Thread: The biggest reason gas is too dam' expensive...

Sebastian Mallaby - Nixonian Fallacy - washingtonpost.com

Nixonian Fallacy
Oil Futures and the Folly of Price Controls

By Sebastian Mallaby
Monday, June 30, 2008; A11

A few years back, when "subprime" generally referred to beef, economists used to congratulate themselves on their progress since the 1970s. Central banks had learned to tame inflation. Politicians had learned to appreciate the folly of price controls. Thanks to the economics profession, policymakers had grown wiser.

Well, inflation has returned. And politicians are out to control prices again, this time in futures markets.

You see this most clearly with oil prices. Barack Obama worries that "unregulated energy speculators may be distorting the market." John McCain complains that "while a few reckless speculators are counting their paper profits, most Americans are coming up on the short end." On Thursday a measure demanding a clampdown on oil trading passed the House402 to 19.

So it's time for a quick refresher: Richard Nixon's early-1970s price controls were a disaster. Administering the controls on energy alone took an estimated 5 million man-hours per year and punished motorists with gas lines. Repeating this experiment by clamping down on oil trading is like burning your hand on a gas stove and then sitting on a barbecue.

Would-be Nixons argue that hedge funds and their ilk are piling into oil futures, driving prices above "reasonable" levels. They note that in 2000, speculators owned just over a third of the "paper oil" traded on the New York Mercantile Exchange but now own more than two-thirds. This buying pressure on paper oil is said to be pushing physical oil up. Stop the speculation, they say, and prices would revert to normal.

The most basic problem with this claim is that 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. Think of a youth soccer team: If it adds two extra players it doesn't become more likely to win, because its opponents will add two players as well.

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.

Why do I think that? Financial behavior often influences the real economy. In the recent mortgage bubble, for example, financiers made mortgages available to people who had been ineligible: They changed the fundamentals of demand for housing. But oil speculation is not like that. Investors who buy paper oil do not alter the demand for physical oil. Every paper claim they buy is a paper claim they will later sell, because they have no intention of converting their paper into real oil stocks. Oil is too expensive and cumbersome to store. A speculator is not going to show up in Cushing, Okla., when his futures contract matures and drive away with a tanker truck full of oil.

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.

Just as in Nixon's day, government's response to runaway prices would have unintended consequences. The most popular proposals would limit how many contracts a speculator can buy or sell on a futures exchange, and prevent trading with mostly borrowed money. But the more you restrict trading on U.S. exchanges, the more you drive trading into the shadowy world of the unregulated swaps market or onto offshore rivals. In the 1980s, Japan tried to prevent futures traders in Osaka from speculating on the Nikkei stock index. Nikkei futures trading thrived -- in Singapore.

Most fundamentally, Nixon's heirs forget that the "speculators" they attack are often trying to reduce risk, not embrace it. Pension funds have piled into oil because they are trying to protect themselves from inflation. Small investors who load up on retail oil funds are mostly doing the same. I know my family will consume several thousand dollars' worth of oil this year, so I logged on to Fidelity's Web site and locked in my price. Does Congress think I'm irresponsible?

Oily Speculations: Financial Page: The New Yorker

Oily Speculations
by James Surowiecki
July 7, 2008

When bad things happen, it’s always nice to have a scapegoat. So, with Americans furious about soaring oil prices, Congress has gone in search of someone to blame. There are a number of usual suspects to choose from, depending on your politics—OPEC, greedy oil companies, lily-livered environmentalists opposed to oil drilling—but now Congress has seized on another set of villains: commodity speculators. “Excessive market speculation,” in the words of Senator Joseph Lieberman, has supposedly inflated the price of oil and other commodities beyond reason. Curb speculation, as a raft of proposed laws intend to do, and oil prices will soon return to earth.

Speculation has been a favorite target of politicians looking to mollify anxious voters since the time of ancient Greece, when the orator Lysias protested that wheat traders had reduced Athens to a “state of siege.” Even in market-friendly America, there is a long tradition of denouncing speculators as dishonest, unproductive parasites; the nineteenth-century preacher Henry Ward Beecher decried their “cool, calculating, essential spirit of concentrated avaricious selfishness.” And not unreasonably: the past century is full of examples of avaricious selfishness leading to the manipulation and corruption of markets. In the twenties, speculators banded together in “stock pools,” trading a particular stock among themselves to create the illusion that its value was rising—in March, 1929, a stock pool succeeded in pushing up RCA’s stock price by almost fifty per cent in less than two weeks—and then dumping the stock when outside investors bought in. In the late seventies, a speculators’ pool led by the Hunt brothers mounted an attempt to corner the world’s silver market, and at one point controlled an amount equivalent to an entire year’s global production.

Given this history, and the fact that recent years have seen a huge flood of speculative money entering the commodity markets—assets in commodity indexes, by some calculations, increased twentyfold between 2003 and the spring of this year—it’s not unreasonable to wonder if there might be something nefarious behind the sharp run-up in oil prices. But there’s little convincing evidence that the oil market is being significantly manipulated. Whatever chicanery is occurring—and we can assume there is some—has only a marginal effect on prices at the pump.

Congress is not, though, just attacking illegal market manipulation; it’s also taking aim at perfectly legal speculation, namely the buying and selling of futures contracts, which are effectively bets that oil prices will go up (or down). Futures contracts can be used by oil sellers (like OPEC ) or oil buyers (like the airlines) to hedge their risks by agreeing to sell or buy oil in the future at a set price. Speculators, by contrast, mostly use futures contracts to gamble on oil prices, and have no interest in buying or selling real barrels of oil. These gambles can be tremendously lucrative, but they don’t directly determine the real (or “spot”) price of oil. That’s set by the people who are buying and selling actual barrels of petroleum. Although speculators could directly distort oil prices by turning their futures contracts into oil and then taking it off the market to drive up prices, a look at oil inventories shows no sign that this is happening.

If speculators aren’t at fault, why have oil prices spiked so high? Fundamental reasons aren’t hard to find. Between 2000 and 2007, world demand for petroleum rose by nearly nine million barrels a day, but OPEC has been consistently unable, or unwilling, to significantly increase supply, and production by non-OPEC members has risen by just four million barrels a day. The prospect of military action against Iran, which would disrupt global supply, seems greater than it did a few years ago. And the plunging value of the dollar has meant that the cost of oil has jumped more in the U.S. in the past year than it has in countries with healthier currencies.

But there’s also something else at work, which the oil guru Daniel Yergin calls a “shortage psychology.” The price of oil—more than that of many other commodities—isn’t based solely on current supply and demand. It’s also based on people’s expectations about future supply and demand, because those expectations determine whether it makes sense for oil producers to sell their oil now or leave it in the ground and sell it later. Currently, the market is assuming that oil will become scarcer, and that global demand will keep rising, especially in rapidly developing countries like China and India. As a result, producers are asking very high prices to pump their oil. Now, it could be that these assumptions are all wrong—that the supply of oil will not be constricted going forward, that concerns about the Middle East are exaggerated, and that higher prices will lead people to cut back on energy consumption, shrinking demand. In that case, oil would turn out to have been hugely overpriced. But that won’t be because of sinister speculators; it will be because oil producers and oil users collectively misread the future.

The difficulty for Congress, of course, is that none of the problems that have driven up the price of oil lend themselves to a quick fix, and most, like the boom in global demand and the inaccessibility of certain oil fields, aren’t under our control at all. That’s what makes speculators a perfect target: by going after them, Congress can demonstrate to voters that it understands their pain, and at the same time avoid doing anything that might require real sacrifice from Americans. Our dependence on foreign oil, together with the fiscal fecklessness that has helped reduce the value of the dollar, means that there is no easy way out of where we are. But in an election year that’s hardly a message that anyone in Washington is going to deliver.

Speculators to Blame for High Commodity Prices? | Newsweek Voices - Robert J. Samuelson | Newsweek.com

Let’s Shoot the Speculators!
The candidates say financial slimeballs are piling into commodities markets and pushing prices to artificial and unconscionable levels. If only it were that simple.

Robert J. Samuelson
NEWSWEEK
Updated: 2:28 PM ET Jun 28, 2008

Tired of high gasoline prices and rising food costs? Well, here's a solution. Let's shoot the "speculators." A chorus of politicians, including John McCain, Barack Obama and Sen. Joe Lieberman, blames these financial slimeballs for piling into commodities markets and pushing prices to artificial and unconscionable levels. Gosh, if only it were that simple. Speculator-bashing is another exercise in scapegoating and grandstanding. Leading politicians either don't understand what's happening or don't want to acknowledge their complicity.

Granted, raw-material prices have exploded across the board. Look at the table below. It shows price increases for eight major commodities from 2002 to 2007. Oil rose 177 percent, corn 70 percent and copper 360 percent. But that's just the point. Did "speculators" really cause all these increases? If so, why did some prices go up more than others? And what about steel? It rose 117 percent—and continued increasing in 2008—even though it's not traded on commodities futures markets.

A better explanation is basic supply and demand. Despite the U.S. slowdown, the world economy has boomed. Since 2002, annual growth has averaged 4.6 percent, the highest sustained rate since the 1960s, says economist Michael Mussa of the Peterson Institute. By their nature, raw materials (food, energy, minerals) sustain the broader economy. They're not just frills. When unexpectedly high demand strains existing production capacity, prices rise sharply as buyers scramble for scarce supplies. That's what happened.

"We've had a demand shock," says analyst Joel Crane of Deutsche Bank. "No one foresaw that China would grow at a 10 percent annual rate for over a decade. Commodity producers just didn't invest enough." In industry after industry, global buying has bumped up against production limits. In 1999, surplus world oil capacity totaled 5 million barrels a day (mbd) on global consumption of 76mbd, reckons the U.S. Energy Information Administration. Now the surplus is about 2mbd—and much of that in high-sulfur oil not wanted by refiners—on consumption of 86mbd.

Or take nonferrous metals, such as copper and aluminum. "You had a long period of underinvestment in these industries," says economist John Mothersole of Global Insight. For some metals, the collapse of the Soviet Union threw added production—previously destined for tanks, planes and ships—onto world markets. Prices plunged as surpluses grew. But "the accelerating growth in India and China eliminated the overhang," Mothersole says. By some estimates, China now accounts for 60 percent to 80 percent of the annual increases in world demand for many metals.

Commodity-price increases vary, because markets vary. Rice isn't zinc. No surprise. But "speculators" played little role in the price run-ups. Who are these offensive souls? Well, they often don't fit the stereotype of sleazy high rollers: many manage pension funds or university and foundation endowments. Their modest investments in commodities aim to improve returns.

These extra funds might drive up prices if they were invested in stocks or real estate. But commodity investing is different. Investors generally don't buy the physical goods, whether oil or corn. Instead, they trade "futures contracts," which are bets on future prices in, say, six months. For every trader betting on higher prices, another is betting on lower. These trades are matched. In the stock market, all investors (buyers and sellers) can profit in a rising market and all can lose in a falling market. In futures markets, one trader's gain is another's loss.

Futures contracts enable commercial consumers and producers of commodities to hedge. Airlines can lock in fuel prices by buying oil futures; farmers can lock in a selling price for their grain by selling grain futures. What makes the futures markets work is the large number of purely financial players—"speculators" just in it for the money—who often take the other side of hedgers' trades. But all the frantic trading doesn't directly affect the physical supplies of raw materials. In theory, high futures prices might reduce physical supplies if they inspired hoarding. Commercial inventories would rise. The evidence today contradicts that; inventories are generally low. World wheat stocks, compared with consumption, are near historic lows.

Recently the giant mining company Rio Tinto disclosed an average 85 percent price increase in iron ore for its Chinese customers. That was stunning proof that physical supply and demand—not financial shenanigans—are setting prices: iron ore isn't traded on futures markets. The crucial question is whether these price increases are a semi permanent feature of the global economy or just a passing phase as demand abates and new investments increase supply. Prices for a few commodities (lead, nickel, zinc) have receded. Could oil be next? Barron's, the financial newspaper, thinks so.

Politicians now promise tighter regulation of futures markets, but futures markets are not the main problem. Physical scarcities are. Government subsidies and preferences for corn-based ethanol have increased food prices by diverting more grain into biofuels. A third of the U.S. corn crop could go to ethanol this year. Restrictions on offshore oil exploration and in Alaska have reduced global oil production and put upward pressures on prices. If politicians wish to point fingers of blame for today's situation, they should start with themselves.

Cafe Hayek: Politicians Make My Eyes Tear Up

From today's Wall Street Journal:

As it happens, though, there's a useful case-study in the relationship between futures markets and commodity prices: onions. Congress might want to brush up on the results of its prior antispeculation mania before it causes more trouble.

In 1958, Congress officially banned all futures trading in the fresh onion market. Growers blamed "moneyed interests" at the Chicago Mercantile Exchange for major price movements, which could sink so low that the sack would be worth more than the onions inside, then drive back up during other seasons or even month to month. Championed by a rookie Republican Congressman named Gerald Ford, the Onion Futures Act was the first (and only) time that futures trading in a specific commodity was prohibited, and the law is still on the books.

But even after the nefarious middlemen had been curbed, cash onion prices remained highly volatile. In a classic 1963 paper, Stanford economics professor Roger Gray examined the historical behavior of onion prices before and after the ban and showed how the futures market had actually served to stabilize prices.

The fresh onion market is highly seasonal. This leads to natural and sometimes large adjustments in prices as the harvest draws near and existing inventories are updated. Speculators became the fall guys for these market forces. But in reality, the Chicago futures exchange made it possible to mitigate the effects of the harvest surplus and other shifts in supply and demand.

To this day, fresh onion prices still cycle through extreme peaks and troughs. According to the USDA, the hundredweight price stood at $10.40 in October 2006 and climbed to $55.20 by April, as bad weather reduced crop yields. Then it crashed due to overproduction, falling to $4.22 by October 2007. In April of this year, it rebounded to $13.30.

Futures trading can't drive up spot prices because the value of futures contracts agreed to by sellers expecting prices to fall must equal the value of contracts agreed to by buyers expecting prices to rise. Again, it merely offers commodity producers and consumers the opportunity to lock in the future price of goods, helping to protect against the risks of future price movements.

Originally Posted by 7thsfsniper

If we had drilled in ANWR and every place else we could have, we wouldn't be in this mess now and we would most likely have the Saudis over a barrel instead of vice versa.

We wouldn't be in this mess right now, but eventually we would be, maybe
20-30 years down the road. Personally, I would rather keep our oil in the ground for now, until there are actual shortages.

Originally Posted by Johnny W

We wouldn't be in this mess right now, but eventually we would be, maybe
20-30 years down the road. Personally, I would rather keep our oil in the ground for now, until there are actual shortages.

Define "shortage."

So it is not the Iranian enigma, speculators are dry clean, the oil companies are just doing their business as usual...there is no scape goat than. The shocking truth than is, that there is a big problem looming and it is coming fast. I did some research and soon I'll be ready to sprinkle my wisdom shower here.

It's a combination of many factors. Dollar losing strength and the inelastic demand of oil being the 2 biggest factors, in my opinion of course.

I think the dollar was trading around even with the euro 3 years ago. Now it's $1.55 for a euro. Convert oil to euro, then the jump wouldn't have been so dramatic.

Being as inelastic as any demand could be, oil traders and producers are just trying to see where the highest pricing point is to maximize their profit.

On the emerging economies like China and India, the people have never experienced $20/barrel of oil. They think $80 is not bad. Couple that with government subsidies, oil demand is very inelastic for them.