The New Cold War
America, China, and the Echoes of History
With high gasoline prices across the United States, the long knives are out for speculators in the oil market. Elected officials worry that pain at the pump might cause them pain at the ballot box this fall. Last month, dozens of House and Senate Democrats sent a letter to the Commodity Futures Trading Commission (CFTC) criticizing federal regulators for failing to police energy markets sufficiently, implying that Wall Street is culpable for the rising cost of gas. At the same time, President Barack Obama asked Attorney General Eric Holder to “pay attention to potential speculation in the oil markets” and reconstitute a task force to investigate whether Wall Street is artificially driving up oil prices. These moves mirror the popular view that reckless gambling in financial markets is catapulting retail gasoline prices far beyond what supply and demand warrant. A CNN poll found that 59 percent of Americans believe that “speculators and other investors who buy and sell oil in the financial markets” deserved “a great deal” of the blame for the rise in gasoline prices that occurred last spring.
What critics derisively refer to as “oil market speculation” is all too often a nebulous, epithetical catchall meant to bring to mind clandestine profiteering by financial tycoons at the expense of the rest of the nation. But casting the blame for high gas prices on speculators is sloganizing populism, not serious oil policy. Wall Street is a morally and politically convenient scapegoat for the country’s energy woes -- and it is the wrong one. Speculation in the oil market, when properly regulated, helps energy prices respond efficiently to shifts in supply and demand, benefitting those that produce and consume energy, as well the economy at large.
In the popular media, the term “speculation” tends to refer to several types of activity that occur in the oil market. The first is the buying and selling of futures contracts, which are financial securities that give their holders the right to buy or sell a certain quantity of oil at a later date. Airlines, oil producers, and refineries all use financial markets to hedge against wild price fluctuations. This is sensible: by securing the right to receive or offload oil in the future at a fixed price, these companies are able to protect their own balance sheets. But the needs of companies that consume oil and those that produce it often do not match up. Financial firms that trade in futures markets help bridge the gap between these companies, assuming risk that they are desperate to shed. Were speculators to stop trading, companies on Main Street, not Wall Street, would suffer the most.
A second common form of oil speculation is precautionary buying by companies that rely on access to oil and fear a future supply disruption. This type of speculation, which can cause gas prices to rise, acts as a form of insurance, both for the imperiled companies and for the economy more generally. It lowers the risk of an extreme spike in prices later on -- or worse still, a dire shortage of gasoline -- by tempering demand and calling forth more supplies. Facing uncertainty, companies are wise to rush to secure oil that they can use in the future. If businesses did not pad their inventories, a disruption could mean catastrophe for them and their customers. Moreover, the relatively gradual rise in prices that cautionary buying prompts is far easier on the economy than the alternative: prices flying through the roof in an oil market caught completely flatfooted by an unforeseen interruption to trade.
Another kind of speculation, which many critics find more objectionable, is the swapping of futures contracts and other complex derivatives between firms that will never actually use the oil, such as hedge funds and other large financial institutions. This kind of trading has grown enormously over the last decade. Assets held in one type of investment vehicle, commodity indexes, have swelled from just $13 billion in 2004 to more than $200 billion today. But despite hand-wringing by policymakers over this infusion of money and extensive scrutiny by scholars and government regulators, there is no definitive evidence that these speculative funds have caused retail fuel prices to diverge for extended periods of time from what supply and demand alone would warrant.
Speculative betting in futures markets can theoretically affect the flow of oil, but the market imposes its own form of discipline rather well. If traders think that Iran might shut down shipping in the Strait of Hormuz this summer, for example, they might accordingly place their bets on oil prices rising in August, thus pushing up the price of oil that month. In theory, the market’s expectations could lead oil companies to dial back production, store oil instead of releasing it onto the market, or order their tankers to dither en route to delivery while awaiting higher prices. Yet if an oil company were to decide, on speculative grounds, to hold back some oil in case of a future disruption and it turned out to be right, it could well turn out to be a good thing for consumers. The decision to wait would end up helping to relieve the shortage when it struck, which would lower prices in the time of need. On the other hand, if the company’s prediction were proved wrong and prices did not rise as anticipated, or even fell, the company would be forced to unload its oil for less than it otherwise would have, also lowering prices in the process. Because the company might well lose money from its incorrect prediction, the market discourages it from taking such a risk. None of these considerations apply if, as some politicians suggest, oil companies or traders are manipulating the market by hoarding oil or colluding in an attempt to profit from higher prices later. But given the vastness of the world oil market, such a conspiracy would be exceedingly difficult to pull off, and there is no evidence that anything like it is occurring.
To see why speculative trading does not mean painfully higher prices, consider the market for natural gas. Over the last few months, financial firms have been even more active in this market than they have in the oil market. More or less purely speculative investors held 60 percent of natural gas futures traded on the New York Mercantile Exchange (NYMEX) in February, compared with only 47 percent of the futures for West Texas Intermediate, a crude oil used as a benchmark in pricing. But none of this has led natural gas prices to shoot higher. In fact, prices in that market plunged to a ten-year low last week on the NYMEX. Thanks to new drilling techniques such as hydraulic fracturing, the United States is swimming in natural gas, and a glutted market has sent prices plummeting. Speculative traders who recognized that the market was imbalanced have enabled, not prevented, this drop in prices.
By the same token, extraordinarily high gasoline prices across the United States reflect a global oil market facing serious strain and historic uncertainty. Sanctions on Iran are biting into the country’s oil exports, while talk of military action has reached a fever pitch. Unrest from the Arab Spring continues to simmer. Unscheduled outages in production around the world, from South Sudan to Syria to the North Sea, are starving the market of crude oil. The buffer between how much oil the world is currently producing and how much it is capable of producing has worn painfully thin. Meanwhile, an insipient economic recovery in the United States and elsewhere has caused worldwide demand to perk up. To make matters worse, oil inventories in the major Western countries are below their five-year average for the seventh consecutive month. Not surprisingly, owing to the perilous conditions in the market, the International Energy Agency warned several weeks ago of a “bumpy ride” ahead for oil prices.
In light of such a complex environment, it should come as no surprise that oil prices have been wildly volatile as market participants struggle to anticipate what is around the bend. Discerning the future path of supply and demand is hardly straightforward when the market is calm, let alone when economic and geopolitical uncertainty are magnifying the risk of otherwise unlikely events. The opaqueness of the world oil market, which is plagued by partial and contradictory data, only compounds the perils of prophecy. But there is no reason to believe that prices would better reflect fair value, or that the economy and consumers would be better served, if speculation in the oil market were severely curtailed. Indeed, the opposite is the case.
Of course, there is the potential for abuse, as there is in any market. The market-based system for pricing oil that exists today, which came into being in the late 1980s, is not immune to irrational exuberance or isolated instances of illegal activity. The United States must continue to regulate its commodities markets. The CFTC is wise to slowly and methodically consider how it implements the Dodd-Frank Act, which was designed in part to increase transparency and improve pricing in the commodities derivatives market, and to study what impact this new legislation will have on oil.
But critics of speculation should be careful what they wish for. As a means of determining the fair value for a barrel of oil, today’s market is far superior to the other pricing systems that have existed since World War II. In the 1950s and 1960s, executives at the world’s largest integrated oil companies enjoyed the prerogative of setting benchmark oil prices, unconstrained by rowdy open-market trading. Political power brokers in OPEC assumed the privilege of administering prices in the early 1970s, which they held until around 1988, when market trading became the main method for pricing oil. Wall Street speculators had nowhere near the presence in the oil market during those two earlier eras that they do today, and yet few would choose to return to those defunct arrangements.
Ever since the days of Rockefeller, it has been a venerable American tradition for high gas prices to cause restlessness among American voters and finger-pointing among Washington politicians. These tensions are only amplified by the partisan rhetoric of an election year. Obama is right to rebut unjustified claims that he is responsible for the vicissitudes of U.S. gasoline prices. But speculators are no more deserving a target.