Sunday, July 12, 2009

Speculators suddenly are the bad guys who are to blame for high oil prices. The Obama administration, Congress and leaders in Britain and France are all playing the blame game. As a remedy, governments are proposing rules to limit how much speculation can occur. But blaming speculators for high prices makes no more sense than blaming the messenger for bad news.

At the root of this scapegoating is a misunderstanding of basic economics. Speculators make money by smoothing swings in prices. For example, oil prices rise even before a hurricane hits the Gulf Coast. Why not wait until the hurricane hits and causes damage? If speculators think prices will be higher after the hurricane has hit, they can make money by buying oil before the hurricane strikes and selling it when the price goes up. In general, to be a successful speculator, you buy low and sell high. When more speculators all try to buy more oil in anticipation of the hurricane damage, the price obviously rises.

Is that bad? Hardly. The higher price discourages consumption before the damage and thus helps ensure that oil will be not quite as scarce after the storm. Critics focus on speculators raising prices before the storm, but the prices after the storm are lower than they otherwise would have been. Speculators make money by equalizing prices over time.

If a hurricane is certain to strike, speculators will keep bidding up the price of oil to the point where the price will be close to what it will be after the storm. (Because storing oil is costly, there will still be a slight difference in before-storm and after-storm prices.)

Speculators aren’t causing hurricanes. They are not causing political turmoil in Iran. And they aren’t causing the uncertainties about how oil demand will change from month to month in these uncertain economic times. What they do is simply put their own money at risk to smooth out these swings. If they guess wrong and bid up the oil price only to see the hurricane veer away, they lose money.

To help decide whether speculators or politicians know better, Americans don’t have to go any further than, a futures market. This is one place where people place bets on what will happen not only on economic outcomes but on current political or entertainment events, such as who will win an election or an Oscar. In 2004, speculators on Intrade correctly predicted which presidential candidate would win the electoral votes of every state in that year’s U.S. presidential election. In 2006, Intrade predicted who would win each and every Senate seat up for election. You would think such accuracy would earn some respect among politicians.

If regulators know better than speculators what the price should be, here is a suggestion: They should be out there making lots of money. In the process, they will smooth out price volatility.

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