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

Politicians on both sides of the aisle have issued irresponsible statements regarding speculation.

Speculation on regulated exchanges is a necessary part of the oil market and provides a valuable function with excellent oversight. Advocates of curtailing, or worse eliminating, speculation are unenlightened or do not understand how markets function. Let's separate the myths from the facts.

Myth: Speculators are bad for markets.

Fact: Many statistics have been thrown around about oil speculation. Airlines claim speculation is driving prices higher because speculators trade 66% of all the futures contracts. This is likely a correct statistic. Speculators do the bulk of trading volume because they buy and sell the market. Speculation is the grease, called liquidity, which makes the market engine function. High levels of liquidity mean the market is more competitive and gives participants a tighter bid/ask spread. This makes transaction costs cheaper, and it's much easier for consumers (airlines) or producers (oil companies) to hedge business risks. For every buyer (long), there is a seller (short). It is a zero-sum game. Speculators can lose money. Amaranth Trading lost billions in 2006 because they were wrong. The volatility of the market makes it a very risky way to make a living.

Myth: No one is watching speculators.

Fact: Sufficient checks and balances already exist for oil market participants. Speculators deposit margin money to trade and hold positions. Margins are based on volatility, dynamically set by exchanges, and overseen by the Commodity Futures Trading Commission, which is overseen by Congress. Exchanges use a sophisticated algorithm to establish margins. It calculates the volatility, position concentration, and liquidity in the market, and comes up with a margin dollar number. Traders that cannot meet margins have their positions liquidated by clearing firms. Regulated markets are transparent and "marked to market" every day. Mark to market means that every trading account is margined and debited or credited each and every day according to a settlement price set by the market. Higher margin requirements will decrease volume. Decreased volume means less liquidity and more volatility, which means higher oil prices for consumers. Margins should be set neither high nor low, but appropriate for how the market is trading. Higher margins will limit the ability for businesses to hedge their risk because it will tie up additional capital. If low margins are indeed the reason for high oil prices, then we could manipulate the market and set very high margins on buying of crude, and low ones for selling. The market will reflect the headline price airlines desire, but it won't be the true economic cost of the commodity. There is no need to politicize the process of margins with more government; regulated exchanges do a good job of setting appropriate margins today.

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.