A Defense of Oil Market Speculation
Friday, June 20, 2008
Everybody wants to know why oil prices have increased so rapidly in the past few months. Fortunately, everyone and their brother has the answer, and commonly, they will tell you that "evil speculators" are crushing the American Dream. I recently became suspicious when I saw Dennis Kucinich appear on Bill O'Reiley's show and wholeheartedly agree with each other on this issue. I have two questions, of which I don't know the answers, but which I hope can spur some intellectual thought on the question.
Are speculators to blame?
One thing that I never understood about the "blame the speculator" argument was that it seems to assume that traders only take positions on the long side - which anyone familiar with trading markets knows is not the case. In any liquid market, it is entirely possible that speculators could push prices either above or below what we might consider fair value based on supply and demand fundamentals. Nevertheless, I don't think I have ever heard traders being praised for crushing the price of some asset on the short side, making it undervalued and more affordable to average folks. The reason speculators engage in this behavior to begin with rests on an assumption that supply and demand fundamentals will reflect a certain price at some point in the future.
Consider this scaled-down example: if you go to a minor league baseball game and see a player you think will be the next Babe Ruth, you might purchase his baseball card on the assumption that at some point in the future he will be a hall-of-fame all-star. As more and more individuals see him play, they will want his baseball card, and the value of the card will increase, until eventually its value goes through the roof, even though this player might not be inducted into the hall of fame for decades into the future.
So when you see Clark Griswald on the evening news, griping about filling up his SUV, and saying things like "I don't understand what has changed in this market since the last year, I heard on the radio that demand is down!" Mr. Griswald is missing the bigger picture. Yes, fundamentals have changed only a little in the past year, and yes, demand is down (though only in the United States and other developed countries) but the expectation of a change in supply and demand at some point in the future has changed, and that is why prices themselves are through the roof. All of this leads into my next question...
Are speculatively inflated prices bad?
Conventional wisdom would lead most to say... hell yes!, but I want to know why? If speculators are correct, and in 1, 3, or 5 years fundamentals would have naturally pushed oil prices as high as they are today, then what is the difference? In fact, I have heard convincing arguments that we need high oil prices now; because despite the price, there is still sufficient supply on the market. As I've talked about extensively at my other blog, there is fairly overwhelming evidence that Americans, for the first time in decades, are seriously considering alternatives to what they used to consider god-given forms of energy; developing the alternatives before the real crisis comes is an extremely good way to hedge the damage. Consider two hypothetical scenarios:
Scenario 1: oil prices skyrocket, but supply and demand fundamentals remain relatively unchanged. Americans become frustrated and start seeking alternatives; some start taking the bus, others purchase a bike; a few rent an apartment near their job; most try to trade in the SUV for a sedan. Government sees an obvious problem, new buses get purchased, light rail and rapid transit systems are developed, green industries spring up - blue collar workers find jobs building wind turbines and transit infrastructure. For those who are unable to move or trade in their vehicle right away, there is sufficient fuel available at the local Chevron station, albeit for a premium.
Scenario 2: oil prices skyrocket, supply becomes pinched. Lines start to form at the local Chevron station, panic buying begins, driving prices up even further; small scale violence occurs as Americans try to hoard all available fuel supplies. Public transportation infrastructure collapses under the strain people are putting on it, as government never bothered to buy more buses or upgrade rail infrastructure. SUVs literally become worthless as their trade-in value drops closer to zero; those with triple digit round trip commutes quit their jobs in order to avoid negative personal cash flow - unemployment jumps.
Scenario 1 depicts a world in which speculators are free to dictate the price of oil on the open market. Scenario 2 depicts a world in which speculators are all thrown in jail, - no longer allowed to participate in open markets and immediate supply/demand fundamentals are all that matter. Scenario 1, for the most part, is a depiction of the state of affairs today; scenario 2 is a hypothetical depiction of the state of affairs at some point in the future (exactly when is impossible to know).
Is labeling speculators as evil-doers a little harsh? Should we actually be praising them for providing us with fair warning to the coming fundamental changes in the oil market? Knowing what we know today, can we achieve a "soft landing" when it comes to oil markets and completely avert the "crash landing" that so many conspiracy theorists on the internet harp about? Steven Leeb, author of The Oil Factor and The Coming Economic Collapse, recently appeared on CNN and said his biggest fear was that oil would drop 30 or 40 dollars from its current levels, wiping out the forward progress we've made in the past few months. Leeb's books are well written and make some convincing arguments, perhaps unconditionally blaming speculators is over the top; perhaps we need to rethink preconceived notions of the world around us...
Posted by Rob Pitingolo 9:47 AM
