A Ban on Oil Speculation?

Joseph P. Kennedy II, former Congressional Representative from Massachusetts, and founder, chairman, and president of Citizens Energy Corporation, has a proposal to make energy affordable for all. All we have to do, Kennedy claims, is “bar pure oil speculators entirely from commodity exchanges in the United States.”

Writing in the New York Times last week, Joseph Kennedy (D-MA) explained why he believes that speculators are responsible for the high price that we currently have to pay for oil:

Today, speculators dominate the trading of oil futures. According to Congressional testimony by the commodities specialist Michael W. Masters in 2009, the oil futures markets routinely trade more than one billion barrels of oil per day. Given that the entire world produces only around 85 million actual “wet” barrels a day, this means that more than 90 percent of trading involves speculators’ exchanging “paper” barrels with one another.

It’s true that most buyers of futures contracts don’t actually want to take physical delivery of oil. If I buy the contract at some date, I usually plan on selling the contract back to somebody else at a later date, so that I leave the market with a cash profit or loss but no physical oil. But remember that for every buyer of a futures contract, there is a seller. The person who sold the initial contract to me also likely wants to buy out of the contract at some later date. I buy and he sells at the initial contract date, he buys and I sell at a later date. One of us leaves the market with a cash profit, the other with a cash loss, and neither of us ever obtains any physical oil.

Let’s take a look, for example, at NYMEX trading in the May crude oil futures contract. A single contract, if held to maturity, would require the seller to deliver 1,000 barrels of oil in Cushing, OK some time in the month of May. Last Friday, 227,000 contracts were traded corresponding to 227 million barrels of oil, which is indeed a large multiple of daily production. But it is worth noting that at the end of Friday, total open interest– the number of contracts people actually held as of the end of the day– was only 128,000 contracts, much smaller than the total number of trades during the day, and not much changed from the total open interest as of the end of Thursday. Many of the traders who bought a contract on Friday turned around and sold that same contract later in the day. If the purchase in the morning is argued to have driven the price up, one would think that the sale in the afternoon would bring the price back down. It is unclear by what mechanism Representative Kennedy maintains that the combined effect of a purchase and subsequent sale produces any net effect on the price. But the only way he gets big numbers like this is to count the purchase and subsequent sale of the same contract by the same person as two different trades.

It’s also worth noting that on that same day, there were 146,000 May natural gas contracts traded, which if held to maturity would call for delivery of natural gas at Henry Hub in Louisiana. A single contract represents about 10 million cubic feet, so Kennedy’s calculations would invite us to compare the 1,146 billion cubic feet of “paper” natural gas traded on Friday with the total of 78 billion cubic feet of natural gas that the U.S. physically produced on an average each day in 2011. Once again, the vast majority of Friday’s natural gas futures trades were matched by an offsetting trade during the same day so as to have little effect on end-of-day open interest.

By what mysterious process can all this within-day buying and selling of “paper” energy be the factor that is responsible for both a price of oil in excess of $100/barrel and a price of natural gas at record lows below $2 per thousand cubic feet? I suspect the reason that Kennedy does not explain the details to us is because he does not have a clue himself.

Kennedy’s analysis continues:

Because of speculation, today’s oil prices of about $100 a barrel have become disconnected from the costs of extraction, which average $11 a barrel worldwide.

Here I have a modest suggestion. If Representative Kennedy knows a way to go out and produce another barrel of oil somewhere in the world for $11 a barrel, he would do a world of good if he would actually go out and do it himself, as opposed to simply asserting confidently in the pages of the New York Times that it can be done. People with far more modest fortunes than Kennedy inherited are out there using their resources to try to bring more of the physical product out of the ground.

And many, many more would be attempting the feat if it were remotely possible to produce a new barrel of oil for anywhere close to $11.

If you want to prove me wrong, Mr. Kennedy, then don’t talk about how easy it is to produce more oil– just go do it.

I have a final concern about Kennedy’s policy proposal. How exactly do we define the “speculators” whose participation in the markets is to be banned? Suppose for example, we stipulate that the only people who are allowed to trade oil futures are those who are actually physically producing or consuming the product. If we do that, what happens if a particular producer wants to hedge his risk by selling a 5-year futures contract, and a particular refiner wants to hedge his risk by buying a 3-month futures contract? Who is supposed to take the other side of those contracts, if all “speculators” are banned?

Let me close by pointing those interested in this issue to a recent survey of academic studies of the role of speculation by Bassam Fattouh, Lutz Kilian, and Lavan Mahadeva. The authors conclude:

We identify six strands in the literature corresponding to different empirical methodologies and discuss to what extent each approach sheds light on the role of speculation. We find that the existing evidence is not supportive of an important role of speculation in driving the spot price of oil after 2003. Instead, there is strong evidence that the co-movement between spot and futures prices reflects common economic fundamentals rather than the financialization of oil futures markets.

This post originally appeared at Econbrowser and is posted with permission.

11 Responses to "A Ban on Oil Speculation?"

  1. Aegean1972   April 19, 2012 at 1:17 am

    Very VERY good idea.

    BAN oil speculation now! Is the US gvmnt reading this? what are they waiting for???
    Baning oil speculation should have been enforced a decade ago!

    the longer they wait to enforce it, the worse it will get. Expensive oil is the last thing we want right now. And speculation is a top factor for high oil prices.

    • frogpuddle   April 19, 2012 at 7:31 am

      Aegean1972 should have read the above article before posting his comment.

  2. paul   April 19, 2012 at 8:50 am

    My next door neighbor works on the floor of the Board of Trade in Chicago. When I ask him whats happening in commodities he says two things: hedge funds and Chinese speculators are driving all markets. Up and down. The original purpose of the Board was to help producers and users find a fair price, for today or for a year from now. That is no longer the major influence in the markets. Now anyone who can sign a document that states the money they could possibly loose in trading is not material to their well being can play. And that has caused all the problems. Kennedy may have his numbers wrong but he is on the money about the problem.

  3. John   April 19, 2012 at 9:19 am

    I don't understand Hamilton's argument at all. he writes like there is a perfect balance between buying and selling. What makes any asset price go up (or down)? It goes up when there is more demand to buy than to sell. More traders are speculating the price will be "driven up". Ban (or significantly reduce) oil speculators. If it has no effect on the price Mr. Hamilton can crow about it.

  4. John Cardillo   April 20, 2012 at 12:37 pm

    Did I read this article right? Price of oil ($100) is trading at 10 times the average cost of production($10). Meanwhile paper contratcs (227 million) are trading at 10 times the real contracts (20 million). How can you conclude that speculation has no effect when the data suggests otherwise?

  5. DEK   April 23, 2012 at 8:05 pm

    Oh, Mr. H is VERY correct. Don't you know the speculating in stocks had absolutely nothing whatever to do with the crash in '29. I'm afraid the emperor has no clothes. Driving the market up with futures contracts contributes nothing whatever in value to the economy.

  6. gabriele pastrello   April 24, 2012 at 2:35 am

    Hamilton wrote: "Many of the traders who bought a contract on Friday turned around and sold that same contract later in the day. If the purchase in the morning is argued to have driven the price up, one would think that the sale in the afternoon would bring the price back down. It is unclear by what mechanism Representative Kennedy maintains that the combined effect of a purchase and subsequent sale produces any net effect on the price".
    However, one cannot argue that from the mere fact that 100000 contract were bought and sold in the same day there can be any net effect on price. It depends all on expectations. If in the morning expectations of rising price were strong, and in the afternoon the same expectations were held, it is very likely that the selling of the contaracts were only denting the price, as we see in many graph. The meaning is simply that those who sold were satisfied of the gain, while the other carried on the bet, hoping in bigger gain. But it could be otherwise. In the morning expectations of a rise were high, but during the day they dramatically changed to a downfall, and the price fell. Some buyer liquidated their position, forcing the price still down, while others carried on the bet waiting in a new reversal. The whole point stands on expectation and not on the quantities bought and sold

  7. gabriele pastrello   April 24, 2012 at 2:50 am

    ERRATA CORRIGE: obviously the sentence:
    " one cannot argue that from the mere fact that 100000 contract were bought and sold in the same day there CAN be any net effect on price",
    must be read
    "one cannot argue that from the mere fact that 100000 contract were bought and sold in the same day there CANNOT be any net effect on price"

  8. Odikhmantievich   April 24, 2012 at 9:08 am

    Hamilton makes the outrageous claim, outright, that trading futures can't affect prices. Then tells the policy-maker trying to confront the problem to go frack himself: "if it's so easy to drill oil, why don't you marry it?"

    It's not hard to find explanations of the affect of speculation on oil prices. But Hamilton didn't even try. He just grabbed the first paper that he agrees with and adopted a condescending stance. A good strategy for overwhelming incompetents at dinner parties, I guess.

  9. Tim   April 28, 2012 at 10:04 am

    Check that study:
    The rise of the machine: Does high-frequency trading alter commodity prices? http://www.voxeu.org/index.php?q=node/7841

  10. BJ Clark   April 29, 2012 at 12:37 pm

    The Bretton Woods agreement contained the link between the dollar and gold but also that all oil sales worldwide would be settled in U.S. dollars, establishing the petro-dollar. In 1971 Nixon defaulted on the dollar/gold agreement but not the petro-dollar agreement between Opec and the U.S.government. Todays 100 dollar oil price reflects the monetary inflation adjustment between real money supply increases and oil/gold the public is unaware of and has nothing to do with production costs. So, at the risk of losing the unbelievable and undeserved gift of reserve currency status, the Fed/Wall St . banks/Government defend the 100 dollar price, along with future prices of 200. oil, 3000. gold, 10.00 Gas etc. until the rest of the world refuses to accept dollars as payment for their exports. In the late nineties the banks who caused our current financial disaster were granted immunity from position limits in futures markets which explains the current incredible volatility. This makes it legal for bankers, with no position limits to manipulate every market creating massive bank trading profits and losses to speculators who are encouraged by analysts that oil is dramatically overpriced. The banks know where every stop loss order is and whipsaw markets in both directions several times daily inflicting heavy losses on all victim players long or short. Now you know.