Tuesday, June 24, 2008

Politicians' oil argument is flawed

Due to the sheer amount of misinformation and flat out nonsense being broadcasted on the subjects of oil and commodity prices and the supposed price manipulation by speculators, it's important to seek out information from more truthful or knowledgeable sources, rather than relying on the suppositions of ignorant politicians and media demagogues.

With that in mind, I wanted to share a very fine article with you from today's (June 24) Financial Times. Hopefully, it will help to dispel some of the "evil speculator" myths that are still floating around.

In, "Politicians' oil argument is flawed", John Dizard writes of his surprise over politicians' continued willingness to make dogged attacks on commodity speculators, as traders and index investors are blamed for fueling recent price rises of oil and agricultural commodities.

Here, Dizard responds to those who argue that investment demand for commodities (expressed through investor purchases of long positions in futures contracts) is creating artificially high prices for much needed resources.

"Now if it were true that pension funds, insurance companies, evil hedge fund managers etc were all buying large quantities of physical products such as silos of grain and storage tanks of oil, then the peasants with the torches, and their leaders, would have a point. But the investors aren’t buying physical product.

For example, one of Senator Lieberman’s favourite witnesses, hedge fund manager Michael Masters, compared an 848m barrel increase in index speculators’ positions over a five-year period with the 920m barrel increase in Chinese demand. In other words, the speculators were almost as big as China.

Nonsense. Speculators only increase the demand for oil, or any other commodity, when they buy physical product and hold it off the market. So to match the real Chinese demand over that five-year period, the institutions would have had to build an astonishing amount of storage capacity. Using Mr Masters’ numbers, they would have had to fill storage tanks with more than 40 times the capacity available at the Cushing oil terminal in Oklahoma, which is where the WTI (West Texas Intermediate) oil contract is valued. Didn’t happen."

Ah, now we're getting somewhere. You might also be surprised to hear Dizard's claim that certain government policies are having more of an effect on oil prices than speculators. Read the whole thing and find out why.

And as Simon Denham notes in this Telegraph article, any government legislation that seeks to bar investment funds from the futures market or limit speculation is likely to end up driving trading activity over to European exchanges (disclosure: a family member is a CME shareholder).

"So the US is getting hot and bothered once more about those nasty ‘speculators’ who are apparently driving up the price of oil. The Senate looks to be at odds on whether to pass some type of law restricting ‘non end user’ trading in commodities.

Skipping over the rather unfortunate fact that the price actually rose (from $100 to $135) while the exchanges estimate that speculative positions have been pretty much flat. For the country that has been the bastion of capitalism for the last 120 years to moan about the effects of supply and demand and effectively say that “it is not fair, we want to change the rules”, smacks of desperation.

Fortunately for the UK and Europe (whose Futures exchanges would be the main gainers), it appears that US law makers are going to have another Sarbanes-Oxley moment and cripple their futures exchanges."

So we have that to look forward to...

But that's not the only interesting point Denham makes. He also reminds us how the futures market actually works:

"The fact is that futures markets are ‘no net gain’ exchanges, for every buyer there must be a seller. If a big fund is buying oil, up there must be somebody on the other side willing to sell to them and not only this, but at some point, the buyers must unwind their positions.

This would mean that if they really had been just forcing a market higher by buying everything in sight, then when they came to get out of their long positions, the price would fall just as fast, (in fact probably faster, as the commodity would not have the natural resistance to being in uncharted territory to hold it back)."

As the final thrust to his article, which is aptly titled, "Critics of oil speculators and short sellers are missing the point", Denham notes that the furor in the US over "speculative" buying of oil is balanced by British lawmakers' outrage over "speculators" short-selling bank stocks.

Still he wonders, would anyone complain if the targets of buying and selling were reversed, so that speculators were selling oil and buying banks? We doubt it too.

Related articles and posts:

"Plan to bar funds from commodities garners few fans" - MarketWatch.

"Tighter US commodity trading laws may be boon to foreign exchanges" - Pensions & Investments Online.

"Oil vs. Nasdaq: the "bubble view" - Finance Trends Matter.

"Oil: inflation meets tight supply" - Finance Trends Matter.

"Charles Maxwell: $200 oil possible on supply & demand" - Bloomberg.

"Speculators not to blame for high oil prices" - Robert Murphy, IER.