U.C. San Diego economist Jim Hamilton has long argued that fundamental forces of supply and demand explain oil prices better than "speculation." So it wasn't a surprise that he doesn't think much of Thursday's Washington Post blockbuster by David Cho, "A Few Speculators Dominate Vast Market for Oil Trading." Hamilton closed his dissection of the article by stating:
Cho was trying the best he could to convince us that unregulated speculation was the cause of this summer's spike in oil prices.
But instead he convinces me that he really couldn't find much of a case.
I'm not so sure. Yes, Hamilton raises some fair technical questions about Cho's reporting -- for example, he finds it hard to believe that Vitol, the oil trader recently deemed by the Commodities Futures Trading Commission to be more of a speculator than a specialist in moving around the physical commodity, actually "held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange," in July, as reported by Cho.
That does sound like a lot, though enough details are left out to make me wonder what is actually being claimed here. Surely Cho doesn't literally mean "all the oil contracts," i.e., light sweet, Brent, heating oil, gasoline, and so on. If light sweet alone, are we talking about just futures, or futures plus options? Or is Cho possibly referring just to one very specific contract, such as the August CL futures contract? And were these positions held outright by Vitol or purchased on behalf of its clients?
But it seems to me that Hamilton's questions are more, uh, speculative, than definitive. What does seems clear from Cho's reporting is that a significantly greater proportion of oil futures activity has been dominated by short-term profit-seeking entities than most observers of the market previously suspected. And such a situation could not have come about without major changes in the rules regulating who is allowed to participate in commodities trading. To me, the following history is the nut of Cho's reporting:
For most of the past century, regulators put limits on financial actors to prevent them from dominating commodity exchanges, which were much smaller than the bond or stock markets. Only commercial operations, such as farms, airlines, manufacturers and the middlemen that handle their trading activities, were allowed to buy nearly unlimited quantities. The goal was to allow these businesses to minimize the effect of price swings.
The first major change to this regulatory framework occurred in 1991, when Goldman Sachs, through a subsidiary called J. Aron, argued that it should be granted the same exemption given to commercial traders because its business of buying commodities on behalf of investors was similar to the middlemen who broker commodity transactions for commercial firms.
The CFTC granted this request. More exemptions soon followed, including one to the Houston-based energy trader Enron.
Et cetera. Deregulation, in other words, widened the playing field.
To be sure, most of the economists who are currently commenting on the Washington Post story stand by their previous analysis -- with many of them stressing that there is a difference between "speculation" and "manipulation." Their basic argument appears to be that those who were betting that prices would go up did so because the fundamentals of the global oil market dictated that oil would be an increasingly scarce commodity. But once global demand started taking a serious hit, that narrative changed.
Geoffrey Styles, who spent years working as a bonafide oil trader, has some cogent analysis of all this at his blog, including some useful contextual information on Vitol. His last paragraph makes a lot of sense:
The roughly 20 percent drop in oil prices since the beginning of July should calibrate our estimates of the influence of such speculation. It was clearly not sufficient to maintain momentum in the face of weakening fundamentals of demand, supply and risk. At the same time, our response ought to distinguish between the kind of speculation represented by oil market neophytes hoping to cash in on an attractive investment trend, and the speculation that is an absolute requirement of a smoothly-functioning commodities market. Anyone who thinks the oil market would work just fine with only producers, refiners and end-users has never spent a day trading, or seen liquidity vanish just when a specific transaction was most desirable or necessary, because there was no middleman willing to take it on as a bet. But regardless of whether one variety of speculation should concern us more than another, the market's dramatic response to sliding demand serves notice to policy makers that their best and most productive avenue for addressing the impact of high oil prices is surely prompt and meaningful action on supply and demand, rather than rounding up today's version of the usual suspects.