise revenue, if the floor was achieved with a variable tax). If the goal is to reduce volatility, it makes much more sense to attack that directly rather than play around with trading or regulatory intervention in the hopes that the desired result will be attained.

This article originally appeared on the Economist.com

Comments

[blu:]

Regulation of markets never works. Investors always find a way to circumvent the regulations by indirect means.
Floors and ceilings have been tried many times in the past with terrible results.
There is a fear of oil going back to $147/bbl and for some reason these pro-regulators believe this will forestall that or prevent it.
It is nonsense. Oil will be going much higher and so long as there are markets that trade it, there will be no stopping it. Floors or no.

Jul 09 10:57 AM

[JeffDB:]

Thanks for sharing that article.

It is good to hear some sound reasoning amid all the silliness & political posturing.

Jul 09 10:59 AM

[User 357705:]

Yes! Absolutely a good idea.

Jul 09 11:26 AM

[A Barrel Full:]

"This time, however, oil inventories are bulging, with huge amounts held in offshore tankers as well as in conventional storage. So this time there’s no question: speculation has been driving prices up.

This time, however, oil inventories are bulging, with huge amounts held in offshore tankers as well as in conventional storage. So this time there’s no question: speculation has been driving prices up."

I wonder how someone of the stature of Mr Krugman comes to write this. If the speculators are wrong, they will lose money big time. You cannot permanently buck the market.

Jul 10 08:19 AM

[KirbyJF1:]

“Goldman Sachs has a special Trading program see below


www.bloomberg.com/apps...)

-- reporting the arraignment in U.S. District Court in New York of a former Goldman Sachs employee accused of stealing the program. The prosecutor, Assistant U.S. Attorney Joseph Facciponti, was quoted as telling the court: "The bank has raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways."In letters to the SEC and CFTC, GATA wrote: "The assistant U.S. attorney's comment can be construed to suggest Goldman Sachs considers its own manipulation of markets to be fair, while such manipulation by others would be unfair. The court proceeding described in the Bloomberg News story would seem to impugn all markets in which Goldman Sachs trades.


----------------------...

Remember When Goldman Called for $200.00 oil, My bet was that they wetre getting ready to short all they could as they had all the storage possible for their actual product.

Goldman Sachs has the United States government under control as well as the SEC & CFTC.

Kirby

Jul 10 10:01 AM

[Ferdinand E...:]

Mr 'A barrel full', Krugman can write what he wrote because he is almost as ignorant about the pricing of oil as the people who are talking about regulating speculation. As for my good self, I would be willing to accept this regulation if the people who want to regulate were not even more ignorant on this point than Krugman.

Let me add that the last paragraph in your comment is the beginning of my argument that fundamentals and not speculators determine the oil price, although the way it works is that most speculators are experts when it comes to understanding oil market fundamentals, which certain people are not.

Jul 10 10:59 AM

[JeffDB:]

On Jul 10 08:19 AM A Barrel Full wrote:

> "This time, however, oil inventories are bulging, with huge amounts
> held in offshore tankers as well as in conventional storage. So this
> time there’s no question: speculation has been driving prices up."
>
> I wonder how someone of the stature of Mr Krugman comes to write
> this.

I think the first part of his statement if pretty much just an historical fact. I don't think anyone contests that fact that inventories were bulging earlier this year, and the investors/speculators were paying for extra storage room on oil tankers to hold some of it.

His last sentence, "So this time there’s no question: speculation has been driving prices up.", is of course his own opinion relating to that fact, and for what it's worth, it does make sense to me.

In an article he wrote for the NY Times on May 12, 2008 www.nytimes.com/2008/0... arguing against those claiming the steady price increases from 2004 through 2007 (~25% annually) and then a much bigger spike in 2008 were caused by a speculative bubble. He maintained, rightfully so in my opinion, that if that were the case there should be a growing inventory, as consumers would naturally cut back even more with an artificially high price not supported by the fundamentals and the suppliers would be selling as much as they could into that artificially high priced market. But, as he also noted, that was not the case. In fact, inventories had been drawing down significantly throughout most of that period or rising prices.

The situation was quite different, however, in early 2009. "The Great Recession" had hit and worldwide demand was down significantly. OPEC cut their output, but despite that cut inventories in the US & worldwide were growing to levels far above the norm. Despite the growing inventories, however, and the still relatively low demand, prices continued to rise, eventually more than doubling from their lows.

In reality, supply and demand were still determining market price, but "the speculators" had affected those relationships. We had a rather unusual situation which made hoarding profitable. Futures prices were some $3 or more higher than the current spot prices. This gave inducements to "speculators" to buy oil on the spot market and sell it on the futures market, making enough profit to pay to store it in the interim. That is why we had all of those oil tankers loaded with oil just floating in the Gulf as was reported often in the news.

How & why they did this, and the role the "speculators" played by in effect financing that hoarding is discussed in the middle of this post:

Morgan Stanley Hires Supertanker to Store Oil
www.oilandgaseurasia.c...

"Morgan Stanley hired its tanker at $68,000 a day, the two brokers said. That works out at $1.02 a barrel a month, based on a 2 million-barrel cargo. Benchmark U.S. oil futures are trading at an average of $3.65 more than the previous month between February and June."

So, if I understand this correctly, it would work out something like this. They buy 2 million barrels of oil on the spot market and simultaneously(?) sell 2 million barrels on the futures market for $3.65/ barrel more than they paid. They then rent the ship for $1.02/barrel for that month (counting insurance and other expenses?) and pocket a tidy profit when the oil is delivered.

$7,300,,000 gross profit from the sale of the oil 2 ml barrels X $3.65/barrel
-$2,040,000 expenses for renting the ship for oil storage for 1 mo.
-----------------
$5,260,000 profit per month per tanker

> If the speculators are wrong, they will lose money big time.
> You cannot permanently buck the market.

I definitely agree with that, but I don't think that disproves the hypothesis that speculators had a short term (a few months or so) on the supply/demand equation altering the spot prices for oil over those months vs what they would have been sans the speculators.

As I note in the original post I linked to, I don't think having such an affect is an inherently bad thing. I think it really boils down to whether the speculators are in fact accurate in their predictions. If they are, they help smooth out the price swings, but if they are wrong they exacerbate them.

Jul 10 02:29 PM