Don't blame speculators for Obama's policy decisions

President Obama recently stated he would be forming an inquiry into petroleum futures markets to ensure there has been no price fixing or gouging that might have harmed consumers. The President (and many on both the Right and Left) have made “Speculators” their on-again/off-again scapegoat for high fuel prices for at least the last decade. They posit that speculators have driven up the price of petroleum outside of normal supply and demand and have done so to line their own pockets.

“The truth is, there’s no silver bullet that can bring down gas prices right away,” Obama said in prepared remarks for his opening statement at a townhall-style meeting in Nevada.

“The Attorney General’s putting together a team whose job it will be to root out any cases of fraud or manipulation in the oil markets that might affect gas prices – and that includes the role of traders and speculators. We are going to make sure that no one is taking advantage of the American people for their own short-term gain,” Obama said.

This simply isn’t true. In fact, futures traders have an important job of ensuring that the supply of fuel, food or other products never run out as long as people demand them. Rather, if the President wants to know who is responsible for high fuel prices, he need only look in the mirror. It is the government that has played a heavy hand in raising the cost of fuel and other products to the high levels we see today. The “speculators” are just doing their job and dealing with the consequences of poorly-conceived goverment actions.

Futures traders buy and sell commodities. A commodity is any product that is essentially exactly the same no matter who is providing it. Commodities aren’t affected by from where it’s coming or to what point it’s going. Corn meal, wheat, oranges, coal, iron, pork bellies and petroleum are all commodities. Even many services and finished goods are considered “commodity-like” products, but for the puproses of this discussion only true commodities will be evaluated.

So futures traders spend their whole day studying the marketplace for their particular commodity. Some study weather and pay close attention to drought or frosts or floods to determine what likely price of a bushel of wheat or corn will cost. They may spend hours calculating the current inventory of finished aluminum and the number of 747s Boeing has on its order books to determine next quarter’s bauxite prices. There are literally thousands of resources that these futures traders deal in and work to ensure a stable supply to meet market demand.

Futures traders spend thousands of hours and millions of dollars on computer programs that accurately model market fluctuations based upon factors that most of us don’t even realize are important. New information is received every minute and one small bit of information could drastically affect the result of those models, subsequently affecting the price of a commodity.

The price of a product is a form of communication. The supply factor of price is the producer saying, “This is how much I spent in resources and my valuable time to provide this product to you.” When the price of a product rises, it communicates to everyone that there is a shortage of that product. Consumers have the choice to switch to an alternative or simply use less of it. Producers have an indicator to increase production of it. Entrepreneurs have the option to develop new businesses that produce more of it. It’s immediate communication and the producer and final buyer never even have to know who the other one is.

That’s the communication of supply. There is also communication of demand. No one individual ever says it, but the market communicates, “I demand more of this product!” Producers only have so much product to provide. If there is more demand than there is product, those demanding it start raising their offered price. As the price goes up, some buyers choose to buy less but still have to pay the higher price. Eventually, the amount the buyers are willing to pay matches the amount the producers can afford to provide for that price.

It works the other way around, too: If there is too much supply, consumers will demand a lower price or they won’t consume all of the products. When the price falls, producers know they should switch to producing other products or simply cut production.

All of business, the entire study of economics, is devoted to reaching that point where the amount that people demand of a product matches the supply, and by-and-large the world wide economy does a good job of getting it right. It’s never exact (there are always shortages or surpluses of something, somewhere), but it’s always close.

So the price of oil has risen drastically in the last few months. Producers are communicating that demand has been increasing. Meanwhile, the immediate supply of petroleum hasn’t increased all that much, and the long-term known supply isn’t increasing, either. What’s the cause of this? There are a multitude of factors. Some of the most important ones are:

  • Increasing demand in China, Brazil and other developing countries for petroleum and related products for fuel, plastics and fertilizers.
  • Tight controls over supply coming from the largest producers including OPEC and Russia.
  • Restrictions on drilling for new supplies in developed countries like the United States and other nations.
  • Disruptions in supply due to unrest in oil producing countries like Venezuela, Mexico and Libya.

The commodities traders take all of this into account and put the information into their models. They start making predictions based upon those models and they offer futures contracts to producers. “On a particular date, I will buy some barrels of oil from you for a certain price per barrel.” As they add information to their models, the predicted outcomes change and they buy more contracts or sell the ones they have to other traders. The objective is to buy the contracts at a lower price than they will eventually sell them.

In the meantime, the traders are also working on selling their mature commodities to end-users. The final buying price from the producer is set at some point before the commodity is due, but the eventual selling price may still change. At some point, that price is finalized, too, and the traders give the contract to their buyer, who collects the commodity.

In growing markets, the traders tend to do well. If demand keeps increasing with no increase in supply, or supply suddenly decreases with no decrease in demand, the traders have an easier time buying their contracts low and selling the commodities high. That’s what we’re seeing today: Worldwide demand is increasing and supply is not keeping pace. The traders are making their profits on the inevitable increase in price. Conversely, when the markets decline the traders don’t do as well. Their contracts become less valuable and they may sell them at minimal profit or even a loss.

It’s not the futures trader’s fault that the prices are going up. They’re simply putting all the information together to make sure the price (and therefore the demand) matches the supply of the commodities. Someone who doesn’t understand this may look from the outside and think, “They’re controlling the prices and getting rich off of it!” In fact they may be getting rich, but they’re not controlling the prices so much as they’re ensuring the price offered matches the supply demanded.

Once again, the increasing prices are indicating to the market that the supply of oil is not keeping up with demand. In the case of corn meal, it’s an indication to grow more corn. Increasing iron prices indicate a need to mine more iron ore. Rising oil prices indicate a need to drill for more oil.

There’s a hitch, however, in the oil markets. There’s a restriction on the supply of oil. OPEC restricts its member countries from producing oil, but high prices give a strong incentive to cheat (and most OPEC member states do cheat on their quotas to some degree). There’s nothing the United States can do about OPEC other than invade and conquer those countries for their oil. While many on the Left contend that’s what President Bush did in Iraq, it certainly didn’t have the effect of lowering oil prices! Besides, OPEC only controls about 40% of the world’s oil supply, so there are several more countries that would have to be invaded for such a plan to work to the benefit of this country.

There are two other solutions: The first is to drill for more oil. The United States has plenty of oil that isn’t being tapped. The second is to develop a reasonable alternative energy source. There are entrepreneurs working on myriad different solutions to the energy crisis. Unfortunately, the politicos in Washington and some state capitals have decided that drilling is simply too gauche for a modern, enlightened society. Only 60 offshore permits have been issued since the Deepwater Horizon spill, far below the normal number. They’ve further decided that energy security should take a back-seat to providing corporate welfare for agricultural corporations to produce highly inefficient corn ethanol, harming the private sector’s ability to enter the market with a feasible alternative to this wasteful additive.

So we’re stuck. The price of gasoline is already over four dollars per gallon in some areas and is rapidly approaching that level nation-wide. We can’t drill known supplies here, so we have to look for it elsewhere, increasing the time it will take to get to market, raising today’s price at the pump.

The President is making political hay out of the rise in oil prices, whipping up populist fervor against “Big Oil” and commodities traders.  He’s profiting politically off higher oil prices amongst the economically illiterate. As the President gathers suspects for people manipulating oil prices for personal gain, he’s certain to leave out the most obvious guilty party: Himself.