The only way to intelligently navigate this discussion is to know a bit about how futures markets work. The least you need to know is that in futures markets one buys the right to purchase oil at a future date at a specific price from someone who is selling that guarantee. Most futures contracts are for one to three months in advance but are settled daily after purchase.
For example, assume that we buy a futures contract from you today for 1,000 barrels of oil maturing in August 2011 at $100 per barrel. If tomorrow the same August 2011 contract settles in the market at a price of $100.40, you will owe me $400. If the day after that, August 2011 oil settles at $99.60, I will owe you $400.
We will exchange money in this manner on a daily basis until the contract is up or until someone (perhaps even you) buys the other party out. At the end of August 2011 when final settlement takes place, contracts will either be settled in cash and retired or rolled over into another futures contract. Only 2% of futures contracts result in actual delivery of oil.
How do bets about the future price of oil affect current oil prices? They can do so if and only if those bets increase or decrease oil supply in the here‐and‐now through changes in inventory or production.
If the price for crude oil tomorrow — thanks to the speculators — is higher than the cost of crude oil today plus the cost of storage, then everyone (investors, refineries, your Uncle Phil) could make money by buying crude in the spot market, storing it somewhere, and guaranteeing its higher selling price through the purchase of a futures contract. This would reduce current supply and increase current price while increasing future supply and decreasing future price.
If this is going on we would expect to see some sort of inventory buildup. While crude inventories in the U.S. are increasing, they always increase at this time of year, and this year’s increase is well within the normal range. More important, gasoline inventories are decreasing and decreasing much more rapidly than normal. Hence, there’s no evidence that speculators are reducing the supply of crude or gasoline through increased storage.
Producers, however, could react in the same way to higher futures prices by decreasing current production to allow more future production at higher prices. Alas, we see no evidence of suspicious reductions in producer output that might give this story credence.
More formal statistical tests (known as “Granger‐causality tests” to economists) examine the impact of traders’ behavior on prices within futures markets. Do futures prices follow the bets taken by market participants or do those bets follow prices? A federal interagency task force undertook one such econometric analysis in 2008 and found that futures price changes from January 2000 to June 2008 preceded net position changes by any group of traders. An updated and more rigorous econometric study by economists Bahattin Buyuksahin and Jeffrey Harris found the same thing for July 2000‐March 2009.
These findings undermine the claim that speculators’ behavior increases gasoline prices. “The lack of even Granger‐causality (let alone true causality) between positions and prices undermines the prospect that speculative trading has driven recent dramatic price swings in the crude oil futures market,” concludes Buyuksahin and Harris. “Rather, we believe it more likely that both prices and positions react to the same factors, such as global demand and supply.”
There is no need to repair to conspiracy to answer the question about why gasoline prices are going up. The loss of Libyan crude — about 2% of global supply — has reduced the amount of oil available in the market and gasoline prices track global crude oil prices.
Prices must necessarily rise to reduce global oil consumption because we can’t consume what isn’t there. How much do prices need to rise to reduce oil consumption by 2%? It takes a big increase in gasoline prices to get us to drive even a little less. Economists estimate that prices must rise anywhere from 10 to 20 times the percentage reduction in quantity to reduce demand enough to equal the lower supply. Thus for a 2% supply reduction, prices must rise between 20% and 40%. Average gasoline prices have risen 20% since early February, on the low end of what economists predict.
So put away the torches and pitchforks.