Markets can operate efficiently even when people don't
understand how they work. On the other hand, policymakers can do
untold damage when they don't understand how markets work. A case
in point is the current misguided Senate proposal to regulate
petroleum futures markets.
A 2006 study by the Senate's Permanent Subcommittee on
Investigations (SPSI) is used by those claiming a causal link from
futures market speculation to higher petroleum prices.
However, evidence since publication unequivocally disproves that
finding-using the SPSI's own logic.
How Speculation Can Raise Prices
The only way that oil futures markets can affect price at the
pump is by changing the amount of gasoline delivered to gas
stations. This can happen, but it requires a specific chain of
Take agricultural markets. Farmers will not sell corn from their
silos for $4/bushel today if the price for delivery next year is
$8/bushel, because they will make more profit by waiting and
selling it at the higher price, even with storage and carrying
costs. Therefore, the high futures price can cause less corn to be
supplied today as farmers stock up in anticipation of next year's
Because many farmers will take advantage of this opportunity,
today's price rises. At the same time, next year's price goes down
because more corn has been stored for use at that time. The only
difference in price will be the storage and carrying cost.
It is possible, though, that a bubble will emerge: Speculation
on futures markets can hold too much corn off the market and raise
price to an unsustainable level. However, the speculative bubble
will pop when the silos can hold no more corn or when farmers start
to unload their inventories. At that point the price of all the
corn-both on the spot market and in the silos-plummets, and
speculators lose their shirts.
The SPSI Guessed Wrong
One characteristic of a speculative bubble is the simultaneous
increase in price and increase in inventories. This supports the
theory that a speculative bubble is increasing today's price, but
without rising inventories, there can be no link between higher
futures prices and an impact on the current supply and current
price. This is true for corn, wheat, and anything traded on futures
markets, and it is true for petroleum as well.
In fact, the SPSI report makes dozens of references to this
critical link between higher prices and growing inventories.
Indeed, it is the primary evidence presented to support their
finding of a speculative bubble.
But the SPSI misunderstood what was happening. This critical
link between higher prices and higher inventories is also evidence
of something else entirely: futures markets and speculators
effectively anticipating tighter markets and rearranging
consumption patterns to soften the blow on consumers. The price
response when inventories are sold tells the story.
If, after a period of simultaneously rising prices and
inventories, the inventories are reduced and the price holds steady
or rises, then there was no speculative bubble after all. This
pattern would instead be confirmation that futures markets
anticipated higher prices but didn't cause higher
prices. That is, in aggregate, traders on the futures markets
correctly anticipated deteriorating supply and demand conditions,
saved petroleum for the worse times, and provided additional
barrels when they were most needed.
This is, in fact, exactly what we have seen. At the publication
of the SPSI report, American petroleum inventories were at a record
high of 347.5 million barrels while price was at $70 per barrel
(not including the Strategic Petroleum Reserve). By the summer of
2008, these inventories had dropped below 300 million barrels while
prices made their most dramatic rise in history. As the SPSI report
made clear, speculation in futures markets cannot cause price
increases when inventories are drawn down.
Having not seen the drawdown of inventories, the SPSI was itself
only speculating as to the cause of the higher prices in 2006. It
bet on a speculative bubble. We now know it was a harbinger of a
Far from supporting a claim of speculator-caused petroleum price
increases in 2008, the logic of the SPSI report combined with more
recent evidence makes clear that futures markets built up oil
supplies for the correctly anticipated rainy day. The over 50
million barrels that were, in effect, transferred from several
years ago to this year saved the economy $3.5 billion.
On top of this, futures markets and speculators have other
critical functions, such as providing liquidity and reducing risk
for both consumers and producers.
More Oil, Not More Regulation
Based on a gross misunderstanding of how futures markets work
and what they do, current proposals to hobble futures markets with
additional regulation will harm both consumers and producers of
petroleum and petroleum products. A better solution is to increase
access to new energy sources. If new sources of oil are allowed to
be used, futures markets and speculators will lower the future cost
of oil, which will translate into lower fuel prices at the
David W. Kreutzer,
Ph.D., is Senior Policy Analyst for Energy Economics and
Climate Change in the Center for Data Analysis at The Heritage