President Obama, doing his best imitation of a late 19th-century prairie populist, recently pinned the blame for rising gasoline prices on speculators in energy futures markets. Just as the prairie populists were wrong about the market impact of “paper” futures trading in wheat, Mr. Obama is wrong about “paper” futures trading in crude oil.
The first problem with the attack on speculation in energy futures markets by Mr. Obama and his supporters is that no one can seem to agree on the exact target. Some argue that the problem is related to a wave of investment in long-only commodity index funds that overwhelmed the normal functioning of commodity futures markets, most notably crude oil. Others argue that, no, the real problem is found in the rise of hedge fund trading in these markets. Still others say the problem is actually due to the activities of a new type of “high frequency” trader who enters and exits markets by the millisecond. In his own remarks, Mr. Obama focused on shadowy traders that manipulate markets in the fashion of Enron.
The fact that opponents of “speculation” can’t even agree on the type of trader at fault is in itself a powerful indictment of the charges. One is instead left with the impression of a gang who couldn’t shoot straight rather than a reasoned and thoughtful analysis of energy markets.
The second problem with the attack on speculation is that it is simply not supported by the evidence. Numerous studies have been completed in the past five years on the impact of speculation in commodity futures markets. The evidence in these studies tilts decidedly against the view that speculation has been harmful. There is no “smoking gun” connecting speculation to the rise in gas prices. In fact, just the opposite is likely to be true: Expanding market participation by different kinds of speculators likely reduces the cost of hedging, dampens price volatility and better integrates commodity markets with financial markets.
The third problem is the most serious. The measures proposed by Mr. Obama to address the supposed problems created by speculation will almost certainly do more harm than good. He proposes to increase by six times the money spent on surveillance and the enforcement staff of the Commodity Futures Trading Commission (CFTC) to better deter oil market manipulation. Without clear evidence of an ongoing and systematic pattern of market manipulation, this is a waste of public funds and creates the potential for pressures to find manipulation in order to justify the increased spending in the future.
The president also proposes to give the CFTC the authority to raise margins on traders in crude oil futures markets. This proposal belies a fundamental misunderstanding of the role of margins in futures markets. Margins are first and foremost a form of collateral to assure that the losing side in a futures contract is able to pay up. Raising margins increases the cost of maintaining futures positions, which, in turn, can lead to a shrinking pool of speculative capital available to absorb the orders of those seeking to hedge risks. An increase in price volatility then follows - the reverse of the intended outcome.
The irony in all this is that Mr. Obama, of all people, should appreciate the important role that energy futures markets play in our modern economies. He is a proud citizen of Chicago, which just happens to be the home of the world’s largest futures exchange. I am sure that I am not alone in being disappointed with his latest proposals.
Scott Irwin is a professor of agricultural marketing at the University of Illinois.
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