We’ve heard a lot about how speculation has caused volatility in oil and
other commodity prices recently, and there are calls in Congress to put
constraints on speculative activity in order to stabilize prices and markets, so let's go back to the issue of whether speculative activity has been the driving force behind commodity price movements, oil prices n particular.
To begin, it's important to recognize that not all
speculative activity is the same, and not all of it is bad, and as we look into how to better regulate these
markets, we need to keep the types of speculative activities separate so that we
don’t stifle the good type of speculation as we try to eliminate the types that cause us troubles.
First, speculative activity can arise from attempts to profit from
manipulating the price of a good, and some people believe this type of
manipulative activity can explain much of the volatility in oil prices we have
seen recently. This, obviously, is a bad type of speculation and we should
prevent it to the extent possible.
Second, moral hazard combined with easy money can lead to an undesirable type
of speculation. If market participants have ready access to funds, and if they
believe losses will be covered, say, through a government bailout, then they may
be willing to invest far more than is optimal in speculative ventures. If they
hit it big, they win. If things go sour, the government covers their losses.
A third type of speculation we’d like to avoid is speculative bubbles, and
this is probably what most people have in mind when they hear the term
speculation. Speculative bubbles occur due to “bandwagon effects” where rumors
or some other force causes prices to deviate from their underlying fundamental values in a self-feeding frenzy that drives prices upward in a bubble, or
downward in a crash.
Fourth, speculation allows us to insure against expected future changes in
supply or demand, that is, anticipated changes in the price. If we expect higher
demand or lower supply of a good at some point in the future, that is, if we expect a higher future price,
then speculators will take some of the good off the market today, store it for
the future, and then sell it after the price rises. In this way, speculation
provides insurance against the future fall in supply or increase in demand by having the good available to meet those changes.
Finally, there is stabilizing speculation, for example selling short near
peaks in anticipation of price declines can dampen natural market volatility,
and this is generally desirable. This type of speculation - short-selling - is under considerable
scrutiny right now, but in general this dampens rather than enhancing market
volatility and we ought to encourage the dampening variety.
So yes, by all means, limit the bad type of speculation through regulatory changes. But be sure to keep the types that
Moving next to commodity prices and speculation, I've taken the stance that there is little evidence of the first and third types
of speculative activity, manipulation and bubbles divorced from fundamentals,
and I don't think the second type - moral hazard - made a large contribution.
I've argued fundamentals are the most likely source of most of the price variation, and by
fundamentals I mean any new information that causes people to change their
expectations of supply and/or demand, and I've taken a lot of criticism here over
that stance, the stance on speculative bubbles in particular. So let me add this
to the debate (see also
See You Later, Speculator - WSJ.com):
Scott Irwin takes down Michael Masters, by Jim Hamilton: Econbrowser is
pleased to host another contribution from
Scott Irwin, who holds the
Laurence J. Norton Chair of Agricultural Marketing at the University of
Illinois. Today Scott offers a critique of a recent report by Michael Masters on
the role of commodity speculation.
The Misadventures of Mr. Masters: Act II
by Scott Irwin
The impact of speculation, principally by long-only index funds, on commodity
prices has been much debated in recent months. The main provocateur in this very
public debate is Mr.
Masters, a hedge fund operator from the Virgin Islands. He has led the
charge that speculative buying by index funds in commodity futures and over-the-
counter (OTC) derivatives markets has created a "bubble," with the result that
commodity prices, and crude oil prices, in particular, far exceed fundamental
values. Act I of the Masters farce was his
to the Homeland Security Committee of the U.S. Senate in May of this year. Act
II is now upon us in the form of a lengthy
research report co-authored by
his research assistant, Mr. Adam White, and his testimony this week to a
subcommittee of the Energy and Resources Committee of the U.S. Senate.
My purpose in writing this post is to show that Mr. Masters' bubble argument
does not withstand close scrutiny. He first makes the non-controversial
observation that a very large pool of speculative money has been invested in
different types of commodity derivatives over the last several years. The
controversial part is that Mr. Masters concludes that money flows of this size
must have resulted in significant upward pressure on commodity prices, which in
turn drove up energy and food prices to consumers throughout the world. This
argument is conceptually flawed and reflects a fundamental and basic
misunderstanding of how commodity futures and related derivatives markets
actually work. It is important to refute Mr. Masters' argument since a number of
bills have been introduced in the U.S. Congress with the purpose of prohibiting
or limiting index fund speculation in commodity futures and OTC derivative