Tuesday, June 03, 2008

A Short, Speculative Post

Congress is blaming speculators for the barreling rise in the price of oil, as of this writing $126 per barrel.

In late 1998, oil dipped briefly below $10 per barrel. Where were the speculators then? Interestingly, at that time the U.S. dollar had been appreciating for about 4 years. It had appreciated roughly 25% by then from its bottom in 1995. The dollar is not the only factor*, but it is a significant one that explains the oil price. A good deal of today's gain in the price of oil, denominated in dollars, reflects the depreciation of the dollar.

Speculators are agents that transmit fact-based expectations about future supply and consumption trends into present prices. As such, they facilitate economizing between present and future supply/consumption. If the expectation is that future consumption will be high and supplies will be constrained -- or that nominal demand expressed in dollars will be high due to dollar depreciation -- then speculators will bid up the price of oil today. That is happening now.

The opposite happened in the late 1990s, at least with regard to the purchasing power of the dollar. Expectations were that its purchasing power would strengthen relative to the world's currencies. Therefore, speculators bid down the price of oil.

In regard to the general point of whether speculators can manipulate the market, they cannot alter the long-term or fundamental course of markets. Market prices incorporate such fundamental information. If a speculator positioned himself (incorrectly) against the long-term trend, he would be bankrupted very quickly. For example, if a speculator in the mid-1990s incorrectly bet that oil would go up, he would have lost his shirt.

Blaming the speculators is a lot like blaming the gas gauge for showing that your tank is empty, except that the "speculator gas gauge" is even smarter. It accounts not just for the amount of gas in your tank right now, but also for the nearness of a gas station down the road. The "speculator gas gauge" will adjust to reflect the ease with which you can fill up your tank in the future, thus encouraging you to either consume more gas or less right now, depending on those facts.

The speculator's role is very valuable. If the government restricts it, it will make the markets work less efficiently. Ultimately, this will mean less oil availability because it will become more costly to finance oil production and refining. Capital will demand a higher premium to invest in the oil industry if financial liquidity and quality market information about future demand/supply are reduced because speculation has been diminished by law.



*The key fundamental factors keeping oil prices high in real terms (not just nominal terms, which is affected by the value of the U.S. dollar) are restrictions on Western drilling and the nationalization and cartelization of oil over the past 60 years. These two factors have diminished supply by taking it out of the hands of entrepreneurial oil companies and concentrating it in the hands of a smaller number of unproductive, state-run operations.

On the demand side, large new demand from China would act to keep prices high but in the absence of the supply constraints, prices would not have to rise as much as we are seeing, or could even fall. Consider that oil prices in the United States fell for decades during most of the late 19th and 20th centuries even while U.S. economic growth and oil consumption during much of that time grew at a rate comparable to China's growth rate today.

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