The CFTC’s Flip Flop on Oil Speculation

The CFTC’s Flip Flop on Oil Speculation
IER, July 28, 2009

People, personalities, policies, drapes – just a few of the things the American people have come to expect will change from year to year, and from administration to administration, depending on the philosophy, interest and artistic sensibility of the chief executive.

Here’s what’s not suppose to change: the facts of existence, and the substance of the truth. Unfortunately, in the case of President Obama’s Commodity Futures Trading Commission (CFTC), every bit of analysis the agency did previous to the current regime can be tossed out the window – not because it was wrong then, but because it’s politically inconvenient now.

Observe the latest news from the CFTC this week. On Tuesday, the Commission announced that it will release a report in mid-August blaming the 2008 swings in oil prices on speculators (spoiler alert!) The announcement raises eyebrows because in 2008, the CFTC itself decisively concluded that fundamental supply and demand, not speculation, drove oil up to record highs in the summer of 2008. Bummer if you happen to make a political living off of scaring your constituents with shadows and straw men.

Could it be that the CFTC’s flip flop has something to do with the Obama Administration’s desire to further regulate the financial markets? By placing arbitrary limits on which institutions are allowed to spend their money on certain financial products, the government will make oil prices more volatile, and it will steer even more profits into the huge, politically connected firms on Wall Street. Meanwhile, the American people are still waiting for the government to remove the roadblocks to the offshore energy they were promised last year when two separate bans were finally and formally put out to pasture.

The Social Function of Oil Speculation

The essential insight of Adam Smith was that a market economy harnesses the self-indulgence of individuals and motivates them to serve the common welfare. In a free market, one becomes affluent by creating better and cheaper products or services that consumers are willing to buy.

In the case of speculation, this process actually reduces the volatility of price swings. We have all heard the successful speculator’s motto of “buy low, sell high.” To be more specific, the phrase should really be “short-sell high, cover low.” What this means it that if some investors believe that oil prices will rise sharply in a month, they can profit from this hunch by buying oil futures contracts. If and when the price of oil does rise as they had anticipated, their futures contracts will be adjusted, booking a profit to their trading accounts. (On the flip side, if some investors think oil prices will fall, they can sell—“go short”—oil futures contracts.)

It’s true, as the critics point out, that an investor who purchases oil futures contracts will indirectly pull up the current price of oil. This happens because producers have an incentive to reduce current sales when the futures price gets pushed up. They are effectively diverting some of their scarce supplies of oil to the future, rather than selling it all in the present.

But even if futures purchases push up current oil prices, the speculators perform a service to everybody else so long as they correctly anticipated a price spike. If oil is currently selling at $50, and an investor believes it will jump up to $70 in one month, then the investor will buy futures contracts until the “futures price” gets pushed up to reflect his forecast. In the process, his actions may have pushed the current, spot price up to $55. But that’s a good thing, because now the price will approach $70 more gradually; it won’t shock the market as much when oil hits $70.

Of course, if speculators are wrong, then they do make market prices more volatile. If a price is actually going to fall in the future, and speculators foolishly buy futures contracts because they mistakenly expect a price hike, then yes that does distort markets. But the government doesn’t need to crack down on this antisocial behavior, because the market has a built-in penalty: speculators who guess wrong lose money. And in fact, many investors lost a bundle of money when oil prices collapsed in the fall of 2008. And you didn’t hear the politicians praising speculators for the run down in the price of oil either.

The other thing producers do, and perhaps the most important thing for consumers, is that they are encouraged by the higher price to invest in finding more oil, because they will get a higher price for the oil. They buy equipment, hire people and buy services. They explore for new supplies and add new capacity. By combining their risked capital, additional human resources and intelligence, they bring new oil to the markets. New oil supplies help producers meet the increased demand and prices fall. This is supply and demand working to meet the wants and needs of consumers and there is nothing sinister about it.

Even Paul Krugman Agreed that Speculators Didn’t Cause the 2008 Spike

So we see that even when speculators move prices, so long as their forecasts are correct, they are actually helping to stabilize prices. Ironically, the point is moot regarding the 2008 price swings, because many analysts from across the political spectrum did not believe that speculation drove those movements. Instead, the underlying supply and demand conditions were the best explanation for why oil rose so high by the summer of 2008, and then collapsed in the fall.

The “smoking gun” in this conclusion was the fact that oil inventories were not rising during oil’s large ascent. Independent analyses by IER and the CFTC pointed to this fact, and Paul Krugman has recently reminded his readers that he too does not believe oil speculators were responsible for the 2008 movements.

All three analyses noted that the only way for speculators to drive up prices, is by giving an incentive for people to take oil off the current market and stockpile it for future sale. Since there was no obvious accumulation of oil inventories during the first half of 2008, oil speculation couldn’t have been the driving force. The reason the spot price of oil rose so much through the summer, was that worldwide supply still lagged behind demand for much of the year.Putting

New Curbs on Financial Markets Will Hurt Consumers

Of course, the real reason behind the CFTC’s change of heart is that it needs to justify its desire to expand its regulatory purview and slap on even more regulations of the financial markets. Specifically, the CFTC wants the power to limit “speculative” purchases of oil futures and other derivatives. The idea is that “physical hedgers”—such as airlines and oil producers—can trade in futures contracts as much as they want, because in theory they are just shielding their businesses from sensitive oil price moves. In contrast, the CFTC wants to crack down on those who buy futures contracts out of purely speculative motives.

This is a false dichotomy, and certainly we can’t trust bureaucrats to know the difference in practice. Airline companies can hold an opinion on oil prices too, and “bet” accordingly—that’s why some airlines invest more heavily than others in futures contracts. So even institutions that are directly related to the oil business can dabble in speculative transactions that will affect oil prices based on their forecasts.

On the other hand, investors who are completely isolated from the oil market might buy oil futures as a “hedge.” For example, during 2008 many portfolio managers gained more and more exposure to oil, meaning they “went long” on oil futures contracts. But they weren’t doing this in order to bet on higher prices. Rather, they could see that as oil kept rising, it was hurting the share prices on many major companies. So in order to protect their clients, the portfolio managers diversified their holdings, by selling off some of their stock and bond holdings in order to buy commodity futures. New government regulations could hinder this very useful tool to shield average investors from large price swings.

Finally, we need to realize that CFTC regulations will not stop large speculators from changing the world price of oil. Politically connected investment firms will easily be able to qualify as an “approved” purchaser of oil futures. And if nothing else, rich investors who want to bet on the price of oil can always take their business to foreign exchanges. Does anybody really think George Soros won’t be able to find someone else in the whole wide world willing to take the opposite position of an oil trade he wants to make?

Of course, we will have to suspend final judgment until we see the CFTC’s new report. It’s possible that every single analyst at the CFTC missed something last year when they concluded that speculation wasn’t driving oil prices. But one can’t help but note the timing of the CFTC’s about face – just as the Obama Administration is pushing for more regulation of energy markets.