DIGG THIS

Since August 2007, the price of oil has nearly doubled from under $70 per barrel to more than $135 per barrel. This is of course a big problem for the world economy. Not only will it cause massive redistribution of resources from consumers to producers, but by making transportation and production that uses petroleum products as an input, it will slow economic growth. And many consumers, particularly in America, are shocked and angered by the high prices. And since it is election year in America, this means the politicians all say they will try to fix the problem.

But as we will see, it is politicians which have caused the problems in the first place, and as no prominent politician except for Ron Paul recognize this and wants to abolish these policies, they instead create false scapegoats. The most popular scapegoats right now are speculators. Investing in commodities has in recent years been increasingly popular and certainly a very successful investment strategy, the case for which libertarian investment superstar Jim Rogers laid out in his book Hot Commodities that I reviewed on the Ludwig von Mises Institute web page. The politicians and their collaborators now charge Jim Rogers and others who have followed his strategy of causing the commodity price boom they predicted and profited from.

Yet this accusation is based on a complete misunderstanding of how commodity markets function, whether intentional or not. Considering how complex the functioning of these markets in fact is, it cannot be ruled out that it is unintentional. And even if it isn't, people need to learn this in order to be able to see through the deception.

Starting with the basics, commodity markets can be divided into spot markets and futures markets. Spot markets are the markets for immediate delivery, futures markets are the markets for delivery at some future point in time, usually not more than a year or so in advance. As futures contracts are constantly traded, it should be noted that someone who buys a commodity with a futures contracts need not necessarily be the one that buys it at the expiration date. But this is not dissimilar to how someone who bought a commodity with a spot contract can sell the commodity to someone else.

And just as there is always both a buyer and a seller in a spot contract, there is always a buyer and a seller in a futures contract. Usually though, the buyer is referred to as having a long position while the seller is referred to as having a short position, but that is basically just semantics. People with long positions are in effect buyers while people with short position are in effect sellers.

What should further be realized is that first of all most commodity speculators invest in futures while what matters for the price of petroleum actually used in the economy is primarily the spot price. Note further that commodity speculators can take both long position and short positions. This implies that commodity speculators may not in fact be contributing to higher prices. If speculators as a group have equally large long and short positions then they will have no effect on futures prices, and if they as a group have larger short positions than long positions then their speculations will in fact lower futures prices.

Moreover, even if speculators as a group have a net long position, the speculators that pushed up the futures price in the first place will, once the futures contract approaches expiration date, face two choices. Choice number one is to sell the contract or sell the underlying commodity to some consumer once the contract expires. Choice number two is to put the commodity in some physical inventory and keep it there.

If the speculators choose the first alternative, then this will push down the price back to the level where it would have been in the absence of the original purchase. In this case, speculation will thus have no effect on the spot price.

If on the other hand the second alternative is chosen, then speculation will indeed contribute to higher prices, at least temporarily. But while that is a possible theoretical scenario, that does not mean it is applicable to the current situation. The fact is that there is no evidence of increased inventories. Indeed, according the Energy Information Administration, U.S. crude oil inventories were 14 % lower in the week ending June 20 than a year ago.

Some have replied to this argument by saying stock building for speculative purposes need not be above ground, it could also come in the form of producers choosing not to pump oil from the ground. But first of all, oil-producing governments is not what is typically meant by speculators. And the issue being discussed was the role of professional speculators acting on the futures markets, not what the governments of Saudi Arabia or Kuwait choose to do, so this argument is basically a case of changing the subject. And secondly, as it happens, no evidence exist that oil producers are choosing to reduce production for speculative purposes. Spare capacity among oil producers is relatively low, especially if you exclude spare capacity caused by, for example terrorist attacks against oil facilities in Nigeria.

What then is the cause of high oil prices and what could be done about it? As I indicated in the aforementioned review, the boom is primarily driven by structural long- or medium-term factors. Demand is growing rapidly because of the rise of China and fast growth in other emerging economies. Meanwhile, while global oil production is actually growing, growth is inhibited in the short term both because of various political factors that stop drilling and because of the fact that even where such political obstacles does not exist, it takes several years to actually extract the oil. Brazil has recently found vast new oil reserves, and no political obstacles exist there to prevent drilling, yet it will be several more years before that oil reaches the world market.

These political factors differ somewhat in their form, but none of them seems likely to go away anytime soon. In Nigeria, as was previously stated, constant attacks against oil facilities are holding down production there, and these attacks looks unlikely to cease. In countries like Venezuela, Mexico and Russia, hostility against foreign investments combined with governments and bureaucrats starving government run oil companies of competence and cash, means that potential oil production is held back. And in the United States, opposition to drilling for environmentalist reasons, mainly by Democrats, prevents increases in oil production.

Another factor that in the short term has contributed to the sharp increase in the price of oil is the Fed's inflationary monetary policies. Because the price of oil is much more flexible than most other prices and it is immediately affected by, for example, exchange rate effects, the short-term effect of an inflationary monetary policy is much greater than the short-term effect on the more sticky prices of regular goods in the supermarkets. That the oil price increased so much after the Fed started its aggressive interest rate cuts was not really a coincidence.

What then can be done about the high oil price? The long-term solution is to reduce or abolish taxation on oil production and to abolish all regulatory restrictions (whether motivated for environmentalist reasons as in the U.S. or nationalist reasons as in Mexico) on oil drilling. Opponents of drilling often reply to this that it won't provide any short-term relief. But while that is true, but there won't be any short-term relief without drilling either and the point of drilling is to provide long-term relief. Moreover, their preferred solution of having the government invest in research to invent more so-called renewable sources of energy is likely to take even longer to provide relief (if it ever provides relief).

To provide short-term relief, different solutions are needed. This means, for example, that the U.S. government should start releasing the oil held in the so-called Strategic Petroleum Reserve, while the Fed should stop its inflationary policies.

Unfortunately, I don't think any of these solutions are likely to be implemented anytime soon, which is one of the reasons why I am not as optimistic as Don Armentano about the possibility of a significant price decline in the near future. However, while the oil price is unlikely to go down, we should always remember that it is governments and not speculators that are responsible for the all-too-high oil price we suffer from now.

June 28, 2008

The Best of Stefan M.I. Karlsson