No, Speculation Does Not Explain Oil Prices

Michael Giberson

Sebastian Mallaby provides a clear exposition of what might be considered the mainstream economics story of why “speculation” is not to blame for the current high level of oil prices.

[A] speculator can buy paper oil only if someone else sells to him. For every trader who bets on a price rise, there must be another who bets the opposite. So an increase in the number of speculative players does not show whether prices will move up or down….

What matters is who those players are: Will they aggressively push the ball up the field, or will they retreat? Sometimes the bulls are more eager than the bears, and prices spiral upward. But this is not some autonomous force that comes out of nowhere. If the bulls have the upper hand, it’s generally because supply and demand favor higher prices. The fundamentals of physical oil drive the psychology around paper oil more than vice versa.

… The uncertain connection between speculation and price trends is clear in recent history. The Commodity Futures Trading Commission reports how much paper oil is bought and sold by commercial users — oil companies, refiners — and how much is bought and sold by speculators. During the first seven months of 2007, speculators as a group tripled the amount of paper oil they owned, buying it from commercial players. But since last August, speculators as a group have not added to their positions — yet this was when oil prices went skyward.

It would be too much to claim that futures prices don’t influence players in the physical market. But to the limited extent that speculators’ influence is real, this is probably a good thing. If speculators see that oil suppliers are headed for trouble and that oil demand is trending up, they express their expectation of a higher price via the futures market. This can deliver a valuable message: Governments and consumers had better adjust before shortages get even nastier.

Tyler Cowen at Marginal Revolution has also been addressing oil prices, most recently seeking to reconcile current high oil prices with a belief in the overall correctness of the Julian Simon view that resource prices would continue to fall in the long run. I don’t find my position listed among Tyler’s list of possibilities – I’m closer to Alex Tabarrok’s view expressed last week: “Finally, on oil – who really cares what the price is? The issue is energy, not oil. I am confident that the long run price of energy will fall.”

Well, many of us care about the price of oil in the short to medium term, after all we have assets (i.e. automobiles, pipelines, refineries, oil rigs, factories) with usefulness tied to the price of oil. But in the long run, as Alex says, it is energy, not oil.

2 thoughts on “No, Speculation Does Not Explain Oil Prices

  1. He is right on the theory but incorrect when he says that for every buyer there must be a seller. After all, one long buyer can buy 10 contracts from as many as 10 short sellers, each of whom sells one.
    This is a common if unimportant mistake.

  2. Surely this is complete nonsense, the price of oil is directly set on the the future market and nothing else. Until the government gets their head out of the sand and stops these speculators the same thing will happen to America as Enron did to California.

    “The declining liquidity of the physical base of the reference crude oil and the narrowness of the spot market have caused many oil-exporting and oil-consuming countries to look for an alternative market to derive the price of the reference crude. The alternative was found in the futures market. When formula pricing was first used in the mid-1980s, the WTI and Brent futures contracts were in their infancy. Since then, the futures market has grown to become not only a market that allows producers and refiners to hedge their risks and speculators to take positions, but is also at the heart of the current oil-pricing regime. Thus, instead of using dated Brent as the basis of pricing crude exports to Europe, several major oil-producing countries such as Saudi Arabia, Kuwait and Iran rely on the IPE Brent Weighted Average (BWAVE).11 The shift to the futures market has been justified by a number of factors. Unlike the spot market, the futures market is highly liquid which makes it less vulnerable to distortions. Another reason is that a futures price is determined by actual transactions in the futures exchange and not on the basis of assessed prices by oil reporting agencies. Furthermore, the timely availability of futures prices, which are continuously updated and disseminated to the public, enhances price transparency.

    [11] The BWAVE is the weighted average of all futures price quotations that arise for a given contract of the futures exchange (IPE) during a trading day. The weights are the shares of the relevant volume of transactions on that day. Specifically, this change places the futures market, which is a market for financial contracts, at the heart of the current pricing system.”

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