Planet Gore

An Unconventional Fix for Fuel Prices

An astonishing thing happened last Thursday and Friday: oil on the New York Mercantile Exchange rose by almost $17 per barrel, or roughly 14 percent. At the same time, the wholesale price for unleaded gasoline added another $0.36 per gallon, or 11 percent.

Media and analysts were quick to blame this unprecedented spike on the declining value of the dollar, on brewing tension between Israel and Iran, and on increasing demand for oil in China, India, and other expanding economies. But this was a market event, not an economic or geopolitical one: Futures trading and speculation is unquestionably putting upside pressure on oil prices.
Those skeptical about investors’ role in rising energy costs should be persuaded by last week’s events. The time has come to consider new commodities-futures regulations in order to prevent an unnecessary speculative oil spike, with all the collateral economic damage that will attend it.
Nothing makes conservatives queasier than regulation, especially of financial markets. But oil’s meteoric rise from $50 in January 2007 to almost $139 on Friday calls for drastic measures that might solve this crisis without a measure as drastic as the gas tax Charles Krauthammer proposed on Friday.

In the past, energy price appreciations of last week’s magnitude have typically been caused by supply disruptions — like the 1973 OPEC embargo, or the 4 million barrels per day in lost production that followed the Islamic Revolution in Iran in 1979, which restricted international oil supplies for several years and caused a spike in prices.
In this decade, though, world oil production has continued to rise, making it difficult for simple supply and demand to explain the explosion in oil’s price from $20 in 2002. The Energy Information Association reports that since 2002, world petroleum production has risen from 76.995 million barrels per day to 84.594 million barrels per day in 2007, a 9.87 percent increase. Over the same period, demand has gone from 78.036 million barrels per day to 85.354 million barrels, a 9.38 percent increase. So total world oil production actually rose faster than demand, but prices increased by almost 400 percent nonetheless. Kind of throws a monkey-wrench into blaming this crisis on China and India’s lust for crude, doesn’t it?
The fact is, the explosion in oil futures trading on the various exchanges around the world has unquestionably been a huge factor in the nearly 200-percent increase in oil prices since January 2007. How huge? Estimates vary.
Back on May 5 (or $24 ago) energy economist F. William Engdahl claimed that 60 percent of the $115 that oil cost per barrel (a full $69) could be chalked up to “pure speculation driven by large trader banks and hedge funds.” Mary Novak of Global Insight similarly told the Pittsburgh Tribune-Review that the speculation was the culprit in driving up the price of oil: she estimated that without such speculation, “the price of crude could plummet to $75 or $80 a barrel.”
And that’s probably a conservative estimate, given all the activity on the New York Mercantile Exchange that’s being driven by index and pension funds. The Financial Times reported on Thursday that these passive, speculative investors in commodities “have invested $260bn (EUR169bn, £133bn) in commodity markets, compared with $13bn just five years ago. Much of this money is in oil.” FT noted also that “the daily volume in the 2008 contracts on May 21 was 657.391 contracts, equivalent to 657m barrels or nearly 8 times the daily crude oil production. [emphasis added]” Think that level of trading volume is not impacting prices? Think again.
The time has come to consider some regulatory fixes. I offer three for your consideration: reducing the position limits that speculators can be long or short; increasing the margin requirement for speculators; and empowering the Commodities Futures Trading Commission to regulate energy contracts traded by Americans on exchanges outside the U.S.
Reducing Position Limits for Speculators

Each commodity future traded on an American exchange has a fixed limit as to how many you can own or be short. This is designed to prevent someone from cornering the market. However, this limit is the same for everyone — whether you are a supplier, an end-user, or just a speculator.
Maybe this is the problem. After all, when commodities trading began in Chicago in 1848, it was designed for farmers, ranchers, slaughterhouses, and food producers to be able to flatten out cyclical and seasonal fluctuations while locking in prices months out. This made it easier for them to run their businesses.
However, today a very small percentage of oil contracts are being bought and sold by oil companies or end-users looking to hedge against future price movements. Most sales and purchases are coming from traders with exclusively one goal: to make money on oil’s rise or decline.
To be sure, this is nothing new. But, since momentum trading became all the rage in the ‘90s during the tech-stock bubble, it has been the prevailing investment strategy for most professional speculators. In the early part of this decade, residential real estate saw most of the pile-on cash. More recently, it has shifted to commodities, and energy in particular.
As the Financial Times has noted, financial institutions now have $260 billion invested in commodities (mostly energy), compared with only $13 billion in 2003, a staggering 1,900 percent increase. Think this might have something to do with the nearly 600-percent increase in the price of crude since the beginning of 2002? You bet.
As such, reducing the number of contracts on which a speculator is allowed to be long or short would drastically reduce trading volume and the upside pressure on prices.
Increase the Margin Requirement for Speculators

To purchase stocks on margin, investors must put up 50 percent of the purchase price. In the commodities market, investors are only required to put up 10 percent. In oil contracts, this can be as low as 7 percent. And hedge funds might only have 1 percent of their money on the line — or even less — allowing them to purchase significantly more contracts.
If margin requirements for traders and investors were raised, the amount of contracts they could hold for a given dollar of their own money would decline, reducing the demand for contracts. The Financial Times agrees:

The best way to counter speculation is to make it less profitable. Step one is to protect the regular traders in the real oil economy (those who intend to close their positions by making or taking delivery of oil) and charge them a lower margin than those who have no intention of plying the oil trade. The purely financial traders must be made to pay a proper price for their speculation. This can be done simply by increasing the margin that they have to put down to trade as open interest, from the current 7 per cent to about 50 per cent.

Re-modernize the Commodities Futures Modernization Act of 2000

The final element in the volatile oil-price mix is the fact that American investors and hedge funds can purchase an unlimited amount of energy contracts on foreign exchanges, such as London’s Intercontinental Exchange. As NewsBusters reported back in 2006, legislation signed by President Clinton in December 2000 removed trading on such exchanges from regulation and oversight by the CFTC.

As a result, an American investor or hedge fund can purchase an unlimited number of contracts on these foreign exchanges — with absolutely no position limits — which dramatically adds to oil demand internationally.
Last month, the CFTC did announce an initiative designed to refocus its attention on foreign energy markets. However, it fell short of eliminating the loophole which allows investors to skirt American position limits by trading on international exchanges.
Waiting for Bubbles to Burst Isn’t Sound Policy

Speculation is an integral part of the free-market economy. However, speculation in inelastic commodities — the things we all need every day in order to survive, like food and energy — can have enormous impacts on our personal finances as well as the economy. The connection between the recent explosion in oil prices and speculation on futures exchanges is clear: it’s both logical and salutary to reduce or prevent such non-essential price pressures.
To be sure, the pure anti-regulation capitalist might argue that doing such could end up having unintended consequences — and that the bubble will burst on its own, moving prices dramatically lower. That’s true — proven by precedent time and again.
But how high will it go before it crashes — and at what cost to the economy and the consumer? This is especially important given the amount of money financial institutions currently have at risk, and the possibility of future government bailouts like the one that followed the sub-prime mortgage collapse earlier this year.

America is now experiencing its third asset bubble in only ten years. When the first one burst, it was followed by a recession, a three-year bear market in stocks, and the largest loss of net worth in the country’s history. While there is debate over whether the real-estate explosion this decade was a bubble or a boom, its bust is currently having a very negative economic impact, the end of which we have yet to see.
There certainly could have been some simple investment-banking regulations that would have limited the number of worthless, product-less companies that came into the market in the 1990s, but which had no business doing so. Similarly, tighter lending rules would have prevented the kinds of loans that made it possible for individuals and speculators to purchase houses they couldn’t really afford.
Are we ever going to learn from the past, and act to quell bubbles as they’re happening rather than waiting for them to burst — and only then create legislation to prevent that asset from bubbling again? And shouldn’t the price of basic needs like food and energy be determined by simple supply and demand ratios, without the added pressure of momentum traders with billions of dollars at their disposal?
As a pure capitalist, I’m all for defending the free market. However, with food and energy prices going through the roof largely due to commodities speculation, calling these markets “free” seems a tad oxymoronic.

Noel Sheppard is the Associate Editor of the Media Research Center’s NewsBusters.

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