I long ago ceased being surprised by the sheer number of people – particularly politicians whose grasp of basic economics rarely gets beyond the ads for X-ray specs and sea monkeys in the back of their Archie comics - who opine with absolute certainty that current conditions could not possibly be “normal” and that prices/wages/supply/demand are either being manipulated by sinister (translated: non-governmental) forces or must be “market failure”.  That so-called “market failure” is inevitably an example of governmental failure is a topic for another day.  For now, let’s deal with the wrongheaded notion that we don’t need to address oil supply issues because the price is only being inflated by those dastardly “speculators”.

Contrary to popular belief, speculators provide a very real and valuable service to the economy.  First of all, by creating a market for futures contracts, the speculator takes on the price risk of the supplier ensuring that the end price warrants the initial investment.  In agricultural products in particular, this transfer of risk ensures that supplies will be higher because farmers need not worry about a potential price collapse that might dissuade them from planting.  Second, the speculator – at the risk of his own resources – removes product from supply during one period in anticipation of greater demand in some later period.  If he has speculated correctly, he will make a profit.  The short term impact is that the reduced supply raises short term prices, but eventually, the speculator must return the product to aggregate supply, reducing prices to a level below what they would otherwise be at that later date.  Thus, the speculator stabilizes overall supply and significantly reduces price volatility.  That oil prices still appear to be quite volatile is not an indication that speculators do not perform this function but, rather, is an indication of just how little impact speculators have on oil prices.

How can this be?  After all, back in May, Michael Masters of Masters Capital Management, LLC gave spectacular testimony before the Senate Committee on Homeland Security and Governmental Affairs demanding that the practice of “index speculation” be banned because of the massive impact on the price of oil that results.  Alas, the only thing truly spectacular about this testimony is the magnitude of the errors in the supposed analysis.

Note that, in the scenario mentioned above, the average price of the commodity over time remains completely unchanged.  All other things being equal, the impact of speculation is that the price of the commodity rises earlier by a given amount and is reduced at a later time by a like amount.  The ultimate price of the commodity is still determined in its entirety by supply and demand.  How is that different in the oil futures market?  It isn’t.  In fact, it is even less likely that speculators in the oil futures market can materially impact price than in any number of other commodity markets.

Say you choose to invest in gold.  This is a common practice and many people own shares in “inflation hedge” instruments.  As an individual investor, you can actually remove from circulation an amount of gold and place it in a vault somewhere.  So long as that gold is locked away, the available supply is reduced by a like amount.  At the same time, the investor gains no return on that investment until such time as he returns it to the marketplace.  There is still ultimately no impact on the long term average price (again, all other things being equal), but the time horizon is such that it may be several years before the return to circulation of that commodity impacts the market price.

With oil, such a scenario is essentially unheard of.  None of the speculators in the marketplace are actually taking ownership of Texas tea no matter how sweet the crude might be.  The only players in the marketplace actually removing significant quantities of product from the market are government entities.  The US government has socked away 705 million barrels of in the Strategic Petroleum Reserve.  Japan has the second largest reserve with a capacity of nearly 580 million barrels.  All that is being traded in the futures markets is the ownership of a commodity to be delivered on a specific date.  Thus, when the illustrious Mr. Masters uses the wheat futures market as an example of speculators run amok and tells us, “the current Wheat futures stockpile of Index Speculators is enough to supply every American citizen with all the bread, pasta and baked goods they can eat for the next two years!” he is neglecting the obvious fact that no actual wheat is owned by such speculators at all.  For that matter, just how likely is it that speculators would remove wheat from the marketplace, presumably until it spoils, guaranteeing a loss of their investment?  The whole premise is absurd.

Oil futures contracts can go out years but the reality is that the trading of such contracts is overwhelmingly concentrated in the short term.  More than 90% of trading today (July 14) in oil futures contracts is concentrated in those due for redemption within the current year.  Further, when Mr. Masters breathlessly announces that index speculators “roll their positions by buying calendar spreads. They never sell (emphasis in original)”, he is misstating the fact that such rollover activities exchange one short-term contract for another and represents a sale in and of itself.  Still no change in the supply or consumption of oil takes place.

Finally, to get a handle on just how much of an impact speculators have on the oil market as a whole, consider:

Much has been made of the increase in the futures market.  To stick with the figures used in congressional testimony, the amount of unrefined oil traded on the futures market jumped from 147 million barrels (1/1/03) to 830 million barrels (3/12/08), a 465% increase.  But to assess the magnitude of such an investment, one must compare it not to the supply of oil from a single supply source over some short delivery period, but to the global marketplace over the total long term period of production.  Current world oil production exceeds 86 million barrels per day so the amount traded in the futures markets amounts to a no more than 2.6% of annual production, but, again, that’s just the production within a single year.  If you consider that nearly 277 billion barrels of oil were produced worldwide over the decade ending in 2005, the impact of speculation on long term oil prices can be put into real perspective.  So much for the theory that $40-$70/bbl of the current price is due to speculation.