Rossputin.com Rational Thinking About Our World

As the stuffed shirts on Capitol Hill fulminate about evil speculators driving up the cost of oil, many of us who understand economics and markets better than politicians do have written about the misguided and dangerous proposals to rein in "speculation" in commodity markets.

Never mind that what the critics are defining as speculation would be called investment in any other scenario, and never mind that the majority of the new "speculative" money is coming from pension funds and other large investment pools simply trying to diversify among asset categories and make the best returns for those people whose financial futures they are entrusted with.

On Tuesday, in both his prepared remarks and in answers to questions from Senators, Federal Reserve Chairman Ben Bernanke offered the best defense of speculators and the best general explanation of oil prices that I've heard from anyone in a position of significant political power.

Following are the highlights of Bernanke's testimony specifically related to oil markets and speculators:

From his prepared remarks:

The elevated level of overall consumer inflation largely reflects a continued sharp run-up in the prices of many commodities, especially oil but also certain crops and metals. The spot price of West Texas intermediate crude oil soared about 60 percent in 2007 and, thus far this year, has climbed an additional 50 percent or so. The price of oil currently stands at about five times its level toward the beginning of this decade. Our best judgment is that this surge in prices has been driven predominantly by strong growth in underlying demand and tight supply conditions in global oil markets. Over the past several years, the world economy has expanded at its fastest pace in decades, leading to substantial increases in the demand for oil. Moreover, growth has been concentrated in developing and emerging market economies, where energy consumption has been further stimulated by rapid industrialization and by government subsidies that hold down the price of energy faced by ultimate users.

On the supply side, despite sharp increases in prices, the production of oil has risen only slightly in the past few years. Much of the subdued supply response reflects inadequate investment and production shortfalls in politically volatile regions where large portions of the world's oil reserves are located. Additionally, many governments have been tightening their control over oil resources, impeding foreign investment and hindering efforts to boost capacity and production. Finally, sustainable rates of production in some of the more secure and accessible oil fields, such as those in the North Sea, have been declining. In view of these factors, estimates of long- term oil supplies have been marked down in recent months. Long-dated oil futures prices have risen along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to come.

The decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices. The precise size of this effect is difficult to ascertain, as the causal relationships between oil prices and the dollar are complex and run in both directions. However, the price of oil has risen significantly in terms of all major currencies, suggesting that factors other than the dollar, notably shifts in the underlying global demand for and supply of oil, have been the principal drivers of the increase in prices.

Another concern that has been raised is that financial speculation has added markedly to upward pressures on oil prices. Certainly, investor interest in oil and other commodities has increased substantially of late. However, if financial speculation were pushing oil prices above the levels consistent with the fundamentals of supply and demand, we would expect inventories of crude oil and petroleum products to increase as supply rose and demand fell. But in fact, available data on oil inventories show notable declines over the past year. This is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil or other commodities in the longer term.

And from the Q&A:

Question from Senator Tom Carper (D-DE): "The third factor that we keep coming back to is the role that speculation is playing. We've touched on this at least indirectly here today. Just give us some advice. I think we're going to debate -- seriously debate, probably before the beginning of next month, legislation dealing with speculation to try to curb the excesses that may be occurring there. If you could give us some advice, it would be timely and much appreciated."

Bernanke:

Well, I think, as I said, based on the evidence that's available, I would not estimate that speculation or particularly manipulation is a significant part of the rise in oil prices. That said, the CFTC and others are looking at the data and trying to evaluate that. These are very difficult matters. We don't want to do anything that will stop the futures markets from having their legitimate functions, serving their legitimate functions of providing liquidity and hedging.

So, you know, my advice would be to go slow and carefully and to take the insights that you get from the CFTC and others who are directly -- associated directly overseeing these activities. I would -- despite the concerns -- and I fully understand the concerns about high gas prices -- I don't think it's likely that you can have a big effect on gas prices with short-term moves in the futures markets. And I would urge careful and deliberate action in this area.

And a question from Senator Mel Martinez (R-FL): "I wonder if you might dwell just for a moment on the speculation side as to why you don't see that as a fundamental part of the problem, but then also what we could do to be more helpful in the area of transparency and oversight."

Bernanke:

Well, there would be -- there are a number of pieces of evidence against the view that speculation is a primary force. I mention in my testimony the absence of hoarding or inventories that you would expect to see if speculation was driving prices above the supply/demand equilibrium. There are a number of studies which show that there is little or no connection between the open interest taken by noncommercial traders in futures markets and the movement -- subsequent movements in prices. It's also interesting to note that there are many commodities, or at least some commodities, that are not even traded on futures markets, like iron ore, for example, which have had very large increases in prices. So I think the evidence is terribly weak.

That said, I think that transparency in futures markets, information available to the overseer, the CFTC, is a positive thing.

One never knows whether the Senators actually cared about the answers to these questions or whether they are just looking for backup for something they're planning to do no matter what. I hope that Republicans in Congress heed Bernanke's words and recognize that attempts to curtail "speculation" will do far more damage to the most liquid commodity markets in the world, right here in the US, than they will do to lower American's cost of living.

An Open Letter to Congress

From John J. Lothian

When futures prices go up, they are advertising for selling. When prices go down, they are advertising for buying. With futures prices going up for crude oil and many other commodities, a truth has emerged in the cash markets that we have not grown our farming, drilling, mining or processing capacity to meet the increasing demand of a developing global economy. High commodity prices are sending an important message.

We need to listen to that message and respond.

We need to respond to higher prices with more selling. We need to find a way to meet the growing global demand with real production of oil, metals, grains, fibers and many other commodities. We need the higher prices to spur the investment in that production. This is a demand pull rally in prices, not a supply shock. We should not be shocked that millions of Chinese who work in factories in cities (rather than in agriculture in the country) need to buy food, transportation and clothing. This change in lifestyle has created a change in demand with higher wages and a rising living standards. Look at the label on the goods you buy and the clothes you wear and you can find similar economic /human migration stories in other countries around the world.

Laws artificially muting market prices will only make the problem worse. And messing around with a global problem in a narrow nationalistic way, especially in a way that exacerbates the problem, is the kind of thing that can lead to wars. People need to be fed, clothed and kept warm. They need transportation to get to work and move their goods and services around the world. History has shown free markets are the best mechanism by which this can be accomplished.

One of the tragic economic errors after World War I and causes of World War II was the rent control laws in Germany in the 1920s. With an upper bar on rent prices due to a well-intentioned but tragically flawed law, it was difficult to find housing. People would not move because they were locked in to a rent-controlled apartment. Landlords were forced to accept less than the open market would yield, and as a result they would let the apartments fall into disrepair because they could not afford to pay for the upkeep. New housing was not built, because the return on the controlled rents was less than the cost of capital to build it.

Listen to what the higher prices are telling us. We need more selling. More selling can come from new supplies, or from consumers switching from one choice to another. Higher prices spur changes in consumption. They create the economic conditions for new technologies, systems and ventures to emerge and compete. These are the ingredients of economic growth. Government should not pick the winners, the market should.

Some investors figured all this out before others. This spurred the development of an investment class in commodities, using futures contracts as proxies for the underlying physical products. Long-only commodity index funds have emerged as a major fundamental factor in the futures markets. Billions of dollars are linked to indices of commodities.

While traditionally these participants would be classified as “speculators,” they are in fact investors. Many of these funds fully fund each and every contract they buy. Margins on a $16 contract of soybeans might be $3000, but these investors are putting aside the full $80,000 to invest in these commodities on an un-leveraged basis.

These investors are putting their capital on the line, daring the market to find the selling to match their buying. There is nothing wrong or illegal in the way these market participants are using the futures markets. In fact, there is a lot that is right about it. Millions of investors use similar investing strategies to invest in other asset classes, including equities, fixed-income and real estate funds. The free flow of capital into this area is delivering an important message we need to heed. We need more selling. We need more production, processing and refining capabilities. We need to spur the market to allow alternatives to develop. We listen and respond to the market every day. This is no time to stop listening.

Proposals in Congress to raise the margins on futures contracts would have no impact on many of the long-only index funds as they have 100% in cash or equivalents of the contracts’ value. On the other hand, increased margins would reduce the number of traditional speculators. That would lead to less efficient markets, higher execution costs and generally higher prices.

When Treasury Bonds were introduced in the 1970s, the bid-offer in the cash market for Treasuries was regularly a full basis point wide, or $1000 between the bid and offer. The successful introduction of Treasury bond futures allowed that bid-offer to narrow to 1/32 or $31.25. Investors offered transparent, liquid markets can do more with their money.

Speculators come in different shapes and sizes, the same is true with hedgers. Commercial concerns are impacted by these higher prices and the accompanying volatility. Some hedges are held for months on end, and spiraling capital costs can kill a company. Some grain elevators have stopped taking forward-priced contracts because they can’t afford to finance the hedges for the farmers. This is a concern. Increased margins on market participants would only make this situation worse. We need more sellers, not less.

Speculators have often been vilified through the ages. In the current real estate crisis, many of the worst impacted areas for foreclosures were where the highest level of speculative activity occurred. Politicians publicly stated about how they wanted to help fix the problems in real estate but did not want to reward the speculators.

The first Treasury Secretary of the United States, Alexander Hamilton, was faced with a similar speculative situation in the early days of the republic. It seemed that many debts had been issued by the 13 colonies during the Revolutionary War to fund it. Original owners of the debt were often soldiers themselves, merchants or others. After the war, convinced these bonds would never be repaid by the colonies; many holders sold their holdings to speculators who paid pennies on the dollar.

Hamilton’s great plan was to nationalize all that debt of the new states and to issue new USA debt to replace it, thereby establishing a national debt market. By repaying the state debt, some owed to foreign holders too, he also raised the credit rating of the country in the world’s markets. However, in order to execute his plan, he had to handsomely reward the speculators who had accumulated the debt from the original buyers. Lucky for us that Hamilton did the right thing for the country and the hard thing to do politically.

As Congress contemplates how to respond to the political and economic risks we are faced with globally because of the jump in commodity prices, let’s remember the tragedy that sprung from German rent controls, the value of transparent, efficient and fair markets and the wisdom and political courage of Alexander Hamilton. Let’s remember higher prices mean we need more selling, not more regulation. Let us remember to listen to the market.