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Want Cheaper Oil? Support Speculation, Don’t Curtail It

Trashing speculators is all the rage, but let's separate the myths from the facts.

by
Jeffrey Carter

Bio

July 24, 2008 - 6:35 am
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Myth: Speculators don’t take “delivery” of a commodity so they only want the price to go higher.

Fact: There are concerns about speculators that don’t take “delivery” of oil. Since commodities have been traded, few speculators ever take delivery. A small majority of contracts are delivered, but all participants want the threat of delivery so the futures price replicates the underlying commodity. The futures market is an efficient way to discover what the actual price should be. A centralized marketplace lowers transaction costs. Speculators are not taking delivery and hoarding oil to keep it off the market and artificially increase the price.

Myth: Speculators are making prices in oil higher for consumers.

Fact: High prices in the oil market have nothing to do with speculation. Demand for oil is “inelastic.” People will pay about any price for oil relative to other commodities. Increased worldwide demand is the cause of price increases. The United States cannot control this demand. Refusal to drill for more oil has constrained supply growth. America has not developed nuclear, wind, solar, or any other types of energy. Because demand has grown with restricted supply, prices have nowhere to go but up.

Conservation is nice, but only higher prices will influence conservation and demand. If we agree conservation is “good,” we can use “positive economics” to encourage it. Increasing taxes on consumption will effect change. Regulations like CAFE standards mean little. We can talk about conservation all we want, but until prices go up, we won’t use less. Lack of refining operations has created a bottleneck on supply. This unintentionally increases the price of energy. Without the ability to turn new supplies into a useful product, we still will have a problem. Lack of refinery capacity causes “whip” in the supply chain for oil. Whip in production increases costs and increases prices. America hasn’t let the oil companies get control of supply chains because it has limited the amount of energy they could get, as well as their capacity to turn it into useful products. We need to end this limitation.

The biggest myth of all is that if the government limits speculation, prices will go back to “normal.” That is far from the truth. It will still occur, but in unregulated places, like unregulated over-the-counter as well as foreign markets where we have little control or oversight. Oil prices will still be set by supply and demand. Businesses and consumers will pay an even higher price, because speculators and liquidity were driven out of the market by federal fiat. Oil prices have dropped in the last few days due to developments in the marketplace, not because of federal action. The solution does not lie with shooting the messengers of price discovery — the speculators.

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Jeffrey Carter is a former member of the Board of Directors of the Chicago Mercantile Exchange, and has been a “speculator” — independent trader — since 1988. He holds an MBA from the University of Chicago and blogs at www.pointsandfigures.com.
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