Blame Governments, Not Speculators for High Oil Price

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Since August
2007, the price of oil has nearly doubled from under $70 per barrel
to more than $135 per barrel. This is of course a big problem for
the world economy. Not only will it cause massive redistribution
of resources from consumers to producers, but by making transportation
and production that uses petroleum products as an input, it will
slow economic growth. And many consumers, particularly in America,
are shocked and angered by the high prices. And since it is election
year in America, this means the politicians all say they will try
to fix the problem.

But as we will
see, it is politicians which have caused the problems in the first
place, and as no prominent politician except for Ron Paul recognize
this and wants to abolish these policies, they instead create false
scapegoats. The most popular scapegoats right now are speculators.
Investing in commodities has in recent years been increasingly popular
and certainly a very successful investment strategy, the case for
which libertarian investment superstar Jim Rogers laid out in his
book Hot
that I
reviewed on the Ludwig von Mises Institute web page
. The politicians
and their collaborators now charge Jim Rogers and others who have
followed his strategy of causing the commodity price boom they predicted
and profited from.

Yet this accusation
is based on a complete misunderstanding of how commodity markets
function, whether intentional or not. Considering how complex the
functioning of these markets in fact is, it cannot be ruled out
that it is unintentional. And even if it isn't, people need to learn
this in order to be able to see through the deception.

Starting with
the basics, commodity markets can be divided into spot markets and
futures markets. Spot markets are the markets for immediate delivery,
futures markets are the markets for delivery at some future point
in time, usually not more than a year or so in advance. As futures
contracts are constantly traded, it should be noted that someone
who buys a commodity with a futures contracts need not necessarily
be the one that buys it at the expiration date. But this is not
dissimilar to how someone who bought a commodity with a spot contract
can sell the commodity to someone else.

And just as
there is always both a buyer and a seller in a spot contract, there
is always a buyer and a seller in a futures contract. Usually though,
the buyer is referred to as having a long position while the seller
is referred to as having a short position, but that is basically
just semantics. People with long positions are in effect buyers
while people with short position are in effect sellers.

What should
further be realized is that first of all most commodity speculators
invest in futures while what matters for the price of petroleum
actually used in the economy is primarily the spot price. Note further
that commodity speculators can take both long position and short
positions. This implies that commodity speculators may not in fact
be contributing to higher prices. If speculators as a group have
equally large long and short positions then they will have no effect
on futures prices, and if they as a group have larger short positions
than long positions then their speculations will in fact lower futures

Moreover, even
if speculators as a group have a net long position, the speculators
that pushed up the futures price in the first place will, once the
futures contract approaches expiration date, face two choices. Choice
number one is to sell the contract or sell the underlying commodity
to some consumer once the contract expires. Choice number two is
to put the commodity in some physical inventory and keep it there.

If the speculators
choose the first alternative, then this will push down the price
back to the level where it would have been in the absence of the
original purchase. In this case, speculation will thus have no effect
on the spot price.

If on the other
hand the second alternative is chosen, then speculation will indeed
contribute to higher prices, at least temporarily. But while that
is a possible theoretical scenario, that does not mean it is applicable
to the current situation. The fact is that there is no evidence
of increased inventories. Indeed, according
the Energy Information Administration
, U.S. crude oil inventories
were 14 % lower in the week ending June 20 than a year ago.

Some have replied
to this argument by saying stock building for speculative purposes
need not be above ground, it could also come in the form of producers
choosing not to pump oil from the ground. But first of all, oil-producing
governments is not what is typically meant by speculators. And the
issue being discussed was the role of professional speculators acting
on the futures markets, not what the governments of Saudi Arabia
or Kuwait choose to do, so this argument is basically a case of
changing the subject. And secondly, as it happens, no evidence exist
that oil producers are choosing to reduce production for speculative
purposes. Spare capacity among oil producers is relatively low,
especially if you exclude spare capacity caused by, for example
terrorist attacks against oil facilities in Nigeria.

What then is
the cause of high oil prices and what could be done about it? As
I indicated in the aforementioned review, the boom is primarily
driven by structural long- or medium-term factors. Demand is growing
rapidly because of the rise of China and fast growth in other emerging
economies. Meanwhile, while global oil production is actually growing,
growth is inhibited in the short term both because of various political
factors that stop drilling and because of the fact that even where
such political obstacles does not exist, it takes several years
to actually extract the oil. Brazil has recently found vast new
oil reserves, and no political obstacles exist there to prevent
drilling, yet it will be several more years before that oil reaches
the world market.

These political
factors differ somewhat in their form, but none of them seems likely
to go away anytime soon. In Nigeria, as was previously stated, constant
attacks against oil facilities are holding down production there,
and these attacks looks unlikely to cease. In countries like Venezuela,
Mexico and Russia, hostility against foreign investments combined
with governments and bureaucrats starving government run oil companies
of competence and cash, means that potential oil production is held
back. And in the United States, opposition to drilling for environmentalist
reasons, mainly by Democrats, prevents increases in oil production.

Another factor
that in the short term has contributed to the sharp increase in
the price of oil is the Fed's inflationary monetary policies. Because
the price of oil is much more flexible than most other prices and
it is immediately affected by, for example, exchange rate effects,
the short-term effect of an inflationary monetary policy is much
greater than the short-term effect on the more sticky prices of
regular goods in the supermarkets. That the oil price increased
so much after the Fed started its aggressive interest rate cuts
was not really a coincidence.

What then can
be done about the high oil price? The long-term solution is to reduce
or abolish taxation on oil production and to abolish all regulatory
restrictions (whether motivated for environmentalist reasons as
in the U.S. or nationalist reasons as in Mexico) on oil drilling.
Opponents of drilling often reply to this that it won't provide
any short-term relief. But while that is true, but there won't be
any short-term relief without drilling either and the point of drilling
is to provide long-term relief. Moreover, their preferred solution
of having the government invest in research to invent more so-called
renewable sources of energy is likely to take even longer to provide
relief (if it ever provides relief).

To provide
short-term relief, different solutions are needed. This means, for
example, that the U.S. government should start releasing the oil
held in the so-called Strategic Petroleum Reserve, while the Fed
should stop its inflationary policies.

I don't think any of these solutions are likely to be implemented
anytime soon, which is one of the reasons why I am not as optimistic
as Don
about the possibility of a significant price decline
in the near future. However, while the oil price is unlikely to
go down, we should always remember that it is governments and not
speculators that are responsible for the all-too-high oil price
we suffer from now.

28, 2008

M.I. Karlsson [send
him mail
] is an economist working in Sweden. Visit his

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