Congress continues to wrangle on measures to curb the alleged influence of speculators on oil prices. Republicans want to insert provisions on offshore and ANWR drilling, while Democrats prefer to focus on enlarging the regulatory powers of the Commodity Futures Trading Commission (CFTC).
However the political maneuvering turns out, cracking down on investors will only harm consumers. There is no hard evidence that speculation is responsible for high oil prices and the proposed legislation would hamstring the beneficial role that futures markets play in our economy.
The theory behind the various bills is simple: Institutional investors such as mutual funds have been betting on rising prices by buying futures contracts in oil, but their very behavior itself pushes up prices. Some analysts have suggested that without this speculative demand, oil prices would fall to $70 per barrel. The evidence doesn’t support this theory.
If the price of oil were really supposed to be $70, but speculators were holding it up around $140, then there would be a massive surplus of oil hitting the market. Producers would be selling more barrels and end users would be purchasing fewer barrels, leading to an ever-growing glut of unsold oil as the months rolled by. Oil inventory data, however, shows nothing unusual in the past two years.
Goldman Sachs and other investment banks aren’t hoarding oil. Rather, these institutional investors unload their futures contracts before they mature and reinvest the money in a different batch of futures contracts with a later delivery date. These alleged price manipulators never take physical delivery of a barrel of oil.
So if speculators aren’t driving up oil prices, what is?
The simple answer is supply and demand. World oil output has been stagnant since 2005, while demand among developing countries, especially China, is booming. When demand outstrips supply growth, prices rise to ration the available product.
An added twist to the story is the weakening U.S. dollar, whose fall against the Euro accounts for about 15 percent of the rise in dollar-denominated oil prices over the past year.
The United States government’s own July interagency task force report should have put the nail in the coffin of the “greedy speculator” theory. Its analysts found no statistical evidence that changes in the positions of hedge funds and other nontraditional participants preceded changes in the price of oil. If anything, the causality ran the other way, with large investors periodically adjusting their holdings after oil prices changed.
Futures markets provide a valuable service by allowing oil producers and consumers to hedge away their risks from volatile prices. For example, an oil producer can confidently invest in a new field, and an airline can confidently add a new route, if they can lock in an agreeable price for future purchases of oil. Oil futures contracts act as an insurance policy for those who are very sensitive to oil prices, and foster greater output and lower prices for consumers.
Institutional investors aid this process by providing liquidity to the futures markets. It is ironic that the government has raced to bail out Fannie Mae and Freddie Mac, huge institutions that provide liquidity to the mortgage market. Deep and liquid markets are just as important for oil futures.
Institutional investors also allow average Americans to hedge against further rises in oil prices. Managers of pension funds aren’t really betting that oil will keep rising. Rather, they are shielding their clients’ investments in traditional stocks and bonds, which get battered as energy prices continue to soar.
The government has options to lower oil prices, such as opening up ANWR and offshore areas to development. Increased regulation of oil futures markets will not reduce oil prices, because investors are not responsible for the increase. The proposed crackdown might actually increase prices, because it would reduce the liquidity in the futures markets, causing oil producers to operate more cautiously.
The new regulations will also make it harder for average Americans to protect their assets from further commodity price increases, while the true wheeler dealers can always place their oil bets on foreign exchanges.
Robert Murphy is a senior fellow in business and economic studies at the Pacific Research Institute