President Obama’s choice to head the Commodity Futures Trading Commission, Gary Gensler, reassured members of Congress that he is committed to fighting speculation. Thus continues the political game that started in early 2008 when oil prices climbed to $148 a barrel. Pundits and politicians blamed financial speculators.
The price of oil collapsed in the second half of 2008 as soon as it became clear that the demand was shrinking and would continue to do so because of the global economic slump. Here’s a surprise: the price of oil is determined by supply and demand. The economic downturn had a dramatic impact not only on current worldwide demand but expectations as to future demand.
You’d think that as the facts sank in, charges that speculators drove up prices would end. But these days vowing to fight evil speculators makes good show and Mr. Gensler had to demonstrate that he’s with the agenda handed to him by Mr. Obama, which is “regulating some of the unsound practices and excessive leverage that helped cause this crisis.”
The word speculator might conjure up the image of shady figures operating on the edge of the law. Nothing could be further from reality. The so-called commodity speculators are mainly institutions such as public and private pension funds and university endowments. They sought to diversify their portfolios and enhance their return by investing in commodity indexes and, to a much smaller extent, in hedge funds that trade in this market.
Commodity investors don’t directly buy commodities because that’s not practical and they can get better returns and use much less capital by buying commodity futures contracts. Futures are a form of derivative that has existed for centuries and long traded on exchanges such as the Chicago Mercantile Exchange, which post prices just like public equity markets.
Producers and users of commodities want to reduce their risk and lock in prices. It was this need that drove the development of futures for commodities like wheat and pork bellies in the 19th century. Airlines and utilities hedge their risk by using energy futures. This is possible because there are other market players that can take the risk.
Without this mechanism, a variety of businesses would face far greater uncertainty and the supply of their product would be less reliable. So, futures markets and trading play an essential role in the economy.
When commodities became expensive, politicians and pundits pointed to the system as the culprit. Hence Mr. Gensler’s statement that as head of CFTC he would implement new policies such as limiting futures trade positions.
Yet there is evidence that other factors caused most or perhaps all of the oil price increase. On the macro level, the Federal Reserve cut rates in 2007 and early 2008, causing the US dollar to depreciate sharply. Being denominated in dollars, oil prices rose in tandem. Stanford professor John Taylor points out how closely correlated oil prices became at this time with the federal funds rate.
A recent report from JP Morgan Chase offers another explanation. Analyst Lawrence Eagles found that in the 12 months between July 2007 and the oil price peak in July 2008, there was a surge in demand for diesel. Diesel imports by Australia, China, Chile, India, South Africa and the Middle East jumped. Mr. Eagles found that this created demand for additional crude oil equivalent to exports from Nigeria or Iraq, on top of the demand that was needed to meet strong growth at the time.
As he points out, the Commodity Futures Trading Commission analyzed a mass of trade data from this period and concluded that there is no evidence speculators pushed oil prices higher—they were reducing their net long positions as prices spiked. A combination of the diesel demand spike and the dollar decline resulting from Fed rate cuts probably explains almost all of the 2008 oil price increase.
Speculators nevertheless remain the whipping boy, as were their predecessors in times past whenever the price of a necessity became unpleasantly high. In late 18th century Paris, it was rumored that a secret society was exporting all the grain in France and then importing it back again at 10 times the original price—despite the fact that all grain exports from France had been forbidden for 100 years! Some attitudes don’t change.