Oil Speculators ‘R’ Us

Oil Speculators ‘R’ Us

Op-ed in The National Review
August 21, 2008

Those dastardly speculators! As well as oil
company CEOs, traders in commodity futures have become convenient
whipping boys for politicians of both parties in the blame game for
skyrocketing oil prices. Both Barack Obama and John McCain

But
for Democratic leaders of the House and Senate, speculators serve as an
especially attractive diversionary target. Under mounting pressure for
not opening up American lands to oil exploration, bashing speculators
seems to be the perfect way for Democrats to change the subject from
drilling and claim to provide Americans immediate relief at the pump.
It’s no surprise that in her radio address
on Saturday, in which she said she will introduce a large omnibus bill
that will — in her careful phrasing — “consider opening portions of the
Outer Continental Shelf for drilling,” Pelosi added that the same
measure will “address the role that undue and excessive speculation
plays in driving up the price of oil.” have hurled pejoratives at them and called for reining them in.

 Of all the “poison pills” Democrats could attach to the bill to escape
blame for not allowing drilling, the anti-speculation provision could
prove most divisive to Republicans. Although GOP members of Congress
now seem united in fighting the Democrats on drilling, many are still
folding when the Democrats bring anti-speculation measures to the
floor. In a House vote
right before Congress adjourned in late July, more than 40 Republicans
joined Democrats in voting for further regulation of the commodities
market, and the political newspaper Politico reports that GOP leaders had to scramble to keep more from defecting.

But
blaming speculation reveals itself to be a fool’s game the more
policymakers know about how it works and who engages in it. And as much
as politicians seem to enjoy bashing speculators, even Democrats seem
to have trouble when it comes to pinpointing just exactly who they are.

Take, for instance, Rep. Bart Stupak (D., Mich.), chairman of
the House Commerce Subcommittee on Oversight and Investigations.
According to Dow Jones Newswires,
“Stupak identified Goldman Sachs and Morgan Stanley as firms whose oil
trading activities warranted closer review.” But when pressed on CNBC,
Stupak denied that he had fingered any specific financial firms, and said: “We’re not investigating Goldman Sachs or anybody. We’re looking at the macro picture, not the micro.”

But
a couple weeks later, Stupak had a new target: pension funds. That’s
right, pension funds that invest for the retirement of rank-and-file
employees including firefighters and teachers. “All those speculators
getting the blame for driving up the price these days — just who are
they,” asked the Associate Press. “For part of the answer, look in the mirror.”

The
AP story reports that pension funds have invested about $70 billion in
crude oil futures, citing the research firm Ennis Knupp &
Associates. Just as a great many Americans are oil company owners
through their retirement savings, so too are they oil speculators.

Most
speculation critics in Congress have danced around the trading done by
pensions, but Stupak has expressed outrage that workers’ retirement
money could be raising the price of oil for them. "Your pension fund
manager may be using your retirement money to drive up the price of
oil," Stupak declared at a hearing, according to AP. "What would happen
if pension fund managers decided to increase their commodity investment
by another 20-fold?" he asked.

But the question Stupak and other
lawmakers should be asking is what would be the consequences of
curtailing pension funds and other American investors’ ability to hold
certain types of commodities, as bills from Stupak and Senate Majority
Leader Harry Reid propose to do. It’s not speculative to say that these
measures would greatly reduce retirees’ returns, cause more American
jobs in the financial sector to go offshore, and do nothing to bring
down the long-term price of oil.

Hedging commodities is simply
planning for the future, and although some of the technologies involved
are new, the practice is centuries old — older than even the American
republic. In The Wealth of Nations in 1776, capitalism’s
founding father Adam Smith wrote of “forestallers” and “engrossers” who
bought and stored corn in times of plenty and sold it when harvests
were bad. As former CEI senior fellow Christopher Culp has written, there is a “clear similarity between the speculators and arbitragers of today and Smith’s corn merchants.”

Many
businesses also hedge so that they won’t have to pass on a commodity
price increase to consumers all at once. Many airlines, hit hard by the
oil spike, have called for reining in speculation. But airlines engage
in hedging themselves, and it is clear some are better at it than
others. A Politico story
written by Lisa Lerer notes that Southwest Airlines “hedged its oil
bets, locking in 70 percent of its fuel at $51 a barrel. Today, the
airline pays about $2 a gallon for jet fuel.” (Full disclosure: Like
millions of other Americans, I enjoy flying Southwest and, as noted in
the tagline below, have bought stock in the company. Its hedging
strategy is just one example of what a well-run airline it is.)

Stupak
and other critics do attempt to distinguish between oil futures bought
by oil-using industries and those bought by investors such as pension
funds. But the distinction usually amounts to splitting hairs over the
trading technology. Harry Reid, who raves about electronic innovation
when addressing liberal bloggers’ conferences, sounds downright
technophobic when talking about energy traders. “Right now, Wall Street
traders are raising gas prices with nothing more than the click of a
mouse,” Reid declared when introducing his Stop Excessive Energy Speculation Act.

Stupak
charges that commodity investors such as pension funds aren’t hedging
for what he calls “legitimate anticipated business needs,” but
speculating to make money. “Their trading is speculative, and not for
the legitimate business needs of a user or producer.” says a summary of Stupak’s Prevent Unfair Manipulation of Prices (PUMP) Act.

But
pension funds and other investors are indeed buying oil futures for
legitimate financial needs: the need to hedge a falling dollar and
declining stock prices. “The investments have paid off,” notes the
Associated Press article. “The Standard & Poor's GSCI index, which
tracks a basket of commodities, has gone up 19 percent in the past five
years, compared with just 9 percent for the S&P 500 stock index.”

But
despite the descriptions of institutional investors’ money “flooding”
into oil and other commodities, most pension funds still only have
commodities as a very small share of their portfolio. In Pelosi’s home
state, the California Public Employees’ Retirement System, the AP
reports, has $1.3 billion in commodities, but that’s still just one
half of 1 percent of the fund’s total assets of $240 billion. This
seems like a prudent allocation to have some layer of protection for
workers’ money against expected inflation.

And this gets to the
issue of the degree to which commodity investing by pension funds and
others is really affecting oil prices, even in the short term. The
expert Stupak and other Democrats have trotted out at their hearings is
Michael Masters, a somewhat mysterious Virgin Islands-based hedge fund
manager. “Hardly anybody had heard of him prior to his appearance
before Congress beginning May 20 to sing songs Democrats wanted to
hear,” writes
columnist Robert Novak. Among those “songs” is Masters’ sensational
claim that limiting speculation would reduce oil prices about 50
percent, by $65 to $70 a barrel in a month after the proposed
regulations were enacted. Of these claims, New York Times business columnist Joseph Nocera, a political liberal, writes, “There are so many holes in this argument I scarcely know where to start.”

And speaking of New York Times
liberals, the speculation debate has awoken the inner professional
economist in none other than Paul Krugman, who hurls pejoratives at
Masters that he usually reserves for Republicans. “I think his
testimony is just stupid, …” Krugman wrote.
“This is really, really dumb.” Krugman argues that speculation has
little to do with the oil spike, because there is no evidence of excess
inventory, and the futures price has not varied that much from the spot
price, which is the price for immediate delivery.

His conclusions are remarkably similar to those of a paper
from the free-market Institute for Energy Research (IER). Krugman and
the IER differ on long-term solutions — Krugman opposes drilling and
favors the Al Gore approach of conservation and alternative energy —
but they agree that increased demand from developing countries is the
main factor in the oil-price surge and that speculation is having
little effect. What both emphasize is that paper or electronic trading
doesn’t negate physical delivery of a commodity. “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 contacts,” the IER
report states. Similarly, Krugman states, “Buying a futures contract for oil does not

Even
if speculation were found to be boosting the price, it would be
counterproductive to ban it. Futures and forward contracts are just
bets that commodity prices will go up in the future. If the bets are
wrong, then the speculator gets clobbered and prices go back down for
consumers.

But if the speculator is right, than even a
temporary rise in prices sends us valuable signals about what is
happening with a resource. And any limit on speculation might lower
prices in the present, but not do anything to prevent their inevitable
rise in the future, just as the prices of coal, potash and other
materials have skyrocketed in the past few years despite very thin
futures markets for those commodities (Hat tip to the July issue of Lee Bellinger’s Independent Living,
a sharp financial newsletter that unfortunately is not online.). And
the lull of temporary lower prices would have stopped us from doing
what we needed to do — i.e. more drilling and/or building of nuclear
facilities — to cope with the long-term demand trends of the resource.

Depending
on public policy, speculators anticipating a resource’s future can just
as easily lower as well as raise prices in the present. The sudden drop
in oil prices we are seeing could be in part attributable to the
upcoming expiration of Congress’ ban on offshore drilling, and
speculation that the ban — even under Democrats — is not going to be
renewed. The vastness of the oil reserves that are more likely to be
tapped would increase future supply and may be making it rational for
speculators to liquidate their holdings in the present. If the ban is
indeed allowed to expire on September 30, we may see even further
immediate declines in prices.

As Smith wrote of the
forestallers and engrossers in 1776, “By making [consumers] feel the
inconveniences of a dearth somewhat earlier than they might otherwise
do, he prevents their feeling them afterwards so severely as they
certainly would do, if the cheapness of price encouraged them to
consume faster than suited the real scarcity of the season.” More than
230 years after The Wealth of Nations was published, Adam Smith’s wisdom on the value of speculators still rings true. [emphasis in original] reduce the quantity of oil available for consumption; there’s no such thing as ‘virtual hoarding.’”

John Berlau is director of the Center for Entrepreneurship at the Competitive Enterprise Institute and author of Eco-Freaks. He owns shares in Southwest Airlines.