Ok, Then… Where are They Hiding all of the Cheese?

Congress has been busy grandstanding about how they are going to solve the high price of oil by cracking down on speculation in the oil markets. In fact, not less than nine bills have been introduced by our elected officials, who clearly have no idea how futures markets actually work or why they even exist. Of course it is very convenient to blame hedge funds and other speculators for today’s oil prices, instead of looking at the structural problems of our petroleum based culture and the lack of leadership and political willpower to support significant investment in technology development or encourage conservation since the first oil crisis began in 1973.

Interestingly enough, the Federal government purchased and warehoused cheese during the 1970’s in an effort to support cheese prices. Prices are driven by supply and demand, so if you want to raise price levels in the short term, you must limit supply. Congress apparently believes that hedge funds are hoarding barrels of oil in their office suites in New York and Connecticut today. In truth, the futures markets and speculators are all that stands between $140 a barrel and $250 a barrel. Let me explain…

When oil prices are going up, oil refineries and end-users are more likely to hoard oil at today’s prices, because they expect that if they wait to purchase supply later, the price will be higher. Instead of hoarding, they can hedge this market risk through trading in the futures markets, and speculators support this hedging strategy by taking the other side of the trade. Similarly, producers are less inclined to pump and ship as much product today if prices are expected to rise tomorrow. Again, hoarding the cheese is prevented by the liquidity of a robust futures market, which allows producers to hedge instead of to hoard. Finally, if an oil company is considering whether to invest capital in new production, they must consider whether it will still be economically viable if current oil prices were to drop. Again, the futures market provides a trading strategy to minimize these risks to producers and their lenders.

The fact is that more trading and more participants—including speculators—in futures market drives more efficient pricing for hedging strategies that prevent price bubbles from developing. Moreover, a seemingly thoughtful proposal in Congress to limit speculation by raising margin requirements from approximately 10% today to 50% would do more than just discourage some high stakes speculators; it would have the unintended consequence of raising financing costs for fuel distributors, forcing them either not to hedge—thus increasing risk of bankruptcies and supply disruption—or to raise prices to end users to compensate.

Congress needs to look elsewhere for solutions to high oil prices. If they succeed at driving speculators from the futures market, it will have the same effect as Congress hiding the cheese.