Onions, Eggs, Parrots & Oil Prices

By George Noga

Is Speculation Causing Higher Gas Prices?

The Obama Administration and its state sycophant media blame speculators for the high price of gas – $4.00 at the time of this writing.Never mind that when Bush was president these same folks blamed high gas prices on Bush and Cheney’s connection to the oil industry; where were the speculators then?

Politics notwithstanding, this blog post will take an objective, fact-based and principled look at the role speculation plays in oil prices.

As of March 12, 2012, Brent Crude (we must use the cost of imported oil as that is what we buy at the margin) was trading around $125 per barrel. Inasmuch as there are 42 gallons per barrel, this translates to $3.00 per gallon. Taxes alone are $.48 and, along with the costs of refining, transport and vendor markup, nearly exactly $1.00 is added resulting in the price you pay at the pump of $4.00.This relationship has held true for several years whether crude was $58 or $125 per barrel.

Hence, it is clear speculation plays no role whatsoever from the time a barrel of crude is purchased through the price you pay at the pump. If speculation enters into the price of gas at all, it must therefore be included in the price of a barrel of crude.

Supply, Demand and Parrots

On the first day of class, my economics professor averred a parrot could be trained to be an economist – when asked any question, all the parrot would have to do was squawk “supply and demand” and it would be right nearly every time. So it is with oil. When futures market traders (speculators if you insist) act, their calculus of the future price of oil includes myriad factors. They must carefully assess and assign value, inter alia, to the following:

  1. Increased demand from China, India, Brazil and other rapidly developing countries
  2. Global economic growth rates
  3. Value of the US dollar – currently shrinking rapidly
  4. Decreasing domestic exploration and production outlook
  5. OPEC – although weakened, it still has considerable clout
  6. Libya and other hot spots and disruptions in oil production and flow
  7. Iran and the prospects of war with Israel and closure of the Straits of Hormuz
  8. Failure of alternative energy sources
  9. Existing stocks (inventory) of crude oil which have fallen over the past few years
  10. The length of time involved and the carrying cost

All the above influence future supply and demand and determine the price of oil for future delivery. Each trader carefully assesses and weighs all these situations before risking his capital.

It is impossible to know precisely how much each factor (and all interacting together) affects the future price of crude oil. Nevertheless, it is certain these factors, all involving future supply and demand, determine prices in free markets based on the composite wisdom of each trader acting individually. Okay – so how does speculation enter into the equation?

George Noga

The Role of Speculation – An Onion Omelette

Yes, Virginia, there are speculators! But as you are about to learn, their role is different than you may have believed. Please consider all the following.

Hedging Versus Speculating

A significant part of futures markets is hedging whereby buyers and sellers trade solely to lock in a future price for delivery. These traders are engaging in commerce and are not speculating. No one regards hedging as problematic for gas prices.

Speculation Creates Orderly Markets

Speculators are essential for liquidity and maintaining orderly markets; they help rationalize prices across time. Speculation actually reduces volatility in prices – as you will soon see in the case of onions.

Speculation is All About Supply and Demand

Speculation is about supply and demand and nothing but supply and demand. Speculators make money when they reach correct conclusions about future supply and demand; they can lose a fortune if their analysis is wrong or unexpected events intercede. Because all markets represent collective wisdom about supply and demand, speculation centered on future supply and demand is part and parcel of efficient markets. It is not merely gambling.

The Problem is Uncertainty; Speculation is but a Symptom

The underlying issue with gas prices is uncertainty; if there were no uncertainty about future supply and demand, there would be no speculation. Without scrambling the situation too much, let’s crack open the lesson of egg futures. Long ago, eggs were seasonal and egg production could and did vary from year to year. There was a vibrant futures market for eggs. Once egg production became year round and the future supply and demand for eggs became highly predictable, the futures market for eggs became irrelevant. Hence, the real issue is uncertainty – a great deal of which is caused by the very government that now blames speculators.

Speculation Reduces Volatility

In 1958 onion growers were concerned futures market trading exacerbated the volatility of onion prices. They successfully lobbied Congress (via an up-and-coming Michigan congressman named Gerald Ford) to ban onion futures and Congress complied; the law still stands. So, what happened? For crying out loud, onion prices became much more volatile – much more volatile than oil prices. In 2006-2008 onion prices soared 400% and subsequently crashed by 96%. Absolutely no speculators. How much of that volatility do you want? Note: Onion growers now want to peel back the ban and return to futures trading.

Speculation Can Help Conserve Scarce Resources

If speculation were to increase gas prices, how would it work? The story being bandied about on the Internet is that higher futures prices may be causing some producers to withhold supplies, hoping to realize higher prices in the future. Let’s say, a arguendo, this is true. If there is indeed a disruption in future supply, such a hold-back would be beneficial as it would result in more supplies of oil during a time of disruption – a public good.

Are Speculators Beneficent Angels When Prices Fall?

Speculators are convenient bogeymen and whipping boys when prices are rising. Why is it we never hear anything about speculators when prices are falling – as they are much (about half) of the time. Were speculators beneficent angels when oil prices fell to $50 per barrel?

Back to the Question: Does Speculation Raise Gas Prices?

My goal, as is the goal of all good analysis, is to present the facts and logic in such a way as to permit readers to draw their own valid conclusions. I hope I have accomplished that mission. I also conferred with a commodities expert, someone who has traded futures successfully for over four decades; his response was: “Speculation cannot hold the price of oil far from the market-clearing price for long; consumption falters and OPEC ramps up production. About the most that could happen would be a very short term rise or fall.”

Maybe – Sometimes – Slightly – Briefly

My conclusion. It is impossible to prove speculation never has any impact on the price of gas. Nevertheless, the most one can assert is that it may, sometimes have a slight effect for a short while. Nevertheless, there seems little question but that speculation on balance is an economic benefit that reduces price volatility. Blaming speculators for high gas prices is pandering to the uninformed and the refuge of scoundrels seeking to misdirect blame from themselves.


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