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speculation in oil markets (Tom Palley)
Source Jim Devine
Date 08/06/24/20:49

June 24, 2008
Beating the Oil Barons

OVER THE PAST eighteen months, oil prices have more than doubled,
inflicting huge costs on the global economy. Strong global demand,
owing to emerging economies like China, has undoubtedly fueled some of
the price increase. But the scale of the price spike exceeds normal
demand and supply factors, pointing to the role of speculation and
underscoring the need for policy action to clean up the oil market.

Reflecting their faith in markets, most economists dismiss the idea
that speculation is responsible for the price rise. If speculation
were really the cause, they argue, there should be an increase in oil
inventories, because higher prices would reduce consumption, forcing
speculators to accumulate oil. The fact that inventories have not
risen supposedly exonerates oil speculators.

But the picture is far more complicated, because oil demand is
extremely price insensitive. In the short run, it is technically
difficult to adjust consumption. For instance, the fuel efficiency of
every automobile and truck is fixed, and most travel is
non-discretionary. Though higher airline ticket prices may reduce
purchases, airlines reduce oil consumption only when they cancel
flights.

This illustrates a fundamental point: in the short run, reduced
economic activity is the principle way of lowering oil demand. Thus,
absent a recession, demand has remained largely unchanged over the
past year.

Moreover, it is relatively easy to postpone lowering oil consumption.
Consumers can reduce spending on other discretionary items and use the
savings to pay higher gasoline prices. Credit can also temporarily
fill consumer budget gaps. Although the housing boom in the United
States which helped in this regard ended in 2006, consumer debt
continues to grow, and America's Federal Reserve has been doing
everything it can to encourage this. Consequently, for the time being
the US economy has been able to pay the oil tax imposed by
speculators.

Unfortunately, proving that speculation is responsible for rising
prices is difficult, because speculation tends to occur during booms,
so that price increases easily masquerade as a reflection of economic
fundamentals. But, contrary to economists' claims, oil inventories do
reveal a footprint of speculation. Inventories are actually at
historically normal levels and 10% higher than five years ago.
Furthermore, with oil prices up so much, inventories should have
fallen, owing to strong incentives to reduce holdings. Meanwhile, The
Wall Street Journal has reported that financial firms are increasingly
involved in leasing oil storage capacity.

The root problem is that financial markets can now mobilize tens of
billions of dollars for speculative purposes. This has enabled traders
collectively to hit upon a strategy of buying oil and quickly
re-selling it when end users accommodate higher prices a situation
that has been aggravated by the Bush administration, which has
persistently added oil supplies to the US strategic reserve, further
inflating demand and providing additional storage capacity.

Absent a change in trader beliefs, the current oil price spike will be
broken only by a recession that exhausts consumers' capacity to buffer
higher prices, or when the slow process of substitution away from oil
kicks in. Thus, economic fundamentals will eventually trump
speculation, but in the meantime society will have paid a high price.

Whereas oil speculators have gained, both the US and global economies
have suffered and been pushed closer to recession. In the case of the
US, heavy dependence on imported oil has worsened the trade deficit
and further weakened the dollar. [the weaker dollar means then means
that US$ oil prices rise relative to the euro price, etc. The US$'s
fall might also have a speculative element. -- JD]

This sobering picture calls for new licensing regulations limiting
oil-market participation, limits on permissible trading positions, and
high margin requirements where feasible. Sadly, given the conventional
economic wisdom, implementing such measures will be an uphill
struggle.

But some unilateral populist action is possible. A major form of
gasoline storage is the tanks in cars. If people would stop filling up
and instead make do with half a tank, they would immediately lower
gasoline demand. Given lack of storage capacity, this could quickly
lower prices and burn speculators.

By Thomas I. Palley, Copyright Project Syndicate

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