Wednesday, June 25, 2008

Free Market Proponents Call for Regulation on Speculative Oil Futures Trading: Define Irony

Analysts say speculative oil trading is to blame for gas prices at $4 a gallon. Congress considers regulation and legislation. What happened to market forces of supply and demand?

In the 2005 movie Syriana an oil company executive quotes Nobel Prize winning and renowned economist Milton Freedman: “Corruption is government intrusion into market efficiencies in the form of regulations”, he says. Freedman, one of the strongest proponents of the free-market, promoted the view of minimal government intervention in the markets as a means of creating political and social freedom.

We are born and raised according to the theoretical concepts of the free market and we are diligently taught the rules of the ‘vanishing hand’ and market forces at work. Our economic upbringing and formal academic education teaches us about market efficiencies and perfect competition only to face, later in our lives, a very harsh and different reality.

Gloating isn’t the best of qualities, yet I couldn’t avoid it when I read about a recent congressional panel regarding rising oil prices. Four senior analysts testified before congress claiming speculators are to blame for $4 a gallon gas prices.

The four senior analysts are: Michael Masters, who heads up Masters Capital Management, Fadel Gheit of Oppenheimer & Co., Edward Krapels of Energy Security Analysis and Roger Diwan of PFC Energy Consultants.

All four analysts agreed limiting speculators’ participation in energy markets will lead to sharp drop in oil prices to the economically reasonable level of $65-$75 derived by supply and demand.

Apparently Congress is looking to revise legislation to do just that. There are several bills at work trying to limit or even remove speculation from energy markets.

More than 63% of oil futures owned by speculators

According to the Energy and Commerce Committee speculators now control overwhelming amounts of the oil futures market.

The economic function of a future contract is to enable any corporation to hedge its business and fix the price of oil in a future business deal, either paid for or sold. Imagine oil companies who wish to raise the level of certainty behind their revenues. They will offer future contracts to buy oil in certain prices in a future given time. Should a trucking company find those prices reasonable a deal is closed today with known prices for both enabling them to smoothen out uncertainties in future business.

The level of contracts owned by speculators rose from 37% of the contracts in 2007 to 63% in 2008 with the rest owned by oil refineries, trucking companies, wholesalers and other end users.

Imagine all that speculative money removed from the market. Suddenly an overwhelming over-supply is created and prices drop sharply.

The following are more charts presented before the committee. They are real eye openers:

The massive increase in speculative investments is evident from the charts. Another important observation is the level of relative growth in speculative investments:
More regarding economic theory, free markets and reason

Projecting the case of speculative investments on Milton Freedman’s entire economic philosophy is a huge over-simplification and I won’t be going that way. I only wish to illustrate the delicate balance that need be between the freedom of markets and government regulation.

Lack of proper regulation enables speculators to take advantage of market failures. Sadly it’s not a perfect world and there’s no real ‘vanishing hand’, perfect competition and market forces. There are opportunities and opportunists grabbing what is left open for grabbing.

There’s no doubt speculative activities contribute to market efficiency. The price of a lack of proper regulation and supervision can be very high.

Ayn Rand, the noted author and philosopher who wrote the infamous book “Atlas Shrugged” believed and promoted, wholeheartedly, the concept of freedom and objectivism. She is quoted for writing, much like Milton Freedman that “Every government interference in the economy consists of giving an unearned benefit, extorted by force, to some men at the expense of others”.

As an idea these words echo strongly. The problem is they are often correct the other way around. A Lack of government interference in the economy might give unearned benefit, extorted by force, to some men at the expense of others.
If we’ve sunk deep into philosophy than we may also recall Thomas Hobbes and Jean Jacques Rousseau’s words regarding the government:

“That a man be willing, when others are so too, as far forth as for peace and defense of himself he shall think it necessary, to lay down this right to all things; and be contented with so much liberty against other men, as he would allow other men against himself” (Thomas Hobbes)

“As soon as any man says of the affairs of the State "What does it matter to me?" the State may be given up for lost” (Jean Jacques Rousseau)

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Praveen Puri said...

Hi Dorian,

I believe that knee-jerk reactions from politicians who want to be seen as "doing something" tend to cause problems in the future.

I don't agree with the statement:

A Lack of government interference in the economy might give unearned benefit, extorted by force, to some men at the expense of others.

The speculators are not using force and they earn their return by adding liquidity to the market.

"Speculator comes from the Latin speculari, to spy out, examine.

A successful speculator uses his insight to buy low and sell high.

It's a beautiful symbiosis: the more a speculator buys low / sells high, the more he adds liquidity to the market, and the more reward he gets.

I would say that eliminating the speculator's reward would be extorting them.

If the politicians want to eliminate speculation, they should first talk to Southwest Airlines.

Southwest is the only airline making money because it was able to afford to pay for fuel hedging.

If there were no speculators to add liquidity by trading futures contracts, then hedging would be nuch more difficult and expensive to achieve.

Chad @ Sentient Money said...

I have disagree with Praveen and agree with your post Dorian. Speculation is a problem right now. Here is link (not my site) to a great article on oil speculation:

By the way, I just found your site Dorian and have enjoyed it.

Dorian Wales said...

Hi Praveen and Chad,

Thank you for your comments.

Praveen, I believe the mere fact hedge funds and other speculators are able to generate legendary returns tells us a lot of the story.

I agree liquidity is essential to the markets but just take a look at the US Dollar and the Icelandic economy, or oil for that matter that seem to have fallen victim to heavy speculation.