Andreoli on Oil and Fuel: Never trust a politician to explain oil prices

I believe in markets. I believe that when supply falls short of demand, prices increase; and in doing so send signals to consumers to conserve and producers to invest. I bet you agree.

Yet, when it comes to the price of oil and fuel, a significant portion of the population believes that Wall Street speculators are responsible for driving prices above the level supported by the fundamentals of supply and demand. While this explanation may be politically expedient, it reveals more about the politicians who have been promoting it than the oil market itself.

Shortly before penning this article, 70 members of Congress signed a letter addressed to the Commodity Futures Trading Commission (CFTC) urging the agency to lower position limits and increase margin requirements. Position limits cap the number of open trades that a single firm or individual can take, and margin requirements are the amount of collateral that must be posted to protect against credit risk.

Position limits can conceivably have some effect on the market-moving power of an individual institution, but to date nobody has demonstrated that this power currently exists. Lifting margin requirements, on the other hand, is like using a screwdriver to hammer in a nail. Margin requirements are tools for managing credit risk. They are not designed to dampen prices or minimize volatility. More importantly, increasing margin requirements will disproportionately impact traders with less capital, thus concentrating power in the hands of the larger players. 

The letter further urged the CFTC to “utilize all authorities available to…make sure that the price of oil and gasoline reflects the fundamentals of supply and demand.” To borrow the language of the Dodd-Frank Act to which the letter refers, the CFTC is being pressed to curb “excessive speculation.” But precisely when does speculation become excessive?

If excessive speculation is defined as speculative activity that pushes the price above the level supported by the fundamentals, the letter will fall on deaf ears.

The CFTC’s own investigation of the impact of speculation on the oil market determined that there was no evidence that the 2008 price spike resulted from the actions of speculators. Rather, the report concluded that the price spike was the result of surging global demand and stagnant production—a viewpoint that happens to be supported by the data.

At the request of Congress, the Congressional Research Service (CRS) studied the effects of speculation on oil prices. The CRS concluded that although rising prices are correlated with an increase in speculative positions, the line of causality could just as easily run in the opposite direction than is commonly assumed. It is not unreasonable to suspect that tight markets and rising prices lured investors to purchase oil futures.

The CRS clearly states that: “The data do not support an argument that recent oil price spikes are the result of large, sudden inflows of speculative funds.” Regarding margin requirements, the CRS further concluded that there is “no empirical evidence that higher margins dampen price volatility.”

If the actions of the 70 signatories in Congress prove anything, it is that the CRS findings have fallen on deaf ears.

Market fundamentals in 2012
So, are the market fundamentals different this time around? Yes and No.

When demand grows faster than supply, surplus oil production capacity diminishes. During the prolonged price run that culminated in the 2008 price spike, surplus oil production capacity diminished from 9 percent of total liquid fuel consumption to just over 1 percent.

The global recession that ensued pulled down demand, and surplus capacity climbed to over 5 percent. Since the first quarter of 2010, surplus capacity has been declining and prices have been rising. This time around, however, tightening markets have been accompanied by rising geopolitical tensions that threaten to wreak further havoc on oil markets.

Geopolitical risks are to some extent priced into the futures market, and as high as prices are today, they would be much higher if Europe was not at risk of diving into a debt-induced recession.

Rising prices suppress demand and inspire upstream investment in exploration and production. As such, they are precisely what the world needs given the trend in declining surplus capacity.

The short answer is a qualified, yes. Speculators and hedgers collectively set the price through the positions they take on futures markets, but they are only reacting to the fundamentals. Of course, these same energy traders are also responsible for the historically low natural gas prices that we currently enjoy, and in both the oil and natural gas futures markets, trades are based on a reasoned analysis of market fundamentals adjusted to a risk premium.

Given that this is an election year, it’s easy to understand the temptation to scapegoat, and Wall Street speculators make an easy target. But speculators are not to blame. They simply translate the fundamentals into a price, and they do so collectively through their trades.

The position limits and margin requirements outlined in Dodd-Frank won’t solve the problem of high prices and high volatility, though they will likely transfer some trading from the more regulated NYMEX to the less regulated Intercontinental Exchange, which is where Brent oil futures are traded.

And this brings up another relevant point. If NYMEX speculators are driving the price up, why has the price for WTI fallen against Brent? The answer is simple. Speculators are reading the fundamentals, and the fundamentals of WTI are different than Brent.

Political grandstanding and “sloganizing populism” is not only ineffective; it is counterproductive. Chasing scapegoats confuses the average Joe, which will only make intelligent energy policy that much more difficult to design and enact.

More importantly, chasing scapegoats does nothing to help your bottom line.