THE EFFECTS OF SPECULATION IN THE OIL MARKETS 7/11/2008

The role of speculators in the oil markets has been much maligned of late, perhaps for good reason. Traditionally, speculation and speculators provide for a much needed source of liquidity; as in the case of the farmer whose bean crop is still in the field, but needs the cash to pay for the seed or taxes, etc. A speculator steps in, offers so much per bushel today and then bears the risk that bean prices will still be at that level or higher once the crop comes to market. The farmer gets his money and avoids ongoing risk, the speculator hopes to get his money back and make a profit. Both sides are happy. But sometimes the farmer can’t get as much as he needs because so many farmers planted beans that year, or the speculator finds that climate conditions made for a bumper crop for beans and there are so many beans available that they’re worth less when brought to market than he thought they might be. Other times just the opposite is true and the speculator can make extraordinary profits. Speculation and speculators aren’t bad, but rampant speculation can bring extraordinary consequences well outside of the intended liquidity benefit for which speculation has been allowed in our economy and markets.

Commodities traders (speculators) have taken the speculation concept nearly as far as the free market system we enjoy will tolerate, perhaps further. The executive and legislative branches of government are looking at regulating the role of speculators and tightening the system used for trading and re-trading commodities contracts. While I would normally eschew such consideration, this may the time and oil may represent the case for it. It is estimated that some $30 - $40 per barrel of the price of oil comes from the effect of commodities traders in the oil markets. I’m a staunch believer in The Kudlow Creed offered by Lawrence Kudlow (Chief Economist, Prudential Annuities and CNBC/Wall Street Journal contributor) which states, ‘free market capitalism is the best path to prosperity’, but in this case we may have gone beyond the good sense employed in a free market system and extended the effect of speculation to a more detrimental end.

At a time when our economic has slowed, the value of the US dollar has weakened, and global demand for oil has begun a long anticipated climb, this level of speculative activity may be unbearable.

Jeff Thredgold, of Thredgold Economic Advisors, estimates that today’s oil pricing breaks down as follows: of $140 per barrel some $70 represents the fundamental price based on basic supply and demand models, political an military concerns in the middle east represent another $15 in excess cost, a weaker US dollar represents another $15 and the effect of speculation represents the remaining $40. Such a premium is crippling for many American families, certainly has an adverse effect on business, and has placed an enormous burden on the US military’s transportation budget – all at a time when the economy needs stimulation rather than the added weight of the proverbial mill stone around its neck.