Speculators have entered the conversation once more with President Obama's proposal to police their manipulation of oil markets. Almost immediately his Republican opponents lambasted the effort as nothing more than a political ploy. Industry leaders stepped forward to warn consumers, with stricter regulations prices will rise. Who holds the reigns of truth here? Or does this all too familiar debate reinforce the need for a new approach?
The President's plan requires oil traders to put up more of their own funds for market transactions, increases monitoring and institutes market manipulation penalties with more teeth. Many debate about the actual role speculation has on oil prices beyond the traditional economic principles of supply and demand. They argue if prices are increased artificially due to market speculation the global markets would see surpluses, something they say is not occurring. Perhaps not globally, but we do see that here in the US. Currently, the US demand for oil is low, oil production is at some of the highest levels in years and the primary storage facility in Cushing, Oklahoma is at capacity and undergoing expansion. Cushing is also the destination for Canada's oil sands crude, delivered by the proposed Keystone XL pipeline.
The factors which would traditionally balance oil prices out are not doing so. Demand is low, supplies are high, production is strong yet prices at the pump have been steadily increasing well before the typical annual peaks during the run up to summer. Yes, there are supply and demand factors globally that are influencing prices but these do not account for all the increased costs. Some say speculation accounts for as much as 60% of the barrel prices. But according to a 2011 Goldman-Sachs admission that percentage was a much lower 20%. A St. Louis Federal Reserve study found between 2004 and mid-2006 speculation contributed more to the price of oil than both global supply and demand combined. The study concluded, even though global demand is the primary long-term driver, from 2004 to mid-2008 speculation accounted for 15% of the cost per barrel. It was a significant contributor to the boom and bust cycle of this commodity.
How does the cost of a barrel of oil translate to the price at the pump? Today, April 20, 2012, a barrel of oil is trading for $101.89. Utilizing the formula for calculating the price at the pump, today's barrel price translates to $3.64 per gallon. Taking the St. Louis Fed's study into account speculation could conceivably be adding 55 cents to an otherwise $3.09 per gallon pump price.
If speculation is reigned in, if additional regulations are placed on this practice to reduce the ability to manipulate the markets, would prices indeed drop? There is a traditional lag time between the barrel price and that paid at the pump, 3-6 weeks and a 2.5 cent decrease for every $1 drop per barrel. So, no, consumers will not see a change overnight. But if industry consultants are correct consumers will actually see increases in the price of gas if limits are imposed on futures trading. A report by the oil industry consultancy, IHS, concluded;
“...proposed limits on oil speculators like big banks and hedge funds in the commodities markets are seen leading to fewer opportunities for energy producers and consumers to mange risk. That will in turn lead to to fewer investments from energy companies, fewer jobs in the sector and higher prices for consumers.”
These are legitimate concerns. It does make sense that limiting trade will restrict monies within the market for trading and hedging future development expectations against future profits. A slowdown in these ares would, along this line of reasoning, lead to a reduction in projects taken on resulting in fewer jobs and lower production. This is a logical outcome.
While these arguments appear valid, they are also very familiar. Dire consequences such as these are frequently referenced by industry consultants when new regulations are proposed. Environmental regulation is the usual target in this area. Provisions of the Clean Air Act were predicted by the auto industry to create an “unreasonable risk of business catastrophe” which may well lead to a “complete stoppage of the entire production.” or according to Lee Iaccoca “...could prevent continued production of automobiles after January 1, 1975.” New emission standards for coal fire power plants introduced in the 1990's were predicted to cause a “quiet death for businesses across the country.”. In reality, since their implementation, the economy grew by 64% and a global market for smokestack scrubbers was created and American manufactures greatly benefited. The effort to reign in chlorofluorocarbons (CFC's), used as refrigerants, was again predicted to cause a “severe economic and social disruption.” . But the resulting new technologies improved productivity, cut costs by 30% and opened up overseas markets to American manufacturers.
While the President's proposed limits are focused on the financial markets, these examples of dire predictions from environmental regulations that never came to pass, highlights the questionability of industry doomsayers' forecasts this time around. Given the influence of speculation on short-term fluctuations, or those boom and bust cycles, its impact is diminished in the long-term where traditional economic principles of supply and demand are the primary drivers. This introduces additional doubt to IHS's findings associated with long-term investment, development and pricing trends.
If speculation is a significant influence on prices and, for the sake of argument, restricting those speculators will limit investment and business operation for future development then what can be done if we're essentially caught in this Catch-22?
We get ourselves out of the commodities markets. Will wind, biofuel, solar be hotly traded commodities? Will they be subjected to the volatile fluctuations of global markets? No. All these energy problems that continue to crop up, that get rehashed every election cycle can be traced back to the booms and busts of the financial markets. In the end, this supports the argument for the transition to renewables. Their use has been a source of derision and pipe-dream dismissals for decades. Denounce them as socialism, berate policies promoting them as a government take-over of individual freedoms but the logical conclusion is always the same. In order to break free from the market price roller coaster, to mitigate the booms and busts that cause so much consternation, the conclusion is simple. The solution is hard but no less necessary. We need to get off fossil fuels.