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 have hurled pejoratives at them and called for reining them in.
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.”
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 [emphasis in original] reduce the quantity of oil available for consumption; there’s no such thing as ‘virtual hoarding.’”
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.