Speculation in overdrive

ALBUQUERQUE -- With gasoline pushing $4 a gallon, many Americans are wondering when prices will come back down. But the outlook is pretty gloomy. And the idea that these prices are here to stay seems to be sinking in. A recent report by John Fleck for the Albuquerque Journal describes the increased use of public transit and purchases of fuel efficient cars in the Albuquerque area.

These are positive effects of rising fuel prices, in terms of shifting our economy away from fossil fuels. But Fleck also described the pain being felt by commuters who have no choice but to drive, as did the Independent’s Denise Tessier in a report describing efforts to mitigate hunger in relation to rural low-income families not being able to afford long round trip drives to and from the grocery store. In the short term, the rising prices are a serious problem for many.

The Wall Street Journal reported earlier this month that the Goldman Sachs Group is predicting the price of oil, which has climbed to a little over $130 a barrel, could range between $150 and $200 a barrel by October. At the rate its going, this reporter thinks $150 could happen a lot sooner.

“That would put oil at unprecedented price levels, even going back to just after the Civil War,” Stephen Brown, an energy economist at the Dallas Federal Reserve Bank, told the WSJ. The article goes on to say such prices could push gasoline to $4.50 a gallon.

Explanations for the rising cost of fuel are varied, and the solution, in the short term anyway, is elusive. Senator Jeff Bingaman, citing from testimony given before several Committee on Energy and Natural Resources hearings, spoke forcefully from the Senate floor on May 12 about one possible culprit: speculation in the oil markets. Here are excerpts from his remarks:

Bingaman went on to call for increased regulation of futures markets, especially those outside the U.S.

In light of Bingaman’s remarks, I couldn’t help but notice that Carl Gutierrez of Forbes on May 16 cited the Goldman Sachs prediction itself (that oil would rise to $150-$200 per barrel by October) as partially responsible for the subsequent continued climb in oil prices. The prediction makes it so, according to Gutierrez, which seems to give credence to arguments that speculation is at least partially responsible. According to Gutierrez,

After it bet correctly on the subprime mortgage market, investors seem to be willing to listen carefully to Goldman Sachs, and the brokerage house’s bullish energy forecasts are lifting the price of crude to new heights, bringing it ever closer to the $150-$200 range the firm’s oil analyst recently predicted.

The Independent was curious about Senator Domenici’s position on regulation of the oil futures market. His spokesperson, Matt Letourneau, explained that its plausible that oil speculation is partially responsible but that they had not conclusively determined it was a factor so had not taken a position on it.

 

Is speculation driving up the price?

The run up is probably based both on speculation and market fundamentals. Speculators buy oil because they think it’s going higher, but they don’t say “oh, I just have a feeling oil’s going higher.” Speculators making those decisions have been trading oil for years or even decades, and they recognize there are more forces at work than just supply and demand.

There are fundamental reasons why oil will stay high. But it’s my feeling (culled in large measure from talking to oil traders) that the move from $60 to $130 in the last 12 months is maybe 55% fundamentals and 45% speculation. So retracing the speculation move would bring oil back down around $100 give or take.

My understanding is that we’re dealing with a global market so would imposing regulations on speculators really have a significant impact on the price?

When it comes to oil and energy trading, there are two main places to trade. Here in the US, the Chicago Board of Trade (CBOT) was founded in 1848, and the Chicago Mercantile Exchange was founded in 1898. They merged last year, and the combined group is in the process of taking over the NY Mercantile Exchange. For the purposes of this discussion, it’s easiest to look at them all as one large entity.

However, the biggest and most active oil and energy futures market is the Intercontinental Exchange (ICE), which is an electronic market based in London. Some people estimate ICE handles up to 80% of all oil and energy trading around the world. Technology has become so seamless that commodities trading can essentially be done 24 hours a day from almost anywhere in the world.

As it currently stands, regulating that global market is difficult because the body that regulates the US exchanges “generally oversees, but does not substantively regulate” ICE. However, regulation across both the US markets and especially ICE would likely have a significant short term effect on oil prices.

So how would regulation happen?

Technically, the Commodities Futures Trading Commission (CFTC) and the National Futures Association (NFA) are the two organizations specifically charged with regulating futures trading in the US. The CFTC is federally regulated and has five commissioners who are appointed by and serve at the pleasure of the President, so they would likely act on any call from the White House for more regulation. The NFA is the industry self-regulatory body.

ICE falls under what’s commonly known as the “Enron Loophole”, which is a congressional exemption from regulatory oversight. Congress would first have to close that loophole, paving the way for the CFTC to regulate ICE the way it does the other US futures markets. One way the CFTC regulates the market is through limiting the number of futures contracts one trading firm can hold, which limits the ability of a single firm to corner large chucks of the market. Those limits exist on the NYMEX and CME, but not on ICE, which is one of the main reasons why so much more trading is on ICE.

Another example of regulation involves the margin required to trade futures. Because futures trades don’t result in any immediate exchange of goods, traders and their parent companies are required to prove they have a certain percentage of the pledged cash available. This is called the “margin.” By raising margin requirements, you limit the purchasing power of all traders, and force banks that can’t meet their margin requirements to stop buying and in some cases start to sell contracts. Oil prices would fall as a result, although it’s no more than a guess as to how much.

Thanks for explaining this for us, Trevor. It’s very complicated. But it sounds like regulating the market might help stabilize prices even if they don’t come down.

It’s very possible.

 

print Share