Speculating about Speculators

This past Sunday morning (June 15), I took in Fox News Sunday with Chris Wallace. His lead-off segment had Wallace moderating Senators Kay Bailey Hutchison (R-TX) & Byron Dorgan (D-ND), along with Red Cavaney, President of the American Petroleum Institute. The full transcript can be found here.

The questions and answers took the twists and turns one might expect, including Wallace pointing out that long-proposed drilling in the Alaska National Wildlife Refuge (ANWR) would impact upon an area smaller than Reagan National Airport, in an overall area roughly the size of South Carolina. Senator Dorgan seemed to be supportive of increased drilling in the Gulf of Mexico, and extraction from the oil shales of Montana and the Dakotas. True to the Democrat playbook, of course, the ANWR remains off-limits.

However, what struck me most was the demonization by Dorgan of oil "speculators" in the futures markets, and the effect they're having on oil prices. Sadly, Chris Wallace either suffers from a lack of curiousity, or is ignorant to the machinations of the futures markets themselves. Consequently, an opportunity to confront the latest illogic from the Left was lost. See how the following exchange veered from a question regarding the arrogance of governments deciding what is a fair profit (in relation to taxing any wind-fall), into an answer about speculation:

WALLACE: Senator Dorgan, let me bring in another part of this equation, because the Democrats' big idea in this area is a windfall profits tax on Mr. Cavaney's employers, the big oil companies, to finance alternative energy as well as more conservation.

How does the government decide what's a reasonable profit and what is a windfall profit? And how do you answer the fact that back when this tax was imposed in the '80s, domestic production dropped and foreign imports increased?

DORGAN: Yeah. Well, let me talk about Exxon just for a moment. Last year, Exxon used $31 billion of profits to buy back their stock and only half as much for drilling and exploration.

I mean, you know, look. With respect to a windfall profits tax, it's constructed so if they're using that money to expand supply by drilling, they wouldn't pay it. I mean, that's the approach that makes sense to me.

But I want to talk about one other thing. This issue of production is a canard. We're producing more in this country. Some Democrats, including myself, have supported additional production as well.

But let me say this. There is nothing at this point that justifies the price of oil or gas in this country with respect to supply and demand. Every month since January our domestic crude supply has gone up. Demand is going down because the economy is slowing. And yet the price of oil and gas are going through the roof.

Why? Because there's an orgy of speculation going on in the futures markets, an unbelievable amount of speculation by hedge funds, investment banks and others, that are driving up prices for the American people.

And that ought to be one area at least where Democrats and Republicans can work together to say let's wring this speculation out of...

I added the bold emphasis to show how and where Dorgan is now off-topic, and into his talking points. Unfortunately here, Wallace takes the bait and takes the interview deeper into this area:

WALLACE: Well, let me just follow up directly on that, because there is talk you're blocked on — you want a windfall profits. They want more drilling. You're not going to be able to pass either of those, it appears.

Are you willing to separate out some federal action to stop oil speculation?

DORGAN: Absolutely. Absolutely. I proposed that. I think others have proposed it. We ought to get at this. There's nothing with respect to supply and demand that justifies the current price. This is all about a lot of speculators.

Will Rogers talked about that eight decades ago, people buying things they'll never get from people that never had it, making money on both sides. These are people that don't want to take delivery of oil. They want to speculate in the market, and they've driven up prices in a dramatic way.

WALLACE: Senator Hutchison, how big a problem is oil speculation? And maybe we can work out a deal right here in this studio. Are Republicans willing to agree with Democrats, separate out and go after the oil speculators?

HUTCHISON: Well, let me say that I think all of us would agree that we need transparency. We need to understand this.

But the way that we can stop the speculation is to show that we are going to do what we can, using our own natural resources and our own creativity, to increase the supply of oil and gas and renewables in our country.

And all of the Democratic proposals don't produce one ounce of a barrel of oil.

WALLACE: But to answer my direct question, would you agree to — legislation on oil speculation, separating it out.

HUTCHISON: Well, I think if you are talking about a cartel that speculates and fixes the prices, that is absolutely something that Republicans and Democrats would agree on.

But if you're talking about people going into the market of their own free will, not controlling anything, then it is a market issue. And I think transparency would be a good add, and I would work with Senator Dorgan on that.

I think we need to look at the whole issue and understand it. But if we bring up supply, we will bring down the price.

With that as the backdrop, to my point: What are the "speculators" actually speculating upon? What motivates them to risk their investment capital? As it turns out, the answer is fairly simple: they are speculating that the future price of oil will be higher than it is today. They do this by buying and selling futures "contracts", that commit the "seller" to deliver to the "buyer" a certain quantity of the underlying commodity (in this case, oil), at a certain price, and on a certain future-date. Collectively, these global speculators are placing a bet on the continuation of the uptrend in oil prices.

To take their side of this bet, the speculators make certain assumptions, which would result in a winning bet. Based on popular commentary, the following are key motivators:

1. An expected increase in global demand for oil, due to the the explosive growth in China, India, and other areas of the developing world. An increase in demand, with all else being equal, will lead to an increase in prices;
2. A down-dollar (for dollar-based futures trading) will result in a relative increase in the price of oil. That is, if the dollar falls in value relative to other major currencies, global commodities will cost more in dollars. Actually, some economists believe that up to one-half on the increase we've seen in the U.S.A. is related to the steady decline of the dollar since 2004;
3. Continued political unrest, particularly in the oil-rich Mid-East. Sometimes referred to as a "fear" premium, any instability in this region (whether it's unrest in Iraq, Iran, Lebanon, Syria, or the collective threats against Israel) has a negative impact on oil prices, as investors need to be "rewarded" for taking risk associated with future deliveries.

However there's a major one that's oft overlooked (or ignored?) by our media, and one that bears particular mention as we approach the general election: market expectations of future increases in the supply of oil.

Just as an increase in demand can lead to higher prices, an increase in supply will lead to lower prices. If the community of futures speculators believe that the politicians will act to increase supply (say, by opening up the ANWR), then they'll have a negative price-trend to factor in, which would diminish their odds of their winning their bet. It's no coincidence then, that the largest portion of the increase in oil prices coincides with the Democrats winning control of the House and the Senate, and that they're now positioned to also win the White House this fall. With this political reality as the backdrop, the likelihood of increased drilling is just about nil. So long as the Dems kow-tow to their environmental and anti-capitalist special-interest groups, there will be no new exploration; no new refineries; and no increase in domestic production. No increase in supply? Higher prices!

Finally, the idea of regulating the futures markets in some way may sound like an interesting idea to the ill-informed, but the reality is that oil is a global commodity, and futures are traded globally, not just in the markets we can regulate here at home. Restricting futures trading in the U.S.A. will only drive trading to other global venues, resulting in no impact at all.

As it has been for years, the only practical solution to our current energy woes is the act now to increase supplies, and in support of a policy that will immunize us from the whims of the OPEC cartel and other oil-suppliers that aren't friendly to the U.S.A.