An Anti-Speculative Frenzy

I was worried that my defense of speculation in the oil market, published this week on ForeignAffairs.com, was late to the game, but my timing turned out to be right on. Just yesterday, an op-ed appeared in the New York Times by Joseph P. Kennedy arguing that “pure” speculators should be “banned from the world’s commodity exchanges.”

I am wholly sympathetic to Mr. Kennedy’s motivation—to make sure that the wealthy do not profit at the expense of those of more modest means, who are genuinely hurt by high and volatile prices for staples like heating oil, rice, and other goods. But the recipe for a better-functioning oil market that he cooks up is not the answer.

I’d like to address a few of the major points that Mr. Kennedy makes in his piece. Let’s start with his conclusion:

"Federal legislation should bar pure oil speculators entirely from commodity exchanges in the United States. And the United States should use its clout to get European and Asian markets to follow its lead, chasing oil speculators from the world’s commodity markets."

Commodities markets need at least some what he calls “pure” speculators (meaning those who act as brokers or investors rather than actual producers or consumers of oil) in order to function. This isn’t just my opinion. Commissioner Bart Chilton of the CFTC—hardly a shill for Wall Street—hammered home in a speech last month that “Speculators are necessary liquidity providers to [commodities] markets.” In other words, “pure” speculation is an essential part of the oil market.

Why is that the case? As I tried to explain in my ForeignAffairs.com piece, oil producers and consumers use financial markets to hedge their risk. But they need someone willing to assume that risk. In industry jargon, they need a counterparty to trade with. At times, oil producers and consumers are able to trade among themselves, but not always. That’s where “pure” speculators come in.

For example, Chevron might contract in advance with Southwest Airlines to sell it 1,000 barrels of jet fuel for delivery in New York in 2015. But what if Southwest needs to buy a certain quantity or type of oil for future delivery and no oil producer can commit to providing it for them? That’s when a speculator, acting as a broker, can be useful. He takes the other side of the trade with Southwest for the time being. Then, when an actual oil producer decides it can deliver Southwest what it needs, the speculator sells the contract to the producer. The deal is done. If companies choose to contract with one another directly, rather than through a speculator acting as an intermediary, they are free to do so. But were such intermediaries banned from the market, as Mr. Kennedy calls for, companies that would like to minimize their risk by pre-buying or pre-selling oil would often be stymied.

The amount of damage an oil producer or consumer could suffer by losing out on the ability to hedge is huge. Back to the example of Southwest Airlines—as oil prices trended upward between 1998 and 2008, the company saved more than $3.5 billion thanks to hedging in the oil market, while many of its peers that didn’t hedge suffered. Pure speculators enabled it to rack up that magnitude of savings.

The op-ed also makes the following claim:

"Because of speculation, today’s oil prices of about $100 a barrel have become disconnected from the costs of extraction, which average $11 a barrel worldwide."

This paragraph reflects a misunderstanding about how oil prices are determined in the marketplace. The market price of oil has to do with marginal production costs, not average costs. That means that the most expensive barrel produced to meet global demand is also the one that more or less establishes a floor for prices. Right now, many experts reckon the marginal cost of production is the cost of producing oil shale and oil sands. Barclays Capital reckons that extracting oil from Canadian oil sands requires an oil price of at least $85 to be economically viable. Once you correct for that error, you realize that $100 oil is not far-fetched, especially in light of ongoing geopolitical disruptions.

It continues:

"Pure speculators account for as much as 40 percent of that high price, according to testimony that Rex Tillerson, the chief executive of ExxonMobil, gave to Congress last year."

This claim—that Wall Street speculators account for as much as 40 percent of oil prices—is Mr. Tillerson’s estimate, but I have not seen any publicly available study to support that figure. (If I’m mistaken, I’d love to see the report--please send it to me.) Discerning analysts should bear in mind the circumstances under which Mr. Tillerson provided that estimate. Under pressure from Congress last year, oil company executives were called to Capitol Hill to explain why oil prices were so high. They were right to defend themselves. Oil companies receive far more blame in the popular media when gas prices are high than likely they deserve. Still, I have not seen any data validating the 40 percent figure he cites.

Mr. Kennedy argues that the 40 percent estimate “is bolstered by a report from the Federal Reserve Bank of St. Louis.” That’s far from the case. The report he’s referring to is being cited frequently as evidence that speculators are running wild in the oil market, causing prices to move in whatever direction they’d like. But that’s not the study’s primary finding at all. It concludes that “On balance, the evidence does not support the claim that a sudden explosion in commodity trading tectonically shifted historical precedent” (emphasis mine). The bottom line is that “the increase in oil prices over the last decade is due mainly to the strength of global demand” and that “fundamentals continue to account for the long-run trend in oil prices.” The study suffers from some severe methodological limitations due to a lack of data, which calls into serious question its conclusions about how pure speculators affect prices (it says they were up to 15 percent of the 2004 to 2008 price run-up), but there it is. More on that study in another post.

Oil prices can certainly diverge somewhat from supply-and-demand fundamentals for periods of time. That problem is exacerbated by the opaque and contradictory data about what’s happening in the global oil market, which gets in the way of the market’s efforts to determine fair value for the good. My colleague Daniel Ahn has written an excellent CFR piece describing this phenomenon and its implications for regulation. Oil speculators can and do fall prey to irrational exuberance from time to time. Ultimately, though, you’d still be far more accurate to blame supply and demand than you would Wall Street for pain at the pump right now.

I applaud Mr. Kennedy’s desire for sound, proactive regulation of commodities markets. Traders operating within them should continue to be subject to reasonable rules and restraints to prevent abuse, fraud, and manipulation. Where speculators are guilty of illegal practices, they should answer to the law. The CFTC is wise to weigh policy options to improve these important markets. Unfortunately, Mr. Kennedy’s prescription for fixing them is not the right one.