It's Not the Speculators

People are very passionate on this issue for reasons I don't fully understand, and most of you don't agree with me on this topic, but I side with Jim Hamilton on the issue of speculators in oil markets. Speculation is not the cause of high energy prices:

A ban on oil speculation?, by Jim Hamilton: Joseph P. Kennedy II, former Congressional Representative from Massachusetts, and founder, chairman, and president of Citizens Energy Corporation, has a proposal to make energy affordable for all. All we have to do, Kennedy claims, is "bar pure oil speculators entirely from commodity exchanges in the United States."

Writing in the New York Times last week, Joseph Kennedy (D-MA) explained why he believes that speculators are responsible for the high price that we currently have to pay for oil:

Today, speculators dominate the trading of oil futures. According to Congressional testimony by the commodities specialist Michael W. Masters in 2009, the oil futures markets routinely trade more than one billion barrels of oil per day. Given that the entire world produces only around 85 million actual “wet” barrels a day, this means that more than 90 percent of trading involves speculators' exchanging "paper" barrels with one another.

It's true that most buyers of futures contracts don't actually want to take physical delivery of oil. If I buy the contract at some date, I usually plan on selling the contract back to somebody else at a later date, so that I leave the market with a cash profit or loss but no physical oil. But remember that for every buyer of a futures contract, there is a seller. The person who sold the initial contract to me also likely wants to buy out of the contract at some later date. I buy and he sells at the initial contract date, he buys and I sell at a later date. One of us leaves the market with a cash profit, the other with a cash loss, and neither of us ever obtains any physical oil.

Let's take a look, for example, at NYMEX trading in the May crude oil futures contract. A single contract, if held to maturity, would require the seller to deliver 1,000 barrels of oil in Cushing, OK some time in the month of May. Last Friday, 227,000 contracts were traded corresponding to 227 million barrels of oil, which is indeed a large multiple of daily production. But it is worth noting that at the end of Friday, total open interest-- the number of contracts people actually held as of the end of the day-- was only 128,000 contracts, much smaller than the total number of trades during the day, and not much changed from the total open interest as of the end of Thursday. Many of the traders who bought a contract on Friday turned around and sold that same contract later in the day. If the purchase in the morning is argued to have driven the price up, one would think that the sale in the afternoon would bring the price back down. It is unclear by what mechanism Representative Kennedy maintains that the combined effect of a purchase and subsequent sale produces any net effect on the price. But the only way he gets big numbers like this is to count the purchase and subsequent sale of the same contract by the same person as two different trades. ...[continue reading]...

In the past, I've covered this topic in quite a bit of detail, e.g. see this subset of links:

• Even More Speculation
• Another Iteration on the Speculation Model
• "More Speculation about Those Oil Speculators"
• Speculation Continued...
• Speculation and Oil Prices
• Oil Prices and Speculation
• Speculation and Bubbles
• Did Speculation Drive Oil Prices?
• Paul Krugman: The Oil Nonbubble

I think that, collectively, the material in these links make a very strong case against the speculation hypothesis, but I should be careful to clarify my view. This is from the fifth link on the list, Oil Prices and Speculation (for a more technical treatment, see here and here, i.e. the first two links on the list):

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 help.

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.

But I still think it's correct.

This will likely be successful politically -- blaming the speculators will likely ring true for many -- but I don't think the underlying economics supports the claim that speculation is the primary cause of high energy prices.