Wednesday, June 11, 2008

Do Speculators Cause Oil Price Inflation?

Previously, the esoteric notion of speculators as a predatory investor class was discussed. Many of these institutional investors and pension funds are acting as agents of retirees, public servants, and individual investors in their quest for greater diversification and higher returns. The media has demonized this anonymous notion of speculators while presidential candidates have proffered images of exploitive hedge fund managers that earn billions in fees while Americans suffer at the pumps. Somewhere amongst all this noise lies the truth.

There are two markets for oil that differ in function, but are intrinsically related. The spot market is a delivery market with the spot price representing the current value of oil flowing from the giant oil tankers offloading their black gold in Texas, New Orleans, or other major refining centers. The futures market represents contracts for future delivery of oil consistent with a certain quality level. Futures prices and spot prices often differ, but due to arbitrage relationships are related based on the factors of storage costs, interest rates, and the convenience yield (the current value of holding physical oil vs. oil for future delivery). As the expiration of futures contracts nears, all of these factors become less relevant and the futures price and spot price must converge.

Speculators’ influence on spot oil prices is dubious at best. Ultimately, on any given day, the supply and demand for oil determine the market price. The large sunk costs incurred by previous capital investment in vehicles, power plants, machines, and equipment that require petroleum for fuel results in highly inelastic demand for oil (i.e. a relatively low impact on demand with changes in price). While oil prices have risen well over 100% in the past year, recent reports suggest that fuel consumption in California has only dropped 4% year over year.

With the inelasticity of demand established, consumers plead for additional supply. The large capital investments required to locate oil reserves, build oil wells, and construct pipelines for delivery necessitates long lead times before new production can be brought online. A strong opposition to domestic drilling has further exacerbated this growing problem over the past 5 to 10 years. Currently, supply and demand are in such fragile balance that small shocks can send oil prices soaring (or plummeting).

Speculators, characterized as investors with no intent on taking delivery, have little impact on the market price of oil. If the futures contract expiration date nears and futures are trading rich to the spot price, a speculator could buy oil in the spot market and sell oil futures. When the contract comes due, the speculator would deliver oil to the counterparty of the futures contract, which would be an actual oil consumer. This arbitrage will occur until spot prices and futures prices converge, effectively clearing the market based on supply and demand. Conversely, if spot prices are rich to futures, oil producers would want to sell oil in the spot market at higher prices. That increase in supply will drive spot oil prices down forcing convergence with futures prices.

Ultimately, spot market supply and demand will determine prices in commoditized markets such as oil. The only means of reducing oil prices is to enact structural changes that reduce the demand for oil while concurrently investing in additional supply. While alternative energy sources may possess long term promise, the degree of research and development as well as infrastructure required to support these new technologies ensures that widespread integration is decades away. It would be much more prudent for Congress to avoid meaningless witch hunts and hearings about “excess profits” and instead learn from their prior mistakes by crafting a meaningful energy policy for America.