What's speculation got to do with it?
Toolbox
Published: June 8, 2008
High oil prices have people all over the world up in arms. British, French and U.S. truckers have staged "moving roadblocks." French fishermen have blockaded ports. Vermont's congressional delegation has oil company executives and investment bankers in their legislative sights.
Are speculation, market manipulation and profiteering taking a growing chunk of our oil dollar? Or are high oil prices simply the result of a shrinking supply of oil on the world export market while demand grows? And how much does it matter?
Last week, the Senate Commerce Committee held hearings on the subject. They wanted to hear that oil is overpriced, and they chose witnesses who would tell them that.
The witnesses disagreed among themselves about how much oil is overpriced. Michael Greenberger, former director of Trading & Markets at the Commodities Futures Trading Commission, said speculation was at least 25 percent of the price. Mark N. Cooper, director of research at the Consumer Federation of America, went further. He cited testimony of oil company executives to conclude that oil should be selling for $40 a barrel instead of today's $120 plus, and "two-thirds of the price is baloney."
George Soros, who earned $3 billion last year trading commodities (but not oil, he reported), didn't give a number for the cost of speculation. He did call it "froth" that was apparent only in the last few months, and he cited it last in his list of four main factors affecting the price of oil. The first three were:
u Depleting oil fields and the increasing cost and difficulty of discovering and developing new reserves.
u A backward-sloping supply curve. That is, as the price of oil climbs, producers have an incentive to keep the oil in the ground, where it appreciates in value, rather than sell it for a currency that depreciates in value.
u Fuel subsidies in China, India, many oil-exporting countries, and others, which mean that rising world oil prices don't affect consumer behavior.
Soros grew visibly impatient with Cooper's repeated claim that the "real" price of oil is $40, and at one point he called the presentation "misleading." According to Soros, there is "a speculative froth in the price of oil that has developed in the last few months. But underlying it," he warned, "there is this problem that the cost of replacing existing oil supply is rising, and the oil fields' depletion is accelerating. And there's the rising standard of living in developed world, which means that if we now head into a recession, the price of oil would come down. But once we come out of recession, it would go up again. There's a need to develop alternative sources of energy. We do have also global warming, which is a very serious problem. So while we are focusing on these speculative excesses, we should not lose sight of these underlying problems."
Matt Cota, executive director of the Vermont Fuel Dealers Association, was pleased to see the question of speculation so prominently discussed on Capitol Hill. Greenberger came to the Vermont fuel dealers three years ago, Cota said, and told them that they were getting ripped off by speculators. According to Cota, the volatility in today's market is a major problem for fuel dealers. He cited a 23-cent-per-gallon jump in heating fuel price in a single day last month. For a fuel dealer buying a minimum contract of 42,000 gallons of fuel, it's unnerving to potentially have costs jump $10,000 just from waiting until after lunch to place the order.
At the Senate hearing, Greenberger blamed former Sen. Phil Gramm, R-Texas, for stripping controls on speculators that had existed since 1922 in a "middle-of-the-night" amendment to an appropriations bill being passed as Congress was leaving for its Christmas recess in 2000. As a result, 30 percent of the trades of West Texas Intermediate oil, a key benchmark for world oil prices, are made on exchanges with no oversight by U.S. regulators.
Greenberger is calling on Congress to re-introduce U.S. controls over speculation on U.S. commodities, and both Sen. Bernie Sanders and Rep. Peter Welch are working to do that.
Not everyone who has closely studied the markets is convinced that speculation adds anything to the price of oil. Paul Krugman, the award-winning Princeton economist and New York Times columnist, points out that "there are only two things you can do with the world's oil production: consume it, or store it." Oil is messy and expensive to store, so it's generally bought by folks who burn it or make things out of it. If the price of oil goes up much above the price that matches demand from "burners and makers," then the rest of the oil has to go into storage somewhere.
[Anne—if you use the Krugman figure or my re-draw of it, insert "see figure" language here.]
If oil is priced at a 40 percent speculative premium, Krugman calculates, 2 million barrels a day are being hidden somewhere that doesn't show up in official inventory figures. He challenges those who believe in speculation to show him the oil. (How much is 2 million barrels a day? In a year, it would exceed the entire U.S. Strategic Petroleum Reserve.)
Others argue that the West Texas Intermediate oil, whose trading was the object of the Senate committee's attention, has actually become less expensive relative to other oil. Ron Patterson, a frequent contributor to the data-heavy Web site TheOilDrum.com, compared the price of other crude oil relative to WTI, three years ago and now. In the last three years, the price of WTI is lower compared to every other crude oil traded. It's hard to see how congressional regulation of the WTI trade will lower oil prices in that case.
Has unregulated trade of WTI increased oil prices, had no effect, or dampened them? For help in sorting this out, I turned to someone who has understands these markets, has no particular axe to grind, and – an important qualification – who I used to walk to kindergarten with. Urban Larson now manages an emerging markets fund for F&C Management in London. He pointed out that oil demand has outstripped supply since the beginning of 2006. These are strong fundamental reasons for run-ups in price, and Larson believes that most of the price of oil reflects supply and demand. He's very skeptical that any investor could sustain manipulative upward pressure on the supply of oil, since the market is too huge. (Over $10 billion worth of oil is consumed each day.)
Like Soros (who Larson called "much smarter than I am"), Larson thinks there is some speculative "froth" in the price rises of the last few months, since they have been so rapid without underlying changes in the supply and demand dynamics.
Larson doesn't hear peak oil being discussed much, he says, but I wonder whether what has changed in the last few months is an awareness of the limitations of world oil supplies. The Wall Street Journal has started running articles about it frequently enough that I now check the paper nearly every day. And the oil industry is well aware that two of the most mainstream, independent organizations that project oil availability are sharply downgrading their estimates of future supply.
Given Phil Gramm's history of serving banks while in Congress, I am prepared to believe that his "middle-of-the-night" deregulation package was a boon to his friends in the financial world and hurt everyone else. Gramm has most recently come under scrutiny for his work earlier this year, as John McCain's economic adviser, helping McCain craft legislation to protect investment banks holding bad mortgages — while lobbying for an investment bank that holds billions in bad mortgages (UBS). If Sanders and Welch successfully undo Gramm's deregulation, their legislation could well have multiple benefits.
Bringing down the price of oil is not necessarily one of them, though. Net world oil exports are declining, and their decline appears to be accelerating as the oil-producing countries start using more oil themselves. Some, like the United Kingdom and Indonesia, have recently switched from exporting oil to competing with other importing nations (like the United States) for the dwindling supply of oil exports. Matt Simmons, a prominent investment banker who has financed and studied the oil industry for decades, thinks oil is still far underpriced.
Our congressional delegation seems to like the headlines from targeting investment banks and oil companies. Powerful though they are, those are the easy targets. Michael Dworkin, director of Vermont Law School's Institute for Energy and the Environment, discusses the current energy economy in terms of the seven fat years (of good grain harvests) and the following seven lean years that Joseph planned for in Pharaoh's Egypt, according to the tale in Genesis. According to Dworkin, even with today's energy prices, "I think we're still in the fat years." It's time for Congress to start trying to understand and prepare for the lean years.
Carl Etnier, director of Peak Oil Awareness, blogs at vtcommons.org/blog and hosts radio shows on WGDR, 91.1 FM Plainfield and WDEV 96.1 FM/550 AM, Waterbury. He can be reached at EnergyMattersVermont(at)yahoo.com.
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