This article was originally published at ValuesandCapitalism.com on December 5, 2012.
In recent years, the purported effect of oil speculators in raising the price of oil has sparked much debate and concern. Pundits of various political bents have sought an explanation for the rising price of oil among the activity of speculators, and legislation has recently been considered by Congress that would limit the profit margins of oil speculators with the goal of suppressing costs.
Summarizing perhaps the most prevalent belief about the role of speculators in altering the price of oil, President Obama argued this spring that the American people “can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage and driving prices higher, only to flip the oil for a quick profit.”
Additionally, initiatives like Stop Oil Speculation Now (now part of the National Airline Policy Campaign) have gained considerable support from industries that rely heavily on oil for operations, such as transportation and energy companies. These industries allege that financial speculators drive up the price of oil by buying and selling it with no intention of using it, and that such speculation must end if their corporations are to function efficiently—or “based on supply and demand fundamentals instead of profiteering strategies.”
But these critics of speculators grossly misunderstand the role of speculators in the modern economy, and if their attempts to limit speculators’ activity succeed, the economy will suffer.
To understand why, it is critically important to understand what a speculator does.
In reality, speculators are no different than any other market participant. They seek to exploit price differences in order to make a profit. This is no different than the entrepreneur who begins a certain line of production believing it to be an ultimately profitable investment. Ludwig von Mises explains this well:
The mentality of the … speculators … is not different from that of their fellow men … They guess what the consumers would like to have and are intent upon providing them with these things. In the pursuit of such plans they bid higher prices for some factors of production and lower the prices of other factors of production by restricting their demand for them.
When the popular media refers to oil speculators, they are usually referring to persons who buy and sell oil with the intention of making a profit, rather than using it for any “productive” purpose. Thus, stock speculators are generally defined as “traders who take a position in an asset solely to profit from a change in price.”
Allegedly, these people are driving up the price of oil and making everything worse for the larger public, who need oil in order to go about their daily lives.
Now while there is some apparent truth to the notion that speculators drive up the price of oil, it is not the case that if there were no speculators, oil would be less costly. Indeed, when speculators predict future increases in the price of oil, they bid up the spot price as they seek to increase their own stock in oil. They then plan to sell it at a later date for a profit. Thus, speculators turn future price-increases into present price-increases, often preventing a fall in prices in the present.
But imagine if there were no speculators. If the price of oil were to drop to $1.25/gallon, the amount of oil consumed would skyrocket. Indeed, considering the important place oil occupies in today’s economy, such an occurrence would lead to a general economic boom. And all because there were no speculators to buy up all the cheap oil, right?
Wrong. If there were no speculators predicting future price increases—future changes in fundamental supply-and-demand—there could very well be shortages of oil in the present, as the low price entices consumers to buy far more of it than they need. As Victor Niederhoffer explains:
When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the scarcity by growing or importing more. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus.
Speculators are thus a sort of “price-corrector,” seeking spot prices lower than anticipated future prices. By capitalizing on intertemporal price differentials, they prevent shortages and give other entrepreneurs means to gauge the future price and supply of oil. And as Niederhoffer shows, speculators can drive down the price of oil just as they can allegedly drive up the price of oil. To attribute only price hikes to them is mistaken.
Much more can and should be said about the benefits of speculation. Suffice it to say, however, that speculators are by no means an “unnatural” or harmful part of modern-day financial markets. We should be more careful than to immediately accuse them of messing things up for everybody else.