Curbs on oil speculators a diversion
By Andrea Corcoran and Tom Corcoran
The US Congress, back in session this week, is set to consider legislation that
holds "illegitimate speculators" to blame for pushing up the price of oil.
Congress has an unlikely ally - the Organization of Petroleum Exporting
Countries (OPEC)has given its blessing to the various bills, with its August
report placing about US$30 - or more - of the price of oil, now down to about
$100 from its highs earlier this year of close to $150, squarely on the heads
of "selfish speculators". On July 16, Venezuelan President Hugo Chavez
demonstrated his solidarity with the US legislative branch, saying
he was "waiting for the [oil speculation] bubble to explode ... "
The oil industry couldn't agree more.
The Petroleum Marketing Association of America and New York Heating Oil
Association have placed radio ads in various markets blaming "speculation" for
the high price of oil and urging the US consumer, to tell your congressman to
do something about it.
Jean-Claude Trichet, president of the European Central Bank, agrees as well. On
Friday, September 5, he said, it was a "reasonable conjecture" that financial
investors had distorted the commodity markets.
Many observers think the point already proved as the Commodities and Futures
Trading Commission (CFTC) recently revised upward the share of the futures
markets held by "non-commercials" - that is to say, "speculators" - to about
half.
Threats of a windfall tax and legislation removing all "speculation" from the
market also coincided with a huge drop in the price of oil. Have the stars
aligned? If so many competing interest groups say it is so, then it must be so.
Right?
We doubt it.
What the "anti-speculation" legislation seeks to do is limit the share of the
futures markets held by non-commercials. In the case of oil, a non-commercial
is an entity that does not have the facilities to deliver or receive
significant quantities of oil. Since non-commercials do not need to buy or sell
significant quantities of oil for their businesses to continue operating, the
thinking goes, they are "merely" speculating on changes in the price of oil and
not "legitimately" hedging against commercial risks.
Sounds reasonable enough, but it isn't.
All markets are based on the notion that speculation is good because it
encourages people to anticipate the future and invest in it. Futures markets
provide a means of financially hedging against price volatility in any given
commodity. Since the futures markets give a dollar value to the underlying
commodity, anyone who happens to have any money can use the markets to hedge
against risks the commodity presents to that money. Why would it be legitimate
to hedge against risks oil presents commercial operations, but not financial
holdings (such as a fall in the dollar or any currency, for that matter)?
That aside, were the "anti-speculation" legislation to pass, it would act to
reduce the number of participants in the market. But if you reduce the number
of participants in a market, it becomes easier to manipulate because a smaller
position represents a larger share of the whole.
Would that be in the public interest? It wouldn't, and not just because the
futures markets would become easier to manipulate but because by limiting the
number of participants you increase price volatility. And price volatility
hurts everyone's ability to budget for the future - including everyday
consumers and other persons the law seeks to exclude from the hedging
opportunities the futures markets afford.
We acknowledge it isn't a simple matter to decide how best to protect consumers
against oil market manipulation, because oil is not a particularly easy
industry to understand or explain. But by focusing on the futures markets, the
public's attention is being diverted from various issues affecting the
commercial market in oil. If you can't make sense of what's happening in the
underlying commodity, you aren't likely to make sense of what's happening in
the futures market for it.
And it is very difficult to make sense of the oil business because it is
especially opaque, fragmented, and distorted.
Opaque: Of the world's oil supply, over 70% is held by national oil
companies. These companies are quintessentially political; information about
their operations and assets are driven by government calculus. Thus oil data
are not just trade secrets, sometimes they are treated as state secrets. In
fact, anyone trading in the futures markets must speculate about the intentions
and reportage of governments, because governments are known dissemblers.
Fragmented: In the United States alone there are a variety of different
specifications for gasoline. In California, for example, environmental
standards for gasoline are much stricter than, say, in Texas. Thus, if there is
a surplus of gasoline in Texas it cannot simply be sold in California. The
specifications for gasoline and diesel are different all over the world. So a
surplus in one region cannot automatically be sent to another region in
deficit. As a consequence, oil products are in theory fungible but are not
really so, with the exception of jet fuel, which in fact enjoys a global
market.
Distorted: Various markets are affected by other factors, such as
subsidies or relative taxation. Indeed, over a third of world consumption of
transportation fuels is underpinned by subsidies. Thus gasoline made to
European or American specifications usually cannot be sold profitably in a
country which subsidizes the price.
These three factors obfuscate the market for oil. If these issues are not
resolved - and they must be resolved politically - there is little likelihood
that the oil markets will become more predictable going forward, whether or not
"speculators" have a role in them.
Ultimately, the run-up in oil futures prices is likely the result of a wide
array of factors. This includes, yes, speculators - long or short - looking for
better returns. But the notion that speculation is synonymous with manipulation
is bogus and diverts our attention from the real issues at stake. In fact,
commodities markets can only be cornered by commercial participants - those
players with the infrastructure to withhold from the markets significant
amounts of crude oil or of its products. Financial speculators might have
tremendous demand for paper barrels, but it is basically impossible to corner
paper barrels. There is no physical limit on the number of contracts that can
be drawn up.
By forbidding "non-commercial" traders from trading on the oil futures markets,
one in effect bans those without the means to corner the market in favor of
those who can! This is not an idle concern. Since June, open interest - the
total number of oil futures contracts - has fallen by half.
The anti-speculation legislation would substantially increase funding for the
CFTC, which would probably help address part of the data uncertainty that
perennially dogs the oil futures markets and provide adequate resources to
police them. However, if congress wants to materially reduce the potential for
price manipulation in the oil markets, or address consumer price pain, it would
do better to focus on the integrity and reliability of oil data, supply side
policies, international standardization, inflammatory geopolitics, tariffs and
subsidies - and fiscal responsibility generally - than on "banning
speculation".
Andrea Corcoran is a former director of the Office of International
Affairs and before that the Division of Trading and Markets (now the Divisions
of Market Oversight and Clearing and Intermediary Oversight) of the US
Commodities Futures Trading Commission. Tom Corcoran is a freelance
energy consultant.
(Copyright 2008 Andrea Corcoran and Tom Corcoran.)
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