Wednesday, April 18, 2012

Kennedy's op-ed is sloppy economics

Congressman Joseph Kennedy (D-Mass.) has an op-ed in the New York Times calling for a ban on oil speculation:
Today, speculators dominate the trading of oil futures. According to Congressional testimony by the commodities specialist Michael W. Masters in 2009, the oil futures markets routinely trade more than one billion barrels of oil per day. Given that the entire world produces only around 85 million actual “wet” barrels a day, this means that more than 90 percent of trading involves speculators’ exchanging “paper” barrels with one another.
This seems to be the new trend for Democrats. Not a bad political strategy, actually. Tying rising oil prices and Wall Street speculators together is a pretty smart way to stay on message.

However, it's very sloppy economics, so we'll have to focus on that part. (James Hamilton from Econbrowser has a good post on this too.)

Kennedy makes the point that a speculative catastrophe in the oil futures market would be much more devastating than one in the orange juice market, because there is a lack of available substitutes. On a basic level, that's exactly why we have speculators in the first place.

Speculators buy futures contracts on the expectation that prices will rise in the future. They buy oil today, when the price is relatively low, and sell in the future when supply is expected to fall. For consumers, the price may be higher, but they average out over a long period of time, rather than getting stuck in a hog market. If all the oil in Saudi Arabia disappeared tomorrow, and we knew it was going to happen, speculators would help avoid a complete meltdown of the economy.

That's not to say that oil speculation doesn't play any role in price volatility. Global shifts in demand are the main culprit, but oil speculation is expected to be the next biggest factor. Indeed, it seems as if speculation increases with increase in demand:

There's no point in taking out speculators for raising prices, when speculative prices are the result of growing global demand.

If it's a speculative bubble that Kennedy is worried about, then I don't think taking out speculators is necessarily the best solutions. For one, it's hard to determine how speculative bubbles rise because of the same reasons it's difficult to predict other financial bubbles. Predictions of where demand and supply will be in the future are based off of imperfect information.

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