People around the world are feeling the pain at the pump. President Obama, whose reelection in 2012 may depend on a rebounding American economy, has promised that his energy plan could temper oil prices. Adding to the stakes, minutes from the US Federal Reserve meeting in March 2011 revealed concern that high oil prices could hurt the American economy.
So why have oil prices risen from around $36 dollars per barrel in December 2008 to $110 dollars per barrel now? And what can be done to lower them? Speculation in oil markets, which has little to do with oil demand and supply, is a key part of the problem, and it can be stemmed with several regulatory steps.
Oil prices are determined mainly by the combined behavior of oil traders on markets, the most important one being the New York Mercantile Exchange. When traders believe that oil prices will rise, they buy oil futures in the hope of selling them down the road for a profit. Such buying increases oil prices, and, eventually, the price of gasoline, heating oil, and many other products.
Oil prices started to rise because traders saw clear signs that the US and global economy were rebounding after the Great Recession, creating more demand for oil. The weakening dollar and fears that Middle East turmoil would disrupt oil supplies have also pushed prices higher.
While popular opinion and media coverage often blame Middle East turmoil for higher oil prices, it’s only a partial explanation. After all, the Saudis are pumping extra oil to make up for lost oil from Libya. And while oil traders and many others thought that unrest in Bahrain could spread to oil-rich Saudi Arabia, this has not happened. We now have more oil in the markets than we need, pushing the Saudis to actually lower their oil production.
How speculation drives up oil prices
Only some traders are speculators. Speculators are those who do not produce or use oil, but buy oil futures solely to make a profit on price changes. Data released in March 2011 by Bart Chilton, commissioner of the US Commodity Futures Trading Commission, suggest that speculators have increased their positions in energy markets by 64 percent since June 2008. That’s the highest level on record.
Oil prices have continued to rise despite mixed news on oil supply and demand, a diminishing chance of Saudi oil disruptions, and Japan’s human and economic catastrophe. Such price movements were even more dramatic when oil prices rocketed from $50 in February 2007 to over $147 per barrel in July 2008. Rapid swings in price, which are hard to connect to traditional market forces, indicate the influence of speculation.
Tens of billions of dollars have been placed in US energy commodity markets in the past few years. That money is earmarked to buy oil futures contracts, and it fuels speculation. The pattern is: We’re betting on oil more and more.
What can we do about rising oil prices? News flash to Congress and global leaders: A smarter American and global energy policy would certainly help. But such policies will take time to implement.
Steps to stem speculation
Meanwhile, we must take measures to stem speculation. The Commodity Futures Trading Commission (CFTC) is mandated by the US Congress to ensure that oil prices reflect supply and demand rather than excessive speculation. There are several additional steps that the CFTC should now take:
• Place limits on the number of contracts that traders can hold. The CFTC has been considering such a move, but has so far equivocated, perhaps due to differences among its board members or pressure from some on Wall Street.
• Consider limiting the amount of margin debt that traders can assume. Now, traders can go into serious debt to buy oil futures, and that encourages higher-risk betting.
• Test various regulation solutions by gathering data to see which works best to curb speculation. This testing approach may produce results that will convince those wary of regulation to give it a try, whereas a more rigid approach may not.
Beyond these measures taken by the CFTC, we should also educate the public. Many of us essentially boost speculation by investing in commodities via our investment and retirement funds. American and global leaders should make investors more aware of that, but they hardly ever do.
Regulation is better than the alternative
Of course, tinkering with free markets is complicated. For example, if we only regulate the New York Mercantile Exchange, traders may place some bets on the InterContinental Exchange in London – another global oil market. Ideally, international markets should be coordinated. Regulations would be designed to have universal application across all commodity exchanges.
That’s possible to accomplish, though certainly not easy. Regulators can be encouraged by the recent calls for more global financial regulation, not simply piecemeal reforms within individual countries and exchanges.
I prefer free-market capitalism, but the alternative of not taking action in this case is worse than the downsides of regulating oil markets. Global oil price shocks have historically either contributed to or caused economic recessions. Even if we can dodge an oil-price shock this time around, which is possible, doing so will become even harder as global oil demand rises faster than oil supply in the future – a likely scenario.
It’s time to think about long-term changes to curb speculation-driven oil prices and the impact such prices have on the economy. And it’s time to start taking action now. Hopefully, the CFTC, and a new team that President Obama has just created to explore speculation, will reach this conclusion soon.
Steve A. Yetiv is a professor of political science and international studies at Old Dominion University. He is the author of “Crude Awakenings,” “The Absence of Grand Strategy,” and the recently released “Explaining Foreign Policy.”