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15 May 2011

Speculators are Good in a Free Market

When I was a sophomore at Brown University in 1966-1967, I sat in on the first semester economics course and then took a test to get credit for the course.  I then took the second semester as a regular course.  The course was taught by a Brown Ph.D. graduate student and in a lecture he made it clear that he did not like speculators and that he did not understand their essential role in a free market economy.  I explained it to him after class, making myself late for my next class.  To this day, few people understand the critical and good role that speculators perform.  They are presently being blamed by Obama, Bill O'Reilly, and many others for the increasing price of gasoline at the pump.

Obama claims that there is plenty of oil available and the price of gasoline should not be so high.  But, he says the mean, cold-hearted, selfish speculators are driving the cost of oil up and therefor the cost of gasoline is going up.  There are indeed times when speculators do drive the cost of oil up.  There are also times when they drive the cost down.  The total longer term average of their effect on the price of oil is probably a downward effect.  Let us consider why this is the case.

If you look at the market for a given product, you see the free market price of that product now fairly readily, if you have a free market.  What is harder to figure out is what the future price of that product will be.  Let us take the case of oil, since that is the present example of most interest.  Let us suppose even that Obama is right that there is enough oil now to meet the present demand for oil in the sense that the supply and the demand do not dictate a price increase.  Is it perhaps the case that speculators are driving the price up?  It may very well be the case.  Yes, even Obama can be partly right every now and then.  Even though he has no understanding of economics and business at all, he is sometimes partly right about something in some moment of time.  What he is most likely wrong about is his assessment that the rising price is entirely caused by speculators and that their contribution is bad.

The speculators are bidding up the price of oil because they think that we will before very long face a situation in which the supply of oil will not be enough to satisfy the future demand for it without the price going up more even than the speculators are bidding it up to now.  The speculator makes money only if he is right in his assessment of the future supply and the future demand.  If he is wrong, he will lose his shirt.

So, speculators have recently bid up the cost of oil by buying it.  Why might they do this?  First, the world economy has been in a severe recession with a slow recovery, so present demand is still suppressed.  Countries such as India, China, and Brazil have had rapidly growing economies in recent times, which may surge ahead as the world gets over the recession.  Many people in under-developed countries have been improving their standard of living and are using more energy.  World trade will grow and the transportation of goods will increase.  Meanwhile, OPEC has been limiting its production of oil.  The national oil companies that control the vast majority of the world's presently developed oil fields are very inefficient oil producers.  Will they be able and inclined to increase production by enough to keep prices near present levels as economies continue to recover from the recession?  There is also a loss of production of oil in Libya and some legitimate concern that the unrest in the Middle East may lead to other disruptions of oil production in other countries. 

Even the rather free market oil companies are not able to increase oil production by much, because many countries are closed off to them and because the U.S. will not allow them to develop new oil fields offshore or on any of the vast federal lands.  Even on private land, they are often prevented from oil field development by lawsuits.  At the moment, there are also some oil refineries being threatened by production problems by the flooding of the Mississippi River.  In addition, speculators are predicting the future value of the dollar.  Will it continue to drop as the Federal Reserve continues to print money?  Perhaps the speculators think oil production will not therefor increase enough as demand increases to keep prices at present levels or at those that speculators are bidding the price up to currently.  Perhaps they are betting -- almost surely correctly -- that the value of the dollar will continue to shrink.

Let us suppose that the speculators are thinking this way and they have bid up the price of oil.  When that future time comes and many people are desperate for oil and its products such as gasoline and plastics, the present production oil of that future time would be bid up to very high prices by consumers.  It is then that the speculators let the oil they have been holding back onto the market.  The supply of oil is then increased and the price is driven down.  The speculator makes a profit if he was right about the future direction and rates of supply and demand changes and the value of the dollar.  If we deny him his profit, he has no reason to take the risk of acting on his judgment to try to smooth out price fluctuations.  The speculator takes advantage of price fluctuations to make a profit.  But, his act to make a profit, provides more supply when supply is low or demand is high, so his action reduces the price fluctuations that would otherwise occur.

In an act of idiocy, Congress made it illegal to speculate on the price of onions.  As a result, the price of onions fluctuates much more than most agricultural products.  Its price fluctuations were used as an illustration of what happens when speculators are removed from a market by a recent John Stossel program on Fox Business News.  He also discussed oil and onion prices in a column.  The horrible onion price fluctuation history goes back to 1958.  Because of the ban on onion speculation, onion prices recently went up by 36%, worse than the price increases on oil.

The present price of oil is not up just due to speculators in any case.  Much of the rise is due to the declining value of the dollar.  Obama and the big spending government thugs want badly to distract us from this effect.  They also want to distract us from the effects that past oil field development restrictions have had on oil prices, because they wish to continue those restrictions.  The loss of a large part of the Libyan oil production also causes world prices on oil to be bid up for its present effect on supply and demand.  Some states, desperate for more tax revenue, have also increased the gasoline tax.  The continued requirements for ethanol in gasoline and the increase of mixes to 15% ethanol causes the price of gasoline to go up as well.  All of these problems are caused by governments and our government wants our attention to be on speculators, not on it.  In similar past times, the government has investigated the role of speculators about 30 times and they never find anything substantial in the investigations.  These hearings are dog and pony show distractions just as Senator Hatch complained this last week.

I made the claim that the average effect of oil speculation is probably one of decreasing the cost.  Why would this be the case?  When the price of oil is low, many oil producers will cut back their higher cost production wells.  For instance, there are oil pumps all over the U.S. that pump oil only a few hours a day or less, as oil slowly seeps into the pump area from porous rock.  Delivering this small quantity of oil to market can be a bit expensive and the maintenance of the pumps which work such a small fraction of the time is high.  They simply get shut down when the price of oil goes way down.  Minimum oil production costs and then refining costs for gasoline will set something of a floor for how low oil and gasoline prices can go.  On the up side, however, there are many critical uses of oil and gasoline that make it possible for the price to go very high when demand becomes very great and the supply becomes too little.  Many a driver will still pay for gasoline to drive to work.  Many an American would pay $8 a gallon if he had to.  Many would pay $10/gallon.  Sudden decreases in supply or of demand could result in huge upward price spikes.

Yes, these price increases will bring on increased production.  For enough money, OPEC will crank up their production somewhat.  Those hour a day pumps will surely be turned back on.  Political pressure on the U.S. government will force it to allow some new oil field development.  While some deep water offshore oil fields will take 10 years of development, there are shallow off-shore and land sources that can be developed much faster.  There are old depleted oil fields in which more expensive oil recovery measures can be justified and more oil can be squeezed from them.  Greater effort can be made in refineries to break down large oil molecules to squeeze out more gasoline.  Things can be done to bring down the high prices, but many of them take time to occur.  Over shorter periods, prices can spike upward badly.  These deleterious effects are mitigated by the much maligned speculators.  Speculators are our friends.  Governments, both the U.S. and the OPEC governments, are our enemy.


Michael E. Marotta said...

Anyone whose reality is more than an hour wide is a speculator. Household shoppers stock up on paper products or put extra meat in the freezer. Commuters fill their tanks here now or there later.

Reading the Wikipedia article about onion futures, it is hard to imagine that Sam Seigel and Vincent Kosuga could have survived their own machinations. With the Hunt Brothers and silver, at least silver is non-perishable. Not so with onions.

Perhaps the basic error in academic investigations is dividing the world into businesses, households, and governments, as if the laws of economics were different for them.

It might be said that social security is a form of "taxpayer futures."

Charles R. Anderson, Ph.D. said...

Social Security as a form of taxpayer futures is an interesting thought. Unfortunately, the citizen who may know enough to buy a stock of items on sale, has proven very vulnerable to the politician's promises of future retirement support. It has been clear from the 1960s that the Baby Boomers were going to create a major demographic problem for social security. When the Baby Boomers chose to have few children, they amplified the problems for Social Security. Thus, it has long been clear that Social Security was a dubious bet for late Baby Boomers and those after them. Nonetheless, many people still believe the IOUs of the Social Security system have real meaning. All they mean is that the government will have to tax workers much more heavily as the IOUs are cashed in. Eventually, the taxpayers will rebel and there will be cuts to Social Security. The Social Security speculators will have lost big time, which is something the professionals of the free market rarely do.