Out, Out, Damn Speculators! (The CFTC reverses, impressing few economists)
The Commodity Futures Trading Commission (CFTC) plans to issue a “revised” report on the role of speculation in the recently concluded oil price boom, reversing last year’s conclusion that such betting was not a major factor relative to underlying physical fundamentals. The CFTC’s interim report concluded last year that ”current oil prices and the increase in oil prices between January 2003 and June 2008 are largely due to fundamental supply and demand factors.”
The reversal is said to reflect better data on who was actually in the market, including evidence that some traders had massive positions. But clearly the political bent of the leadership has changed as well, especially after the credit derivatives fiasco last year.
Political Risk As a Fundamental
Without question, commodity indices and other similar funds have allowed a lot of capital to flow into the market, and the fundamentals would not seem to justify prices reaching $147 per barrel. Still, it is hard to make the case that the market didn’t work or that new regulations will prevent future price spikes.
Consider the 1979 Iranian Revolution, when there was no serious amount of trading in oil futures (heating oil contracts had just been introduced). Prices soared for about two years, even as the market came quickly back into balance. And inventories soared even as prices rose.
What both periods have in common is a high degree of political risk to oil supplies, which no doubt created what we now call a “security premium”. This helps explain why people speculated in oil, an activity that will not be eliminated by any amount of regulation.
What Goes Up Can Go Down
Also consider that “speculation” works in both directions. As I wrote back in February, those like T. Boone Pickens who thought that oil prices would reach $200 a barrel lost a lot of money. Jerry Taylor also saw oil prices as a cycle based on physical realities more than speculation, although the latter is an interpretation of the former (and necessarily subjective). As Taylor wrote at MasterResource:
The price spiral had nothing to do with speculators, environmentalists, refining capacity shortfalls, the decline in the dollar, peak oil, price gouging, OPEC, or corporate oil monopolists. Instead, it was plain-old demand – fueled by an amazing economic boom in the developing world and oil price controls in the same – running up against supply that could not easily accommodate this demand surge in the short run. Moreover, a plethora of modest but consequential supply disruptions hit the market, making prices higher still. I also argued that the only way to address high oil prices was to allow the market to adjust without government interference…. And I am happy to report that I told policymakers that the conceit that oil prices would never fall to pre-spiral levels was almost certainly incorrect … and that a price collapse in the near term was as likely as not.
And another example is natural gas prices, also driven in financial markets. Natural gas prices in inflation-adjusted terms have dropped to levels not seen in decades, reflecting market fundamentals, although those looking for scapegoats can superficially finger speculators.
Speculation is natural human behavior. It is not created by institutions, but tends to be created by price volatility, something often found in commodity markets. But history is laden with other examples of speculation, as when Crassus in ancient Rome had his agents buy burning houses (at a steep discount) and then extinguish the flames.
More recently, there are two reasons to disbelieve that new speculative tools are to blame. First, the dot com bubble occurred in the conventional stock market, not on financial exchanges like NYMEX. It was completely transparent, subject to all the normal regulations, and yet clearly got out of hand. Second, as mentioned, commodity indices including natural gas as well as oil have fallen dramatically.
Dislike of speculators, even the more innocent ones, seems to be a historical constant. Because they are not perceived as creating any physical item, they are thought to provide no value. Medieval thought described merchants and bankers as essentially parasites for the same reason. But the fact is that information has does have economic value and speculation’s tendency to generate such information is an important service, something that should be kept in mind when attempting to curtail unliked market trading.
Arguably, reducing the ability to invest on the margin, which has often contributed to price spikes (stocks, houses, commodities) would moderate price movements. But speculation can no more be regulated away than greed, lust or gluttony. As with those human characteristics, it will always find a way to express itself.