Several readers call our attention to testimony by Michael Masters, of
Masters Capital Management, before the Senate Committee on Homeland Security and Governmental Affairs, on the role that speculation has played in recent commodity price movements. Here is what I think Masters is missing.
Masters testified:
What we are experiencing is a demand shock coming from a new category of
participant in the commodities futures markets: Institutional Investors. Specifically,
these are Corporate and Government Pension Funds, Sovereign Wealth Funds,
University Endowments and other Institutional Investors. Collectively, these investors
now account on average for a larger share of outstanding commodities futures contracts
than any other market participant....
In the popular press the explanation given most often for rising oil prices is the
increased demand for oil from China. According to the DOE, annual Chinese demand
for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion
barrels, an increase of 920 million barrels.8 Over the same five-year period, Index
Speculators demand for petroleum futures has increased by 848 million barrels. The
increase in demand from Index Speculators is almost equal to the increase in demand
from China!
One notices right away that one problem with trying to compare demand from index speculators with the demand from China is that the two concepts are measured in different units-- the Chinese demand is measured in barrels per year, whereas Masters' speculation-based number is measured in barrels, with no clear time interval associated with them. But a more fundamental reason you can't add the two numbers together to get total demand is that there is an underlying physical commodity to whose spot price instruments such as the NYMEX oil contract are ultimately tied. There are individuals who use this physical commodity-- namely, consumers who use the gasoline to drive their cars-- and separate entities that produce it-- most importantly today, the national oil companies of the oil-producing countries. The key question is, How would the behavior of these two parties change as a result of a new higher price for the basic commodity they are consuming or producing?
If your answer is, neither consumers nor producers change anything they do at all in response to the price increase, then I agree you could make a case that speculators by themselves could make that price any old number. But I don't believe it is accurate to assume that both consumers and producers would do exactly the same thing, no matter how high the price goes. At a higher price of gasoline, consumers will use less of the physical commodity. Not much less, I grant you, and that's why I agree that speculators are able to have more of an influence than I might have expected. But I would insist that if you drive the price of gasoline sufficiently high, consumers will respond.
And that's a problem for any "paper oil" theory-- if consumers are buying less of the physical commodity, what's happening on the production side? If production doesn't change, then oil must be piling up somewhere in inventory, possibly some just idling in tankers in the Persian Gulf. But no one has an incentive to keep adding more and more oil to inventory forever. So ultimately, the "paper oil" theory is going to require a reduction in the production of actual physical oil.
And that leads you to the question, Why would producers want to cut production? If the answer is, they make more profits with lower production and higher prices, then they would want to make those same production cutbacks with or without the speculation, and you'd have to blame the whole phenomenon on the operation of those profit calculations themselves, with the speculators just a device that got us to equilibrium between supply and demand more quickly.
Now, I personally do accept the view that the "paper oil" speculation has made a contribution in recent months to the increase in the price of physical oil. I believe that this speculation has resulted in a slight decrease in the quantity demanded that has required some modest supply reductions or accumulation of inventory by producers. But I expect that producers will find these changes not to be in their best interests as the demand adjustments become more prominent, at which point the price must return to that governed by the underlying physical fundamentals.
Ultimately, the price must be such that the quantity of physical oil demanded at that price is equal to the quantity of physical oil supplied. Any speculator who promises on paper to buy oil for more than the physical stuff is actually selling for will find themselves at that point with a big, fat paper loss.
