Obama Admin Ready to Put Limits on Oil Speculation

A glimpse inside the minds of speculators. (image: seekingalpha.com)

The Obama administration has taken steps to limit oil speculation as part of its overhaul of the financial system in the wake of 2008’s financial meltdown, the McClatchy Company reported yesterday. While some of the administration’s plans will require legislation, and so are a work in progress, other steps can be taken immediately by executive action, including limiting the number of oil future contracts that big financial institutions can buy.  Other regulations may standardize how derivatives, including derivatives based on commodity contracts, are traded and inject more transparency into derivative trading.

The reason for the administration’s actions? There is a wide-spread belief that speculation, or betting on the future price of oil, was a major contributor to 2008’s record-breaking oil prices. If that is the case, then reining in speculation could rein in the wilder price swings and level-off some of the pricing peaks.

Not everyone believes that speculators are a major driver for oil pricing. For example, Nobel Prize-winning economist Paul Krugman believes that soaring Chinese and developing world demand is the main culprit  behind pricing spikes in several commodities, including both oil and iron ore. However, the evidence for speculation as a force behind price increases is compelling, and includes:
•    In 2008, the volume of crude oil contracts exchanged was 8 times the amount of oil produced worldwide; that level of activity means fast turnover of contracts and frequent buying and selling, common signs of a speculative bubble in any market, whether it’s oil, homes, or tulips.

In the worlds’ first recorded speculative bubble, Dutch speculators in the early 1600s bid up the price of a single tulip bulb to 10 times a skilled worker’s annual wages. (image: alumni.cornell.edu)

•    Recently, the price of crude oil has been rising sharply despite U.S. demand being at its lowest in a decade and the world being awash in oil as supply outstrips demand—a very powerful indicator that the interaction of supply and demand is not the main driver of crude prices.

In fact, many analysts believe that big Wall Street firms—which would include those bailed out by tax dollars—are fueling the price run-up by placing big bets on crude pricing. And not just on crude oil—Wall Street is betting that the price of other petroleum products, including home heating oil, will increase in price, too.  However, the way markets work, a widespread belief that prices will rise becomes a self-fulfilling prophecy: if enough people think prices will go up and are willing to pay more to get a piece of that action, that will itself drive up prices. That was one of the things which caused the housing bubble—since many people and institutions thought housing prices would keep rising forever, they were willing to pay more and more to buy real estate. Similarly, the very fact of big investors betting heavily on oil price increases will, in a free market, cause those price increases.

What might be the effect of the Administration’s actions? The president of the Petroleum Marketers Association, Dan Gilligan, reported to 60 Minutes earlier this year that approximately 60 – 70 percent of oil contracts in the futures markets are held by speculators—not by oil suppliers or users, but by investors betting on the future price of oil. If Gilligan is right and two-thirds of the futures market is made up of speculators, then curbs on speculation (including on the volume or number of contracts the big Wall Street firms can hold) will decrease speculation-led swings in pricing. Moreover, the overall effect should be to lower average pricing. After all, if much of the demand is from speculators, then reducing how much they buy will reduce demand, and reducing demand (when supply remains relatively constant) reduces price.

Since crude oil is turned into home heating oil and gasoline—two things you probably need if you’re reading this post—reducing speculative demand has the potential to save you money, even if you never have, and never will, buy a futures contract yourself.