Tuesday, June 24, 2008

Oil speculation is good, regulations bad

Alright, all you blockbuster government socialists who think that oil "speculation" aka futures trading is to blame for high gas prices, I'm going to have to bust out some Sowell on you. From Basic Economics, Chapter 12:

A tourist in New York's Greenwich Village decided to have his portrait sketched
by a sidewalk artist. He received a very fine sketch, for which he was charged

"That's expensive," he said to the artist, "but I'll pay it, because it is a great sketch. But, really, it took you only five minutes."

"Twenty years and five minutes," the artist replied.

Artistic ability is only one of many things which are accumulated over time for use later on. The Economist magazine defines investment as simply "spending today that yields a stream of income in the future." More broadly, it is not simply the spending of money but, as in the case of the Greenwich Village artist, the investment of time. If the earlier costs, sacrifices and risks are ignored, then the reward for what was done
within the present time period may often seem exorbitant. Oil wells can repay their costs many times over - but they must also cover the costs of all the dry holes that were drilled in the ground while searching in vain for petroleum deposits before finally striking oil.


Speculation as an economic activity may be engaged in by people in all walks of life but there are also professional speculators for whom this is their whole career. One of the professional speculator's main roles is in relieving other people from having to
speculate as part of their regular economic activity. Put differently, risk is inherent in all aspects of human life. Speculation is one way of having some people specialize in bearing these risks, for a price. For such transactions to take place, the cost of the risk being transferred from its initial bearer must be greater than the price charged for the transfer - and, at the same time, the cost to the recipient of the risk must be less than the price charged. The cost to the speculator may be lower either because of more sophisticated methods of assessing risk or be lower because the variety of the speculator's risks lowers his over-all risks.

When an American wheat farmer in Idaho or Nebraska is getting ready to plant his crop, he has no way of knowing what the price of wheat will be when the crop is harvested. That depends on innumerable other wheat farmers, not only in the United States but as far away as Russia or Argentina. If the wheat crop fails in Russia or Argentina, the world price of wheat will shoot up, causing American wheat farmers to get very high prices for their crop. But if there are bumper crops of wheat in Russia or Argentina, there may be more wheat on the world market than anybody can use, with the excess having to go into expensive storage facilities. That will cause the world price of wheat to plummet, so that the American farmer may have nothing to show for all his work and may be lucky to avoid taking a loss on the year. Meanwhile, he and his family will have to live on their savings or borrow from whatever sources will lend to them. In order to avoid having to speculate like this, the farmer may in effect pay a professional speculator to carry the risk, while the farmers stick to farming.

The speculator signs contracts to buy or sell at prices fixed today for goods to be delivered at some future date. This shifts the risk of the activity from the person engaging in it - such as the wheat farmer, in this case - to someone who is, in effect, betting that he can guess the future prices better than the other person and has the financial resources to ride out the inevitable wrong bets, in order to make a profit on the bets that turn out better.

Speculation is often misunderstood as being the same as gambling, when in fact it is the opposite of gambling. What gambling involves, whether in games of chance or actions like playing Russian roulette, is creating a risk that would otherwise not exist, in order either to profit or to exhibit one's skill or lack of fear. What economic speculation involves is coping with an inherent risk in such a way as to minimize it and to leave it to be borne by whoever is best equipped to bear it.


Economic speculation is another way of allocating scarce resources - in this case, knowledge. Neither the speculator nor the farmer knows what the prices will be when the crop is harvested. But the speculator happens to have more knowledge of markets and of economic and statistical analysis than the farmer, just as the farmer has more knowledge of how to grow the crop. My commodity speculator friend admitted that he had never actually seen a soybean and had no idea what they looked like, even though he had probably bought and sold millions of dollars worth of them over the years. He simply transferred ownership of his soybeans on paper to soybean buyers at harvest time, without ever taking physical possession of them from the farmer. He was not really in the soybean business, he was in the risk management business.

He goes on elsewhere to note that speculation, in turn, helps tell farmers what to grow when they are deciding what to plant during planting season. That is, if Farmer John can plant peas or corn, he is likely to consider the price of futures contracts for peas and corn, respectively, in deciding which to plant. Farmer John has no idea why corn futures may be up, while peas futures are down, and he does not care. In this way, agricultural futures actually help signal to farmers what should be planted.

Oil speculators are offering contracts to purchase oil in the future. As oil futures rise, this signals oil producers to invest more vigorously in new equipment, wells, pipelines, refineries and so on.
Regulations on oil companies, however, can prohibit them from responding to the rising prices of oil futures. It is not the speculators who are to blame for foreseeing that the price of a barrel of oil will almost certainly be higher three months from now than it is today. To the extent oil producers are unable to respond to higher oil futures prices by virtue of regulations on oil production, it is government, not speculators, who should be "blamed" for high oil prices.

And neither can speculators arbitrarily bid up the price of oil - if speculators set their contracts too high, they will eat dirt when it comes time to pay out and it turns out they have wildly overestimated the future price of oil. When this happens, you and I get the overbid oil that much cheaper. The primary losers from overly optimistic speculation are the speculators themselves.

Threatening to impose windfall profits taxes, nationalize oil companies, increase subsidies of alternative energy sources or increase regulation on the production of oil all simply contribute to further increasing the price of oil. Speculators are public enemy #1 only because futures contracts reflect the future cost of these regulatory follies today.

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