Common Tragedies

Thoughts on Environmental Economics

Speculation skeptic

Posted by Daniel Hall on December 30, 2008

There has been a bit of discussion in the comments to my previous oil post about the role speculation played in both the rapid rise and spectacular collapse in oil prices over the last 12 months.  Commenter Dave Sawyer sums up the idea:

What about good old speculation? Seems that with the demand growth and price rise, hot money flowed in and further drove up prices. With the credit collapse, and all the associated margin calls, the same then became true in reverse. A demand destruction and speculation downward spiral.

I am reflexively skeptical about arguments that use speculation to explain a large portion of price movements.  Liquidity can probably help push up prices a bit but positing large price increases from ‘hot money’ seems to be an argument that extra liquidity is will primarily encourage investors who are long oil but that same liquidity will do little to encourage other investors to take the opposite bet.  I like these thoughts from Geoff Styles when he sums up the “Energy Lessons of 2008“:

  1. Demand matters as much as supply in determining prices. The difference between oil at $145 per barrel and $40 is only a couple of percent of global demand, or more precisely a swing between steady growth of 1-2% per year and a shrinkage of similar magnitude.
  2. Speculation can amplify prices and market volatility, but it can’t override a dramatic shift in the underlying fundamentals of supply or demand. Leverage increases not only the magnitude of speculative gains and losses, but apparently also the speed of the shift from one state to the other.

Think about that final sentence!

The one additional point I would make is that even if speculation can push up prices a bit in the oil market, the oil that is consumed is actually worth the money that is paid for it.  Even when oil was $145 a barrel, every barrel that was consumed — all 85 million a day of them — was worth at least $145 to the person that was buying it.  That doesn’t mean that oil is worth that much in the long-run — I suspect we are going to see a long-term demand shift in the West that will be comparable to the demand shift that followed the 1970s oil crisis — but in the short-run oil is very, very valuable to those who need it.

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2 Responses to “Speculation skeptic”

  1. Thom said

    I agree completely. Speculators can do all they want for 30 days with oil futures, but when push comes to shove, you have to play the physical game at the end of the month. If you are long, you take delivery (or the difference between the futures price and the physical settlement). If you are short, better have some inventory (etc). Unless speculators had tremendous amounts of storage, there’s not much they can do outside of increasing volatility of the futures price. Since there is little evidence suggesting that speculators were taking large amounts of delivery and sitting on it in hopes of better prices later, its tough to believe that they ’caused’ the run up in prices.

    A better explanation is that demand in India and China has been steadily increasing while supply stayed relatively fixed. We know that in the face of $100+ oil, there was a huge push for more drilling (as evidenced by skyrocketing prices for rigs and crew). Well, all those wells drilled since 2004 (the last time prices were this low) are now probably coming online, at the same time that the world economy is slowing down. Supply pushes out, demand pulls in, and prices fall.

  2. Carlos Ferreira said

    You can’t go over the fundamentals – it is a question of supply and demand. We have all heard how small the price elasticity of demand for oil is, and we know how that translates into a very steep, almost vertical, demand curve. Supply failed to keep up – in the end it was good old price elasticity of demand that served as moderation to consumption. We pulled back, it went over the willingness to pay, as the good old law of supply and demand predicts.

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