Tuesday, June 24, 2008

Oil & Politics

Like oil and water, I think oil and politics don't mix.

Today there is WSJ commentary worth looking at regarding the assertion (by many politicians) that speculators are at fault for the recent increases in oil prices:
On Sunday, Barack Obama rolled out a proposal that will supposedly thwart market manipulation by "a few energy lobbyists and speculators." John McCain chimed in that Mr. Obama was merely following his lead; last week, the Republican denounced "some people on Wall Street" for "gaming the system." If there's a Congressman who isn't calling for his own crackdown, he's gone into witness protection. And sure enough, even this week's impromptu oil summit in Jeddah blamed "speculators" for high prices.

The futures market may be a convenient scapegoat, but it's simply a price discovery mechanism. Major energy consumers – refiners, airlines – buy and sell these contracts to lock in goods at a future price, as a hedge against volatility. Essentially, they're guesses about coming oil supply and demand, as well as the rate of inflation. The political theory is that such futures trading is creating a bubble in the spot market (i.e., oil purchased for immediate delivery) beyond oil fundamentals. Thus, $4 gas.

But there's no inherent reason to "bet" that commodities will go up rather than down. Bet wrong – place all your chips on red, say – and you lose. If a company purchases the future right to buy oil at $140 a barrel and it instead sells for $130, the option is worthless. Besides, somebody has to take the other side of any futures contract: Some are trying to predict where the price will go in the future, while the other side is attempting to sell its future price risk. But no one knows how things will end up.

Mr. McCain calls such exchanges "reckless wagering." But speculators – normally known as "traders" – are really managing the exposure risks of American businesses to higher oil prices. Traders not affiliated with major producers or consumers provide liquidity to the market. Without the second group, futures markets would be determined exclusively by commercial participants. Another word for this is a cartel.
What is important here is that "speculators" are taking risks by making guesses about the future. There is no inherent reason why we should expect a speculator's guesses to be right and thereby be rewarded by large profits. The guesses may be wrong and be rewarded by large losses. It is also important to note the idea that the futures market is a price discovery mechanism. The specific idea is that in the present situation it appears that many believe the price of oil is going to be higher in the future. Given politics here in the United States, and given the potential, at present, for conflicts around the world this might well still be a very good guess.

Consider the finish to the WSJ commentary:
On the other hand, inflation does lead to a misallocation of resources, so it's not surprising that the Federal Reserve's weak dollar policy has driven investors to commodities to protect themselves. Loose monetary policy has caused price jumps across nearly all commodities, including surges in grains and precious and base metals. The Fed's rate-cut bender is the most important reason oil is up so sharply since last August.

The other major factor is supply and demand, as prosaic as that might seem amid today's political agitation. Energy consumption is surging in China and India, and global supply is not growing fast enough to keep up. Congress could do something useful if it opened up America's vast natural resources, which are blocked by environmentalist romanticism. But then, it's so much easier to shoot the price messengers.
The simple supply and demand view of a market should be helpful to us when wondering why oil prices are increasing. The price of oil, as well the price of any good or service, will increase if there is an increase in demand, if there is a decrease in supply, or both an increase in demand and a decrease in supply. The last two paragraphs to the WSJ commentary suggest reason to believe that both demand is increasing and supply is decreasing (at least relative to what it could be).

U.S. oil companies could be increasing supplies over time and into the future, but it seems our national politics, at least up to now, prefers to restrict production of oil off-shore, on-shore on public lands (ANWR), and from oil shales. The oil speculators don't make these sorts of political choices, but they can see these choices and guess that oil prices will be even higher in the future. At least some part of the oil price increases seem to me to involve U.S. public policies. Of course, our national politicians are responsible for these policies. As I think I've seen happen often in the past, when the politicians are themselves the culprits with respect to situations the public doesn't like, the politicians rush to the microphones and to the public meetings to claim it is someone else's fault.

Increase supply, of oil or any other good or service, and be assured the price will be lower than would otherwise be the case.


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