Oil Speculation: Good or Bad?

One of the most difficult things to hear during the Presidential campaigns was the continued bashing of oil speculation. We elect officials to represent us in Washington and carry out the people’s business, yet most do not have even a beginner’s grasp of how our markets work. I don’t know which was worse during the campaign: Obama’s instance that high oil prices were due to the war in Iraq coupled with investor greed, or McCain’s populist pandering that illustrated his ignorance on the topic as well.

In order to understand the truth behind oil speculation, we must first understand a very simple concept of economics: supply and demand’s effect on prices. Speculation does not just begin on a whim. In other words, investors don’t dump investments in other sectors to flock to the commodity market as Paul Krugman would like you to believe. Increased demand is what drives oil speculation. Globalization has caused global poverty to decline rapidly this decade. In fact, since 2002, the world economy has grown 4.6% which happens to be the highest sustained rate since the 1960’s according to Michael Mussa of the Peterson Institute.(1) When economies prosper, an increased demand for oil is the result.

Now that we have established the motive for speculation, the process must be explained. Speculation is not greed driven. It’s a HEDGE against future price increases. If an investor buys oil futures, that person is betting on the fact that oil prices are going to continue to rise. The contract locks them into today’s prices. However, if one person buys a futures contract that means someone else is selling it. The seller has different expectations than the buyer. The seller believes that prices will DECLINE in the future. In addition, the person bidding up and buying oil futures must then turn around and sell the oil later. This means that the more people’s bidding drives up the prices, the greater prices will FALL in the future. The economic growth the world has enjoyed since 2002 has now come to a halt with the global credit crisis. This means that demand for oil is no longer as strong as it was before. As a result, crude oil is currently trading in the low $60 range as opposed to the $140 range this past summer.

Critics of speculation argue that speculation restricts supply. This statement is false. If a person buys an oil contract now to lock in today’s prices, they cannot sit and hold the oil off the market. They have two options: 1) take delivery of the oil or 2) sell the contract to another investor. In any event, when the contract expires, there is no net effect on oil supply.

Think of speculation as an insurance policy. If you own a company whose profitability is severely hurt by high oil prices, it’s in your best interest to lock in today’s price. If you are correct and the price of oil continues to rise, your business can survive and your employees whose livelihood depends on the success of your business will thank you. If you are wrong and prices drop, you will lose money; however you are still in business and can recover as opposed to shutting your doors had the opposite happened.

Should they not be allowed to do this? Are critics saying that business can’t hedge to survive? What’s the alternative? Should companies close their doors, lay off workers and be deprived of capital to grow? Who does that hurt?

The bottom line is this. If speculation was driven out of pure greed, then we would have seen what we saw in early 2008 years ago. After all, if it’s solely greed driven, then these greedy speculators can drive up the price any time they wish. Remember that there are two sides to these contracts. The global credit crisis blindsided the market, and now people are seeing instant relief at the pump thanks to those greedy speculators who are now recovering from losses.

(1) Samuelson, Robert J. “Let’s Shoot the Speculators!” Newsweek (July 2008) Online