Would Obama's War on Speculators Really Reduce the Price of Oil?

Banks and hedge funds have bet billions of dollars on oil in the last decade, but it's not clear whether they're driving up the cost of crude615_Oil_Rig_Sunset_Reuters.jpg

Reuters

With gas averaging around $4 a gallon nationally, President Obama wants voters to know he feels their pain at the pump. And so, in a brief policy speech yesterday, he turned to the Democrats' favorite folk medicine for dealing with rising oil and fuel costs -- clamping down on speculators. 

"We can't afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage, and driving prices higher -- only to flip the oil for a quick profit," the president said. "We can't afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick."

Is Obama fighting a straw man here? Are unscrupulous speculators really making a quick buck at the expense of America's families? And would his proposals really have any impact? The evidence is mixed.  

WHAT'S AN OIL SPECULATOR?

In the popular imagination, an oil speculator is a sort of all-purpose villain, an oil-sucking leech from the sewers of Wall Street. The real picture is more complicated.

When we talk about speculation, we're talking about the futures market. That's where companies and investors go to buy and sell contracts for oil that will be delivered at a later date. For companies that use a lot of petroleum, such as refiners, futures are an essential way to protect, or "hedge," against the risk of price increases down the road. The Commodity Futures Trading Commission, the government agency in charge of policing the oil markets, calls these companies "commercial buyers." Everyone else? They're "non-commercial buyers." 

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These non-commercial traders are the speculators we hear so much about. They're in the market purely to gamble on price swings. This may sound malevolent, but they play an important role by making it easier for everyone, including the companies who really are using oil, to make trades. It's widely acknowledged that without a certain amount of speculation, the market would break down. 

The question is, how much speculation is too much? And is there even any such a thing? 

DO SPECULATORS DRIVE UP PRICES?

As Obama acknowledged in his speech, the world oil market is fundamentally shaped by the economic forces of supply and demand. And right now, there are plenty of rational reasons why the price of oil should be high, from temporary supply disruptions in various oil producing nations, to demand from the developing world, to the threat of conflict with Iran.

But there's also good reason to believe supply and demand isn't the entire story. 

In the last decade, banks and hedge funds have poured billions and billions of dollars into commodities, and oil in particular. Much of this money has been in the form of so-called "commodity-index funds," which let investors buy a set basket of commodities such as oil, wheat, and copper. The enormous growth of these funds came to the public's attention in 2008, thanks largely to Senate testimony by hedge fund manager Michael Masters. At the time, oil was surging towards $150-a-barrel, leaving policy-makers grasping for explanations. Masters blamed the funds, which he estimated had grown from $13 billion at the end of 2003 to $262 billion in March 2008. For perspective, in 2004, the futures market value of all 25 indexed commodities was $180 billion.

Here's a chart from his printed testimony. That growing red eye? Those are index funds . 

Commodities_Market_Futures_Size.PNG

Index funds aren't like traditional speculators. First off, because the amount of money they bet on each commodity is set at a fixed percentage, they don't necessarily respond to supply and demand changes in individual markets. More importantly, unlike traditional speculators, index funds never sell futures,* they only buy. As a result, the theory goes, they create permanent increases in demand. 

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Jordan Weissmann is a senior associate editor at The Atlantic.

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