Commentary

Scapegoating the Speculators

Senator John McCain recently called for a “thorough and complete investigation of speculators” to see if they’ve driven up oil prices. And Senate Democrats plan a new bill aimed at commodity speculators - a witch hunt that’s clearly about oil.

But, much as politicians would like to blame speculators, it’s just not so.

For starters, there’s nothing about futures or options that makes it any more attractive to bet that commodity prices will go up than to bet they’ll go down. Guess wrong on the direction, and you lose money.

[M]uch as politicians would like to blame speculators, it’s just not so.”

The “blame speculators” theorists have several worries. Investors in oil futures don’t take delivery of oil, they note with unexplained suspicion. More, futures and options may involve margin debt and leverage - meaning you might need put only, say, $8 down to make a $100 investment (though you’re still liable for the whole $100 if you’ve bought a lemon). And there’s been a marked rise in investing in commodity-index funds, greatly increasing the total amounts in those markets.

The first complaint is irrelevant nonsense: Investors in oil futures don’t take delivery of oil because they sell their contracts before the contract expires to oil refiners and distributors - who do take delivery of oil.

Yes, if the price of next month’s oil futures goes up, that can encourage producers to slow their sales on the spot market. And a higher price for next month’s oil can encourage refiners to buy more now rather than later. Both reactions could push the cash price up.

But they would also cause oil inventories to rise. And rising inventories always bring the price back down. Yet US oil inventories appear modest at present - so there’s little evidence that speculation had much to do with recent prices (aside from one-day spikes from scary rumors or news).

The second fear turns on the use of leverage and debt. This is mainly concerned with options (derivatives), because that’s where a small down-payment can control a lot of oil.

But there’s no more incentive to bet that the price will go up (called a “call option”) than to bet it will go down (a “put option”).

A call option might guarantee the right to buy oil for $138 three days before the futures contract expires. But if that price turns out to be too high, the option becomes “out of the money” - worthless.

And speculation that oil prices will rise rather than fall has dropped drastically since we crossed $100 mark. The “net long” position on the New York Mercantile Exchange fell from 113,307 contracts on March 11 to 25,246 by June 10 -so nearly as many traders are now shorting oil as are going long.

More: Purely financial speculators needn’t play futures at all. They can simply buy (or short) the exchange-traded US Oil Fund, which tracks the price of West Texas crude. And The Wall Street Journal reports that short interest in that fund is up 140 percent since January, outnumbering long bets by two to one.

Speculators, in other words, are increasingly leaning toward betting the price of oil will go down, not up. So they’re unlikely villains if prices do keep rising.

The third worry centers on investments in commodity indexes by pension funds and college endowments. But this contradicts the second complaint - because these institutions by law can’t use leverage or debt.

Index funds simply buy next month’s contracts and sell them early, during the second week of the month, using the proceeds to buy the following month’s contract. And such mid-month trading can’t affect the price that matters - when futures expire.

The witch hunt got a boost from recent testimony to Senate Homeland Security Committee by Michael Masters of Masters Capital Management, who claims that an influx of cash into commodity-index funds has caused the rise in world commodity prices.

First problem here: The same period saw vastly larger investments in stock-market-index funds - yet the S&P 500 stock index sometimes fell.

By the way, some acolytes are getting this theory wrong. A Washington Post editorial this week cited Masters as blaming hedge funds. In fact, he explicitly blames pension funds and university endowments for investing in those commodity-index funds. (In fact, that strategy is far too cautious for hedge funds.)

In any case, investing in an index of commodity prices can’t lift the prices of individual commodities - any more than investing in stock-index funds could automatically raise the value of individual stocks in the index.

Another variation: Some argue that the sheer increase in the volume of future contracts must have lifted the prices of commodities. Sorry, no: Volume tells us nothing about futures-contracts prices - just as the overwhelming volume of stock trades on Oct. 19, 1987 (Black Tuesday) did not mean stocks were going up.

From November 2000 to November 2001, the volume of crude oil futures contracts in New York rose from 2.8 million to 3.2 million - even as the price of crude fell from $34 to $20.

There is no mystery behind the rise in oil prices. They rose too high too fast because of booming demand for oil for petrochemical products, electric power and shipping from many emerging economies (particularly China, India and the Middle East). Meanwhile, the supply of oil slipped in the US, Mexico, Venezuela, Nigeria and Russia.

But now JPMorgan analysts estimate that oil will drop to $85 a barrel from 2009 to 2011. Even Goldman Sachs analyst Arjun Murti, who recently guessed oil might reach $200, later told Barron’s that oil will likely drop to $75 or less in the long run.

The urge to blame speculators is as big a waste of time as blaming oil companies. Americans want more oil and gas - not more hot air from politicians.

Alan Reynolds is a senior fellow with the Cato Institute and the author of Income and Wealth.