The conventional view taught in business schools is that speculation is good.

Boiled down to its essentials, the argument supporting this view is a very simple one:  suppose there were no one to take the other side of the trade of, say, a farmer seeking to guarantee a minimum price for his corn crop that would ensure he’d cover his costs and have something left over to keep body and soul together.  There may not be enough cereal makers or animal feed producers who want to hedge their costs in the same amounts and at the same time as the farmer.  If not, who’s left to be the buyer of the commodity contracts the farmer wants to sell?  The answer:  speculators, who have purely financial motives and who will step in to stabilize a market by buying and selling commodity futures contracts before prices get too wacky.

In this picture, the main players are the producers and users of commodities; speculators play a minor role, though a convenient one for the theory.

I don’t know whether this was a solid description of the way commodities markets worked a generation or two ago,  or just a product of the many simplifications of the real world that academics need in order to have their mathematical models work more smoothly.  But even if they once were correct, do these ideas still work in a world where prop trading, hedge funds and commodity-based ETFs abound, and where brokers have made it much easier for ordinary investors to buy commodities futures directly?

the case of crude oil

In 2008, after an oil price spike that saw the price of crude nearly double from a starting point of $80, the Commodity Futures Trading Commission issued a report, based on the traditional thinking, which found that speculation played little role in the upward move.  The Baker Institute of Rice University is the most well-known of observers who criticized the CTFC findings.  It said the commission had ignored its own data, which showed a dramatic rise in the involvement of the proprietary trading desks of investment banks, of hedge funds, and of commodity funds in oil trading.  On the Baker Institute’s reckoning, these speculative entities made up half of the market (and they all wanted to bet that oil price would rise).

Apparently in response to this criticism, on July 5th,the CFTC published a relatively large set of data showing the relative importance of hedgers and speculators in various commodities markets, including crude oil.  What called my attention to the report was an article in the Financial Times that says speculators make up a majority of the trading in metals, agricultural and financial futures–but in crude oil, they comprise well over 90% of the trading volume!!  (I’ve cast my (unpracticed) eye over the figures.  I don’t see the 94.5% speculation the FT reports, but most categories of crude show hedgers make up less than 20% of the market.  Same difference.)

my thoughts

The CFTC is proposing that the government limit the number of positions a speculator can hold as a way of limiting their influence.  And the International Energy Agency has already organized a limited release of some of the crude oil stocks held by oil-consuming nations in an effort to cause speculators to liquidate.

CTFC action would just make speculators relocate, however.  The IEA has a worry, too –that speculators have deeper pockets than it does.  Both agencies are treating symptoms, not the root cause, of high oil prices.

In a lot of ways, the current oil situation reminds me of froeign exchange during the Bretton Woods era of fixed currency rates.  During Bretton Woods, countries periodically tried to defend a certain currency level, even though that level was ultimately being undermined by structural economic problems that at least one of the countries involved refused to address.  The banks speculating against the currency exchange rate were, in effect, betting that the structurally weak country didn’t have the political will to make needed changes.  Generally speaking, the banks were right.  They thought it was like shooting fish in a barrel.  Ultimately, the Bretton Woods arrangement collapsed.

The structural issue for petroleum in today’s world is the failure of Washington for more than a third of a century to fashion an effective energy policy that reduces the country’s dependence on crude oil.  In part, this has been a way of protecting a politically powerful but badly run domestic car industry–which is even now lobbying hard against proposed increases in fuel efficiency standards for cars and trucks that would bring the US into line with the rest of the developed world in ten years or so.

The massive speculative bet is that the current situation won’t change much–resulting in higher oil, a lower US dollar and slower economic growth in the US than would otherwise be the case.

investment implications

The straightforward bet on this issue would be for or against the stocks of oil producing companies.  Slow growth domestically and a weaker US$ would also favor US-listed companies with significant operations outside the US, however.  For anyone, like me, in the weak-$, slow-growth US camp, I think the latter group of stocks will do relatively well under most oil price scenarios, making them the better way to go.