The Power of Speculation (In Crude Terms)

Do you buy it? I can’t say I pay any better than cursory attention to economic news and am admittedly a little insecure about my general grasp of economics topics. Perhaps this new writing endeavor I’ve undertaken will motivate me to better familiarize myself with that field.

But it only requires cursory attention to see that the question of whether futures market speculators are in any large part responsible for rising oil prices is key in determining where you fall on national energy policy, particularly the debate over whether we should open up more protected land (and offshore locations) for drilling. The economic argument opponents cite is that it will take a minimum of ten years to begin pumping oil from under any new land that we designate for extraction. Many say that rather than begin a process of extracting oil that won’t be introduced to the market for ten years, we could seize the opportunity created by rising cost of fuel to encourage R&D in newly attractive alternative energy.

But if investment in futures markets are responsible for rising prices, opening up more land for drilling should prompt the speculators to begin selling oil short, thus impacting the market in the near furture, even as we wait around for a decade for the stuff to finally start coming out of the ground. At least, that’s the way I understand people like Glen Beck.

Looking around the web for information on this, one thing that keeps coming up is this testimony from Michael W Masters before two Senate Committees on May 20th. There, he stated,

What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.3 These parties, who I call Index Speculators, allocate a portion of their portfolios to “investments” in the commodities futures market, and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as “Index” Speculators because of their investing strategy: they distribute their allocation of dollars across the 25 key commodities futures according to the popular indices – the Standard & Poors – Goldman Sachs Commodity Index and the Dow Jones – AIG
Commodity Index.4

He then touted a strong correlation between the commodity index investments and commodity spot prices and followed that up with several questionable arguments. Primarily:

In fact, Index Speculators have now stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve over the last five years.10

His footnote leads to an Energy Information Administration table of annual petroleum stocks held. Just a layman’s perspective, but I’m not so sure I believe that 1.1 billion barrels of oil are being warehoused waiting around for futures market investors to deliver their contracts.

For whatever it’s worth some think-tank called The Institute for Energy Research (which I’m sure I’ll one day regret citing) agrees with me:

When Michael Masters says that “Index Speculators have now stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum” (p. 5), we must ask: Exactly where are these incredible quantities being stored?vi The answer of course is that they aren’t being stored anywhere; Masters derives his figure based on market prices of contracts and oil. Except for strategic petroleum reserves held by governments, all of the oil that has been pumped in the last few years has been purchased and used by consumers. This means that the fundamentals are driving high oil prices, not speculators. Masters’ error is even more pronounced when he turns from oil and focuses on food:

Turning to Wheat [sic], in 2007 Americans consumed 2.22 bushels of Wheat per capita. At 1.3 billion bushels, the current Wheat futures stockpile of Index Speculators is enough to supply every American citizen with all the bread, pasta and baked goods they can eat for the next two years! (p. 5)

To repeat, Masters is here committing a very naïve mistake. When large investors buy futures contracts in commodities, they roll them over before the actual delivery. Goldman Sachs isn’t building silos to store all of the wheat that it is allegedly stockpiling. When the futures contracts for June near maturity, the investment bank will sell them to a commercial user and use the money to buy July contracts. Thus the farmers who originally sold the contracts still end up delivering the physical wheat to commercial purchasers, who then sell it to the appropriate parties for it to be turned into flour etc. The investment bank has merely acted as an intermediary, profiting or losing based on which way prices move. But no matter what happens, the wheat is ultimately turned into food.

I don’t think I buy it. The debate over whether futures markets are good or bad for the economy is over my head (at least for now) but until someone shows me some evidence that these speculators are actually hoarding this oil or a better explanation in layman’s terms for how futures are driving up oil prices, that’s where I’m at.