Speculation

During the 2008 presidential campaign Barack Obama took aim at oil speculators, which he criticized for driving up energy costs. Now enjoying the levers of power, President Obama is looking to put his words into action:

With the price of gas at the pump at its highest point in well over a year, federal regulators moved Thursday to prevent excessive speculation by financial traders from driving the cost of oil even higher. The effort to adopt new limits on the trading of oil and other energy commodities is a sharp reversal after years when regulators left those markets alone.

The proposal from the Commodity Futures Trading Commission, which oversees oil and energy trading, would introduce new restrictions on what the largest traders can do. Concerned that some firms can amass such large holdings in energy commodities that their trades can have an outsize effect on the price of gasoline, heating oil or natural gas, officials said they would prevent traders "from establishing extraordinarily large positions."

This is foolishness borne of economic ignorance. While speculation -- partly thanks to the rhetoric of politicians -- has something of a negative connotation, it actually plays a very positive role in the economy. At its core speculation is nothing more than investment. It is simply speculating that some type of event will occur, usually in the short-term, and then investing money in order to profit from the event.

One example is speculating that the price of oil will rise and then purchasing it with the hope of selling at a later date after the price increase has taken place. One speculator, Victor Niederhoffer, explained the benefits of making such bets:

Let's consider some of the principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus.

In short, speculators help provide the market with more information to make smarter decisions. Buying oil, for example, will push the price up and encourage conservation, ensuring more supply exists for the predicted lean times (which the speculator hopes to profit from due to the spike in price which will arise from diminished supplies).

One obvious criticism of speculation is that it could provide false information. What if the speculator is wrong and there is no coming shortage of oil? In that case the spike in prices will never occur and the speculator will lose money on his investment. The prospect of losing money means speculators do not idly place their bets.

The government, however, justifies its current intervention as cracking down on speculators who place such large bets and have such a great impact on the market that their predictions of diminished supplies become a self-fulfilling prophecy:

The agency's plan sets the new trading limits high enough that they would affect only 10 firms, agency officials said. They would not name the traders.

...The proposed limit is designed to avoid a repeat of the experience with Amaranth, a $9 billion hedge fund that imploded in 2006. In a federal lawsuit, the CFTC alleged that Amaranth traders amassed such a large position in natural gas commodities that they were able to manipulate the price. The firm, which has become the poster child for this type of activity, agreed to pay $7.5 million to settle the charges. The agency said on Thursday that its proposed position limits would have constrained much of the hedge fund's activities.

It's interesting that the federal government took such an interest in Amaranth. As wikipedia says:

By 2004-2005, the firm had shifted much of its capital to energy trading. Amaranth’s energy desk was run by a Canadian trader named Brian Hunter who placed "spread trades" in the natural gas market. Hunter had made enormous profits for the company by placing bullish bets on natural gas prices in 2005, the year Hurricane Katrina had severely impacted natural gas and oil production and refining capacity. Hoping for a repeat performance, Amaranth wagered with 8:1 leverage that the price of the March '07 and March '08 futures contracts would increase relative to the price of the April '07 and April '08 contracts (i.e., they were "long" the March contracts and "short" the April contracts).

Unfortunately for Amaranth, they did not. The spread between the March and April 2007 contracts, for example, went from US$2.49 at the end of August 2006 to US$0.58 by the end of September 2006. The decline in the spread was catastrophic for Amaranth, resulting in a loss of US$6.5 billion.

In order words, the government punished Amaranth for its activities by levying a $7.5 million fine after the company had already lost over $6 billion. Which was a greater disincentive for the company making the wrong bet, the government's fine or the punishment meted out by the market?

What therefore see is that the role played by government is at best superfluous, as the market already fiercely deals with those who place bad bets.

Towards the end of the article, meanwhile, we encounter this paragraph:

Whether speculation drives up energy prices has long been in dispute. The CFTC itself issued a report last year saying there is no evidence that financial speculation has unhitched energy costs. Some critics of the new proposal argue that precipitous actions by the CFTC will drive trading away from the United States into less-regulated markets in Europe.

In other words, the actions of the Obama Administration seem to be rooted in both ignorance of how the market works and arrogance that it can do better. It's a terrible combination for good public policy.