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Why Cracking Down on Oil Speculators Will Hurt Consumers – Pacific Research Institute

Why Cracking Down on Oil Speculators Will Hurt Consumers

California drivers are relieved that oil prices have retreated from record highs in July but all Americans should be concerned that the government is still scrambling to “do something” about oil prices. Proposals to curb “excessive speculation” in commodity futures enjoy bipartisan support. Yet cracking down on oil speculators will only hurt average Americans.

In a market economy, speculators serve a valuable function. They anticipate future price movements and bring them about more smoothly. The successful speculator buys low and sells high (or short-sells high and covers low). These actions are inherently countercyclical, and actually keep prices less volatile than they otherwise would be.

Futures markets also perform a vital function. They take much of the risk out of long-term plans, and so encourage businesses to expand their operations. For example, suppose an airline is considering a new route but will only make money if oil prices stay below $130. On the other hand, suppose an oil producer is considering a new offshore rig but it will only be profitable if oil prices stay above $100. If they can lock in a price of $120 per barrel over the next few years, both businesses can confidently expand operations.

New regulations may seriously hamper the operation of these markets. There are already built-in penalties if speculators guess wrong about the direction of prices. The long speculators lose money if prices drop, while the short speculators lose money if prices rise. There is nothing guaranteed about making money in the futures markets. That’s why they call it speculation.

Currently, politicians are blaming speculators for driving down financial stocks and for driving up oil prices. The unspoken premise is that these people are really evil. We are left to wonder why speculators can’t at least have the decency to make their “sure thing” bets by pushing up stocks and down oil. The answer, of course, is that speculators can’t alter prices in the long run.

What usually happens is that the savviest investors spot trends in the fundamentals before others, and then get blamed for being the messengers bringing the bad news. Recently, the “news” has been that world oil supplies are still having a hard time keeping pace with demand growth, and that U.S. financial firms are still reeling from the mortgage mess and credit crunch. No matter what laws they pass in D.C. – even if they ban speculation altogether – these are the economic realities.

What is particularly ironic in the case of oil is that all of the evidence exonerates speculators. For example, if speculators were really holding up the price of oil to $70 above its “true” value – as some have testified before Congress – then there should be a huge glut of oil. That is, at the artificially high prices, producers should be delivering more barrels per day than end users want to purchase. If this were happening, we would see accumulating inventories of crude. Yet the data show the exact opposite, that crude inventories declined while oil prices rose sharply.

The evidence points to simple supply and demand as the cause of high oil prices. Symbolic crackdowns on futures markets will simply make oil prices more volatile. If the government regulates futures investments by mutual funds and other non-traditional buyers, regular Americans will find it harder to protect themselves from rising commodity prices. The government can best help citizens by dropping ill-conceived measures, getting out of the way, and letting markets do their job.

Robert P. Murphy is a Senior Fellow in Business and Economic Studies at the California-based Pacific Research Institute. Contact him at RMurphy@pacificresearch.org.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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