Dumb Politicians And The Oil Speculator Myth

Warning: This has nothing to do with real estate except that higher gasoline prices are making it really expensive for me to go on showings these days. But when I see the president of the United States sending the Justice Department off in search of the boogeyman controlling oil prices I get sick to my stomach. Is the guy really that clueless or is he just playing smart politics? He is a very good politician – I’ll give him that – so it’s possible that it’s the latter. But it’s still a huge diversion.

The unfortunate fact is that a large percentage of the population and congress really believe that speculators can control the price of oil simply by taking huge positions in the futures markets. Of course, 99% of these people have no clue how the futures markets really work so they have no basis for this belief – but the human race has a long history of believing myths and lies.

The fundamental disconnect in this popular myth is that the oil that you and I use is purchased for all intents and purposes in the spot market, not the futures market, and speculation occurs in the futures market. Sure you can buy physical oil through the futures market on one day each month by taking delivery on your contract but at that point the spot price and the delivery price have to be the same. So the spot price drives the futures price, not the other way around, and the spot price is driven by supply and demand – plain and simple, no way around this. The math is really simple: supply = demand = consumption + change in inventory levels. In other words, the only way for a speculator to really impact the price of oil is for them to take physical delivery and to inventory it. But a) that’s really risky and b) it’s not easy to store oil – it’s all gooey and there is limited global storage capacity.

Remember when the Hunt brothers attempted to corner the silver market? OK, most of you aren’t old enough to remember so let me summarize the basics: they took physical deliver of the silver and they lost their asses in the end. Keep in mind that it’s a lot easier to store silver than oil – any old secure warehouse will do.

Let’s work through a really simple example. Let’s say that the spot price of oil, based upon current consumption and supply, is $100/barrel but some evil billionaire speculator, trying to take advantage of the poor unsuspecting consumer who can only be saved by the US government, goes long the front month contract in a big way, driving that contract up to $120/barrel. Since the $120/barrel is not justified by current consumption what will happen when the contract expires? Either the evil speculator closes out his position at $100 or he takes delivery of the oil, hoping to drive up the demand enough to raise prices to $120. But what is he going to do with all that oil since he is just an evil speculator who has no real use for the oil? If he sells it back into the market he sells it at $100/barrel and takes a loss. His only other choice is to inventory it, but in the first place there isn’t enough storage capacity in the world to play this game very long and eventually he ends up like the Hunt brothers.

It all boils down to this: If the price were driven up artificially by evil speculators then demand would be less than supply. That’s economics 101, which most politicians apparently never took. If supply is greater than demand where will it go? Into inventory. Why is this so hard for the politicians to grasp? The problem is that you have all of these rubes propogating this myth about oil market speculation and none of them ever attempt to explain the exact mechanism by which speculation in the futures market can lead to increases in the spot price of oil. If you think you can explain this to me then please be my guest.

In the meantime if you would like to read some academic work on this subject I would recommend these two articles on The Role of Inventories and Speculative Trading in the Global Market for Crude Oil and Causes and Consequences of the Oil Shock of 2007-08.

Skip over all the higher level math and just look at their conclusions. Yes, the Hamilton article does come up with a highly theoretical scenario under which oil prices can go up without increasing inventories but it’s total conjecture and doesn’t change the fact that these authors don’t see a lot of historic evidence of speculation driving oil price increases.