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September 20, 2011

It's All Speculation

History’s first recorded oil speculator set up shop some 2,500 years ago. His name was Thales, and his business was olives, not petroleum. As Aristotle writes, Thales was a philosopher and, an amateur meteorologist, and, after forecasting a bumper olive crop, he trolled from farm to farm buying up the presses used to squeeze the oil that lit Greeks’ homes and softened their skin. When harvest time delivered the bounty he had predicted, Thales leased the presses back to the farmers at a profit.

Aristotle doesn’t say how much Thales drove up the cost of olive oil. It was probably hard to know: Volatile forces of supply and demand were rocking the market even as Thales was cornering it; a run of poor harvests had depressed supply and likely created pent-up demand. The same basic story is true today across global commodities markets. Institutional investors have replaced weather forecasters, but—as food, oil (the crude kind), and other commodity prices surge, and as lawmakers reprise their familiar cry against speculators piling up profit at consumers’ expense—it’s still very difficult to say how much futures traders push up the price of goods that they have no intention of consuming.

As gasoline prices shot past $4 a gallon and rising food prices jacked up grocery bills, scorn for speculators intensified in recent months. The Justice Department announced last week that it would lead a federal investigation into potentially illegal oil speculation. Under a provision of last year’s financial-reform bill, the Commodity Futures Trading Commission has proposed a rule to limit the holdings of any individual trader in several key commodity markets. Republicans have called the moves “distractions” from the need for more domestic production, particularly oil drilling.

The dispute would be easier to solve if economists or actuaries could agree on how speculators affect the price of the commodities they trade. Modern speculators mimic Thales in a core respect: They shoulder big risks and reap the rewards if they bet right. Convinced that oil is going to hit $140 a barrel in six months? There’s a contract for that: You buy at, say, $130 today, for delivery in six months. If the price rises past $130, you sell the oil for that and make money. If it falls below, you lose.

At some point in either a bubble or a panic, economists generally agree, the pressure from feverish speculators begins to push prices up. But how much and to what effect on consumers? “Nobody really knows—that’s the honest answer,” says Michael Masters, founder and chairman of Better Markets, a nonprofit group that is lobbying for strict CFTC position limits. “You can’t prove what prices have done based on financial flows or speculation, just like you can’t prove what prices have done based on supply and demand.”

Still, speculators are thought to have some effect. Mohsin S. Khan, a senior fellow at the Peterson Institute for International Economics who has written extensively on oil speculation and price bubbles, contends that speculators are probably inflating oil prices by about $15 a barrel today, compared with a bump of $50 per barrel in the 2008 spike. Even given the Middle East unrest and a growing appetite for oil in developing countries, Khan said, “there’s something going on in the markets that is not warranted by any fundamentals of demand and supply.” Should Middle East tension ease, analysts at Nomura wrote in March, “we could see a very rapid cool-off in oil prices as speculators exit the space.”

Other economic experts are more skeptical. Scott Irwin, an agricultural economist at the University of Illinois (Urbana-Champaign), calls speculation “a minor or bit player” in global food-price increases, compared with “the enormity of the supply-demand vice that we are in,” including pressures of increased wealth and consumption habits in poor countries, supply disruptions from drought and flooding, and surging demand for biofuel production.

Loose monetary policy has enabled speculation. With interest rates low, investors are flush with cash and increasingly desperate for higher returns—just as they were during the housing bubble. And with a weak dollar, foreign exporters of oil and other commodities raise prices to offset the diminished value of the dollars in which they are usually paid. But speculative or purely financial traders are playing a much bigger role in global commodity markets than they were a decade ago. The volume of trading in commodity markets accelerated rapidly in the run-up to the 2008 oil-price surge. It accelerated again—even more so—in recent months. In the 1990s boom, Masters says, about 70 percent of commodities trading was conducted by producers and consumers who were hedging their bets against market fluctuations; 30 percent of the trading was by speculators with no intent of ever seeing the stuff they were buying and selling. That ratio has reversed today.

Does the increased volume of speculative trading make any difference? Oil prices nearly doubled between January 2007 and January 2008, with West Texas Intermediate crude peaking at $133 a barrel and then crashing to about $40 a barrel a year later. It so happens that billions of dollars flooded into oil-trading funds and then drained out at the same time. But it’s also true that the financial system was imploding and that global trade plunged 12 percent in 2009, the biggest drop since World War II. Did the speculators swing the price, or did investors suddenly realize that the global economy was tanking? Hard to tell.

Better Markets is pushing CFTC to limit speculators to 30 percent of a given commodity. Conservatives are pushing the Federal Reserve Board to rein in liquidity. Meanwhile, there’s at least one market where no one is crying about speculators: Earlier this year, Spanish farmers staged protests over the falling price of olive oil.

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