Oil Speculation Getting Attacked

The Commodity Futures Trading Commission will release a report in August taking a radically different perspective on the oil bubble created last year than when they were under the Bush administration. According to reports, the CFTC has changed its view on the role of speculators and is now gearing up to say that the oil spike was not demand driven:

In a contentious report last year, the main U.S. futures-market regulator pinned oil-price swings primarily on supply and demand. But that analysis was based on “deeply flawed data,” Bart Chilton, one of four CFTC commissioners, said in an interview Monday.

The CFTC’s new review, due to be released in August, adds fuel to a growing debate over financial investors who bet on the direction of commodities prices by buying contracts tied to indexes. These speculators have invested hundreds of billions of dollars in contracts that were once dominated by producers and consumers who sought to hedge against oil-market volatility.

New CFTC Chairman Gary Gensler, appointed by President Obama, said today that the commodities regulator should “seriously consider” imposing a stricter set of limits on the speculative trading of energy futures contracts. This would be a significant shift in thought for the government agency. The National Journal reported yesterday:

At a CFTC hearing, Gensler said it is time the agency assess the impact of speculators and make sure that its rules “address times of volatile or uncertain markets.” While futures contracts are supposed to reduce price volatility, speculators use them to bet on market prices and critics say that magnifies price swings. Gensler also said the CFTC must ask Congress for new authority to set trading position limits on all commodities to prevent market players from moving overseas or into markets outside of exchanges.

After reading all the rationalization on restricting speculators, I have a few questions. First, even if price volatility is linked to investors betting on the market, isn’t the volatility a reflection of something going on in the market that should be weighed? (Put another way, volatility isn’t always bad, and can be a short-term adjustment of the allocation of resources.) Second, how is speculation different from demand? There is demand for immediate consumption, and demand for long-term storage of supplies (speculation). But they are both demand. One is a more politically correct type of demand, the kind that wants the product to use it now. And the other is a less socially acceptable demand, looking to buy and hold on to a product on a bet that prices will rise as the resource becomes scarce, a practice which is reviled by the Krugmannites. But the reality is that they are both demand.

When the report comes out next month saying the speculative trading increases prices, what that will ultimately mean is that demand for a scarce resource increases prices. And that should not be a problem. Unfortunately, speculation is seen as the trade of Shylock these days, and maybe dealt an unnecessary and improper blow by regulators on the heels of this report. Craig Donohue, CEO of the Chicago and New York Mercantile Exchange bowed to politically correct pressures in testimony yesterday:

“We recognize that others have concerns respecting the role of index funds and swap dealers in the futures market, and in particular, the impact that their participation in the markets might have on energy prices.” Donohue said. “We are prepared to respond to those concerns by adopting a hard limit regime for those products.”

This measure “should alleviate external concerns that positions held by these investors and hedgers will increase price volatility or artificially inflate or deflate prices,” he said.

Congressional hears will continue on the subject until the August recess. This may wind up being just another battlefield in the war coming on financial services regulation reform in September.