Oil Speculation

The price of almost everything on the planet has been rising. And so has the inevitable talk of a commodities bubble and price manipulation. The discussion has become front and center in global markets around the world as economies reel under the heavy weight of soaring prices.

It’s simple for a senator to blame high oil prices on speculators. But don’t hold your breath to hear a long discussion of the taxes on every gallon of gasoline and heating oil that the government collects each time we fill up our tanks. Perish the thought.

So who are these speculators, and why and how could the high prices of commodities be their fault? Of course, those are the real questions. But the conversation never really gets that far. The cameras are turned off before the detectives hit that crime scene.

Beyond the Sound Bites: Hoping for Real Answers

To say we are in a crisis is a massive understatement. It’s like saying there was a little fire on the Hindenburg. As oil prices surge and the ebb and flow of trading begins to catch up with the world’s growing population, we can expect to see these prices continue to climb — maybe exponentially.

Meanwhile, the fools in Washington, and those political candidates hoping to get into that asylum, continue to talk the same smack they have for years. Essentially, they’ll say whatever they need to in order to get elected. What else is new?

The problem this time, however, is that the situation is simply too dire. We should not waste time trying to find scapegoats. That won’t solve the problem. It will just distract attention while politicians hope for answers.

But let’s face it. The blame game works. The politicians have an easy target in speculators. After all, the average American imagines Gordon Gekko-type characters slashing and burning their way through Wall Street and making the everyday man’s life more expensive while they water-ski behind their yachts.

So for senators and other politicians, it’s not a tough putt to get the general public to latch on and want to lynch every speculator out there.

But Gordon Gekko was not a speculator. He was a manipulator. He used information he should not have had to do things he should not have done.

That does not matter to the politicians, however. They want to paint every speculator with a broad brush. To the politicians, every legitimate speculator is an unlawful manipulator.

The problem is this: If the politicians restrict legitimate speculation, they will cripple the free market and actually cause prices to surge even higher. Politicians have confused things pretty badly.

Speculation shapes the margins of the markets. Many markets cannot function correctly without some element of speculation at the margins. Few politicians seem to understand that. Or they do, but won’t acknowledge it. Either way, it’s a critical mistake to be focusing on witch-hunts, rather than real answers.

Liquidity, Liquidity, Liquidity

In real estate, it’s location, location, location. In trading, it’s liquidity, liquidity, liquidity.

In case a number of U.S. senators don’t know, one of the most important elements in a free market is a provision of liquidity. It is possible to discover an “active price” only when the market is free and open. This is the job that speculators perform. Without speculators, there cannot be free market capitalism.

Yet even in the face of clear evidence that speculators perform this vital service, all we hear about is how speculators are causing the run-up in energy prices. And then we hear how speculators need to be more “regulated.” It’s absurd and dangerous.

As Richard Rahn of the Cato Institute writes in a great article for The Washington Times, “Many members of Congress make up ‘solutions’ to things they do not understand and cause problems where there are none or make real problems worse, which explains the current run-up in gasoline prices.”


If You’re Not Part of the Solution, You’re Part of the Problem

You may be reading this and saying, “Of course you’re saying this. You’re a speculator!”

Very true, but I am also a consumer who has to buy gasoline and heating oil, just as you do. I also know the risks of assuming any position in these volatile markets. And that risk is calculated each time I trade. There are no guarantees. (How I wish there WERE some guarantees when I lay my cash on the line!)

The other very important factor here is to realize that speculators are not beholden to one side of the market. They are married to movement, not direction.

As far as my trading portfolio goes, I couldn’t care less if oil were moving higher or lower. As long as there is movement, we have trading opportunities.

The problem with blaming speculators is the damage done to the free market can be irreversible.

Richard Rahn goes on to say, “Speculators are not the problem; they are part of the solution, by reducing the risk for producers, refiners and other oil market participants. This risk reduction results in more production of oil, other fuel, food and metals where futures markets exist.”

Once again, he has hit the nail on the head. Reducing the number of speculators in the free market actually has the reverse impact. It drives prices much, much higher.

Can’t We All Just Get Along?

Let me just say that I am one of the biggest advocates of free, open, transparent markets. So are almost all speculators. The integrity of any market is only as good as its participants. And in some cases, I can see the need for more regulation. But the best regulator of the commodity market is usually the market itself. Markets punish unwarranted excesses.

Did you notice that back in July — when oil prices slipped from record highs and even had their biggest one-week drop in history — nobody was calling for speculators’ heads? There were no congressional hearings into the matter, just silence.

The fact of the matter is that speculators were just as active on the way down as they were on the way up, providing the service they do. With or without speculators, prices will continue to climb. The solutions, however, will be much harder to come by without speculators. The speculators are the ones who add liquidity and discover the best free market prices every day.

We must set aside all of the election-year rhetoric and demand better from our politicians, energy producers and even ourselves. We all have to take some responsibility if we hope to find solutions. Simply blaming one group of people is not going to work. The challenges of Peak Oil — if not Peak Everything — remain. Banning speculation means just losing a critical piece of the early warning system.

Kevin Kerr
August 4, 2008

P.S.: While speculators might have gotten their feelings hurt shouldering the blame for high oil prices, many don’t mind at all. You see, the commodities boom is making a lot of them very rich. And nothing is stopping you from taking their lead and playing the game. These guys have been trading in a secret, and very profitable market for years.

The Daily Reckoning