Speculation and the Price of Oil: An Unfriendly Note
Ferdinand Banks, August 29th, 2008
Speculation and the Price of Oil: An Unfriendly Note
By Ferdinand Banks
Not too long ago I took the liberty of publishing several short papers on speculation and the oil price. Needless to say, I felt it necessary to publish them in more than one place, and also to exploit my beliefs in this matter in several lectures, both formal and informal. My opinion – or perhaps I should say my often-repeated opinion – is that speculation is of secondary importance for explaining other than transitory movements in the oil price, and instead the key explanatory factors for oil price ‘trends’ can be derived from orthodox economic logic associated with the buying and especially the selling of physical oil.
One of my favorite daydreams features me standing in front of a blackboard somewhere, discussing e.g. speculation and the oil market, and suddenly hearing a sturdy, confident voice from some corner of the room informing me that I don’t know what I am talking about. It has been so many years since something of that nature happened, that should it take place in the near future, I probably would find myself immediately reaching for a double dose of aspirin or smelling salts, or asking if there was a doctor in the house who could check my hearing. The problem – as the late president Lyndon Johnson once pointed out – is that very few individuals possess an extensive knowledge of financial or financial-like markets, although in my teaching in half a dozen countries, I have never had the slightest problem explaining to first year students how speculation works in commodity markets.
In my investigation of the present oil market picture, the first thing I noticed was that the elite of academic economists were unable to see any value at all in the contention that speculation was behind the oil price rise of the last few years. I see no harm at all in ignoring the judgement of prominent academicians, since many of those ladies and gentlemen occasionally operate in cloud-cookoo land, but the issue here has to do with the interior logic of a very simple financial mechanism. Professor Ben Bernanke, boss of the US central bank (The Federal Reserve), obviously has little or no knowledge of what the oil futures market is all about, however I am generous enough to believe that he could correct this shortcoming in a very short time, and would immediately be able to draw the correct conclusion about what might be called the ‘force of speculation’ in oil derivatives (i.e. futures, options and perhaps swaps). As far as I know he hasn’t expressed himself on this topic, but the US Secretary of the Treasury has, and it warms my heart that Mr Paulson’s verdict matches my own.
A DEFECTIVE POINT OF VIEW
One of my favourite publications was – was – the OPEC Bulletin during the many years in which when they accepted a large number of my articles and comments. They changed their format however, and so now I am in the same position with them as I am with the journal Resources Policy, which I helped to launch with many articles, notes, comments and reviews, but where eventually my humble efforts were judged unworthy, and my name was removed from the list of editors.
In the most recent issue of the Bulletin, there is a long discussion of a song-and-dance for a US congressional committee by Mr Michael Masters, a portfolio manager operating out of the Virgin Islands. According to that seasoned veteran of the financial wars, “While some in my profession might be disappointed that I am presenting this testimony to Congress, I feel that it is the right thing to do.” What he apparently wants is the banishment of a certain component of oil market speculation – identified as oil “index funds” – from the face of the earth.
Unfortunately I am not in his profession, but I definitely am disappointed that the United States Senate Committee on Homeland Security and Governmental Affairs would have the slightest interest in the theories of someone whose reading of the oil price differs so drastically from that of a consensus of financial scholars. Most of the latter have pointed out to academic forums and sometimes to the media that two of the avenues for speculation in commodities are speculation in futures (or paper) markets, which DO NOT lead to the (sizable) accumulation of physical inventories, and speculation in physical (i.e. actual) markets that DO lead to the accumulation of physical inventories.
The latest BP Statistical Review of World Energy shows in a single simple diagram that there has not been the accumulation of physical inventories implied by Masters. I would like to make it clear however that it doesn’t make any difference to me what that or any other diagram or exposition or anything else shows, because Masters and other persons designated by the Bulletin as “energy analysts” have not presented a credible review of how physical inventories influence speculation. Instead they have fixed their attention on ‘open interest’, which is a readily available though for this topic largely irrelevant statistic that measures the volume of transactions in the ‘paper’ market. Moreover, they have misunderstood this item, in that they have failed to take into consideration the frequency of turnover in futures contracts. A contention that an accelerated build-up of non-physical (i.e. paper) inventories is responsible for injurious speculation in the physical market is a concept that would hardly be viable in the finance department of a storefront university, and the same is true of the attempt by the Bulletin’s commentator to tie index speculation to the swaps market.
I have attempted in my new textbook (2007) to clarify these matters, and I can also mention that one of academia’s superstars – Professor Paul Krugman of Princeton University – correctly identified the behaviour taking place in futures markets as analogous in some respects to that taking place in a casino. Incidentally, this is not a bad thing, because this ‘sham’ buying and selling – as it has been called by Professor Michio Morishima – is necessary for providing the liquidity that allows transactors in physical oil to hedge their positions.
A question that might be pertinent here concerns the motivation bringing Mr Masters to Washington in order to make his expertise available to our political overlords. The difficulty seems to be his pique with ‘index speculation’ which, according to the Bulletin article, , has led to the “stockpiling”, via the futures market, of 1.1 billion barrels of oil. My comment here is that anyone who believes this would believe anything. According to the Bulletin, the US House of Representatives has passed legislation directing the Commodity Futures Trading Commission [CFTC] to use its authority to “curb” excessive speculation. This is interesting , because earlier the CFTC unambiguously denied that ‘excessive’ speculation is responsible for the high price of oil.
SEVERAL CONCLUDING OBSERVATIONS
The reason for the Bulletin article about Mr Masters and his crusade against speculation can almost certainly be attributed to the desire of OPEC to convince importing countries that high oil prices are caused by speculation, and not the strategy employed by oil exporters exercising their market power as well as an increasingly impressive knowledge of how the oil market functions.
Here I can repeat something that I published earlier, which is that instead of increased investment by OPEC oil producers, what we are going to witness is the adoption of an optimal development economics scenario by many OPEC countries, with profits from high oil prices being used to promote diversification out of oil. I am certain of this because it is the kind of thing I taught at the African Institute for Economic and Development Planning (in Dakar, Senegal) a few centuries ago. Moreover, the higher the profits the more intensive the diversification. Perhaps the best examples of this can be found in the Gulf.
Can we justify this kind of behaviour with conventional economic theory? The answer is yes, because oil is a wasting asset, and (ceteris paribus) it makes all the sense in the world to preserve it as long as possible. Thus it can happen that a fall in demand for oil will be met by a decline in its output, because regardless of what you may or may not have heard, the value of oil in the ground will not suddenly decline due to the modest availability of e.g. alternative motor fuels.
In the discussion of the influence of speculation on physical prices, it may be easy to believe that a frenzy of speculative buying (in the paper market) will be followed by behaviour in the physical market that will bring about a substantial increase in the price of physical oil. This may of course happen to a certain extent, although there is no scientific reason for the correlation. What about going in the other direction, with a frenzy of speculative selling leading to a price decline. According to the economics and finance that I teach, this will not happen – although, ironically, it could be witnessed at any time, because to a certain extent the real world is different from the one described in mainstream economic theory, though in the matter of oil, at the present time, not so different as many observers believe.
REFERENCES
Banks, Ferdinand E. (2007). The Political Economy of World Energy: An Introductory Textbook. London and Singapore: World Scientific.
Banks, Ferdinand E. (1980). The Political Economy of Oil. Lexington and Toronto: D.C. Heath.
Ferdinand E. Banks
Professor Ferdinand E. Banks (BA,MSc,PhD) is the leading academic energy economist in the world. He has published prolifically, and has lectured at eminent universities and institutions in over a dozen countries, currently serving as visiting professor of oil and gas economics at the Asian Institute of Technology, in Bangkok, Thailand. Former posts include senior lecturer at the United Nations, econometrician and commodity economist with UNCTAD, and professorial fellow at the Reserve Bank of Australia, among many others. Professor Banks has twelve books published internationally, including his latest, The Political Economy of World Energy: An Introductory Textbook.
