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Yes, Speculation Can Drive Up Oil Prices. Here's How.

Whenever oil prices increase and the trip to the pump becomes noticeably more painful, the mantra is repeated over and again: prices are set by supply and demand and the only remedy is to change that relationship.

The right trots out its favorite slogan, “drill baby drill,” to the undoubted delight of the oil companies.  This line of discussion conflates market pricing with energy independence, usually employing the metaphor of a U.S. president bowing to a Saudi prince with unmanly obsequiousness.

Progressive policy makes better sense. More constructively, it advocates demand reduction, conversion from fossil fuels and reasonable development of extraction and transmission facilities. It may not be as virile as Sarah Palin’s battle cry, but at least this policy has some potential for success.

Off in a corner, like some cranky old uncle, another group of folks chimes in with a different view. They complain that it’s the speculators on Wall Street that are driving up the prices. Everyone from Alan Greenspan to Tim Geithner is visibly dismissive of this complaint. After all, they reason, markets are perfect reflections of supply and demand, so any deviation from the dogma of perfectly formed prices must be the product of an unenlightened mind driven by a need to find a scapegoat, preferably with a Wall Street address. Didn’t Robespierre famously proclaim “First, we guillotine the speculators!” We don’t want a revolution, proclaim the devotees of the perfect markets hypothesis.

The thing is that the concern that speculation drives price rises is not actually an uninformed rant. Adam Smith had some important observations, but it is not such a good idea to stop all intellectual inquiry at the raised “invisible hand.” Markets are simply not perfect. It is remarkable that this has not been seared into the brains of people who at the very center of the financial crisis of 2008, the product of a decidedly imperfect market.

First of all, prices are not set by supply and demand. Prices are set by the perception of supply and demand. It must be noted that the Straits of Hormuz were never closed. Nonetheless, the risk of conflict rationally induced a perception that the supply and demand ratio could change dramatically in the near term. That affected current prices because suppliers held back oil in hundreds of subtle ways because converting oil to cash now made less sense than saving some for the stressed market of tomorrow.

Commodities markets, including oil futures markets, exist for two primary purposes. They allow suppliers and purchasers to hedge against future price moves so that they can make long-term business decisions with greater certainty. And they provide a window into the market’s view of future prices that indicate the likely direction of physical prices. Businesses, individuals and policy makers order their activities based on the best collective information possible which is seen through this window. The market-established prices for next month, the month after and for succeeding months are important data points on their own. Someone may analyze projected supply and demand figures, but if the market is telling him or her that prices are moving in a way inconsistent with the analysis, that fact must be considered. 

If trading firms distort this future curve of prices so that the curve strays from levels that would be sensible based strictly on hard, real-world supply and demand expectations, the perception of future supply and demand will be altered thereby. If the perception is influenced so that market participants are more likely to believe in future price rises, they will conduct their business so as to delay converting oil to cash now, unless of course current prices go up enough to compensate them for the perceived opportunity to hold out for better prices in the future.

The markets for oil and other commodities are particularly susceptible to this. Trading volumes have skyrocketed in recent years and information is asymmetrically distributed. There is no prohibition against insider trading in commodities futures or swaps. It is a rough and tumble world.

Then there are the commodity index traders that provide a product to institutional investors that synthesizes actual ownership of market baskets of physical commodities. This product is reminiscent of the synthetic mortgage vehicles of the pre-crisis era.

In order to provide the synthetic ownership vehicle, the bank sponsors must continually maintain futures positions that are in essence a bet that prices will rise. That way if prices rise, they can pay the winnings from the bet to the synthetic commodity owners. And if the bet goes south and prices fall, their obligations to the synthetic commodity owners drop in tandem.

Since futures contracts mature on a date certain (but the synthetic ownership interests are, in theory, perpetual), the commodity index traders are compelled to continuously move into longer dated contracts. They are constantly buying futures that constitute a bet that prices are on the rise in the months to come. This demand drives up the price of the longer dated contracts sending a message that the market believes that prices are likely to increase.

The size of these trading activities is very large compared with the overall futures markets. The constant pressure to lengthen the futures positions of the commodities index traders has an identifiable effect. (See D. Frenk and W. Turbeville, Commodity Index Traders and the Boom Bust Cycle in Commodities Prices.) Of course the price effect is based on perceptions that are inaccurate, and when the prices are so inflated that they lack credibility, they revert to hard supply and demand levels. This describes the boom and bust cycles that have become so familiar.

There is no doubt that hard supply and demand data and forecasts affect prices. However, the pressures on futures prices affect perceptions of supply and demand as well, especially when there is uncertainty in the environment. It is time that the dogma of perfect markets gives way to the obvious truth: perceptions and exotic trading practices matter. Regulating these practices -- as Dodd-Frank mandates in theory but has still yet to do in practice, with these rules facing enormous pushback from industry -- is not the only solution to our energy problems, but it is the best way to provide immediate relief while policies are given time to adjust basic supply and demand relationships.