* Ban economic speculation by lawyers, not commodity speculation

Topics: Regulation
22 Jul 2008

From: "Ervan Darnell (by way of Ervan Darnell )"

>Legislation meant to crack down on oil speculators passed a key test vote Tuesday in the Senate. Democrats want to increase regulation to stop speculation in petroleum markets.
>The test vote on the legislation, which the Democratic leadership backed, was 94-0. [...] Sen. Byron Dorgan of North Dakota, one of the Democrats sponsoring the bill, said the quickest way to lower prices at the pump is to stop speculators from driving up the price of a barrel of oil. [1]

This shows a complete lack of sense of how markets work and is a pathetic political stunt to divert blame from real causes. It's akin to the Kansas school board voting on the validity of creationism. Even the Republicans went along with this nonsense.

>Reacting to the unanimous Senate vote, White House spokeswoman Dana Perino said the Bush administration agreed that speculation had contributed to volatility in the oil market but that "the root causes of high energy prices is supply and demand."

At least Bush showed a shred of sense, though he still missed the mark. On tonight's NewsHour [2], Hutchison (R) expressed how foolish it was while Reid (D) endorsed the idea, so Democrats are totally wrong here and Republicans somewhere in the middle.

Speculators make money by guessing where the market is going in the future, not by bidding it up [2]. If they are wrong, they lose (when market fundamentals push the price back in line). Some money will be made on the way up, but more will be lost on the way down. Speculators profit only if they are right, which in the long run they usually are. Pushing the price of gas up now to reflect the future is a good thing. It signals people to start conserving, finding alternate sources, etc. because things will (likely) get worse. Also, buying the futures contract lowers prices in the future because it means people are hoarding oil for when we'll need it more. Thus, it stabilizes prices in the long run and achieves a more optimal distribution. The Congress's clueless alternative is to (partially) price fix it artificially low and let the well run dry abruptly in the future with no buffer.

It also provides instant feedback. Bush bullies Iran, the price of oil shoots up. The most informed people have provided free information about the cost of policy alternatives. That's good. No wonder the politicians want to prohibit speculation, so you don't know the impact of their bad decisions (this is especially useful when currency traders punish Third World dictators for bad decisions).

There is a third reason: liquidity. Southwest Airlines bought several months of jet fuel on the futures market as a hedge against prices. That's good for them as they can predict better what planes to fly (profitably) and good for the consumer as it helps stabilizes prices. But it requires speculators on the other side. There has to be enough cash in the market to make it interesting for speculators to take such bets. Consumers and supplies of oil alone are not enough to "make a market".

If you believe speculators can run up the price arbitrarily, there is a trivial fix: buy oil futures yourself equivalent to the gas you consume. As gasoline prices and crude oil prices move together (more or less), you'll profit in one what you lose in the other, and thus lock in today's prices (for an insurance premium equal to the option cost). Too sophisticated for the average Democrat you say? Okay, let some enterprising company do it and offer gas at their station where you pre-buy six months worth at a fixed price (and on an installment plan). Nobody does that of course, and for good reason: the base claim is nonsense. Its own purveyors don't even believe it.

It's interesting to contrast this with the mortgage crisis. That too is a case of prices being run up ahead of demand by speculators. And, now, those speculators are losing their shirt, as they should, because prices are returning to their fundamentals (the difference being real estate speculators are amateurs who didn't know what they were doing and commodity speculators are the best informed people anywhere about future prices). In the real estate case, the Democrats are doing just the opposite of the oil futures case, trying to subsidize the speculators with bailout plans to keep the prices artificially high (and reward foolish behavior). Whatever happened to help the poor guy? Prices are falling and housing will become more affordable, but apparently that's a bad thing. Of course, it's obvious why: futures traders are likely Republicans and lower middle income people who invest foolishly in real estate are likely Democrats.

[1] http://www.cnn.com/2008/POLITICS/07/22/congress.oil.speculators/index.html

[2] "pump and dump" works only to the extent that someone is being deceived to buy based on false information. That's a problem, but it's a problem of fraud, not one of speculation.

[3] 7/22/08 NewsHour (no link available yet).

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