The Role of Speculation in the 2007-2008 Spike in Oil Prices.

Over the last 8 years many explanations have been offered on why oil prices gradually increased before spiking upward.  In the United States, Bush administration officials and industry lobbyists consistently blamed conservation groups and the laws that protect our environment for causing high energy prices.  The accusations reached a crescendo in the summer of 2008 as oil prices peaked and chants of Drill here, Drill Now, Pay less dominated the political debate on energy.  In response to those accusations, and as a follow-up to a recent 60 Minutes story on speculation in the oil markets, I offer the following thesis on why oil prices spiked.

While oil prices will drift higher in the long run, I believe several external factors contributed to the recent 8 year run-up in oil prices.  These factors include: 1) President Bush’s decision to go to war and his administration’s saber rattling rhetoric which resulted in a significant “Iraq war premium” that increased oil prices due to supply uncertainties and supply disruptions; 2) the declining dollar explains some of the past increase in oil prices; and 3) a growing public awareness of Peak Oil added mid to long term supply uncertainty to the markets putting upward pressure on oil prices.

These external factors, in addition to the already tight global supply-demand fundamentals, created an environment ripe for speculation.  The opportunity for speculation was further enhanced by President Bush’s strong belief in free market fundamentalism and a lax regulatory environment, which meant that even if regulators wanted to do their job they would be strongly discouraged from doing so.

The following two graphs begin to explore the role of speculation.  The first graph shows the growing disconnect between U.S. oil inventories (a proxy for short term oil supply) and the price of oil.  Beginning in 2004 and continuing through 2008, oil prices increased even though U.S. oil inventory levels were within the historic range.  While additional analysis is necessary, the relationship between oil inventories and oil prices that existed between 1983 and 2003 does not appear to explain oil prices over the last 4 years.

The second graph shows the strong relationship between oil prices and open interest oil future contracts, a proxy for speculative investments.  Open interest contracts are contracts entered into but not yet liquidated by an offsetting trade or physical delivery.  As the number of open interest oil futures contracts increased in recent years, so too did the price of oil.  From a distance this relationship appears compelling and worthy of additional analysis.

My working hypothesis is that institutional investors turned to oil futures as a hedge against the declining dollar and increasing inflation – and perhaps, to make up for institutional losses in mortgage-backed securities.  Very low margins (i.e. down payments) are required to invest in the futures market.  Since low down payment requirements for home mortgages helped fuel the housing bubble, it is reasonable to assume that low margins for futures contracts contributed to a speculative investment bubble in oil futures.

Over the last 8 years there has been evidence of excessive market speculation in the energy markets.  In 2002, investigators at GAO reported that companies had exercised market power by withholding substantial volumes of pipeline capacity, thereby tightening the natural gas supply to increase its price.  In 2003, regulators at FERC concluded that price manipulation had occurred in certain markets and that revelations of improper behavior would likely continue for some time.  Economist Mark Cooper has reported that between 2002 and 2005, two dozen companies settled over 30 CFTC complaints of market manipulation or attempts to manipulate the natural gas market, with fines running in excess of $4 billion.  And in July 2008, the CFTC accused Optiver Holding with manipulation and attempted manipulation of crude oil, heating oil and gasoline futures on the New York Mercantile Exchange.

In order to reduce excessive speculation and protect consumers, some policy options for the Obama administration to consider include: 1) significantly increase the margin requirements on futures contracts; 2) require some level of physical delivery of the oil; 3) increase disclosure and transparency in the futures market; and 4) dramatically increase the oversight personnel and enforcement budgets for regulatory agencies.

Rather than blaming environmentalists for higher oil prices, one could more readily blame institutional investors and Bush administration policies for contributing to the run-up and spike in oil prices.  Although the Republicans were in charge for the last 8 years the Democrats must share the blame.  President Clinton did sign the Commodity Futures Modernization Act in 2000 which reduced regulatory oversight, and Democrats have long joined Republican efforts to deregulate markets.  Together these past bipartisan actions increased the potential for today’s speculative bubbles.

My hypothesis on a speculative bubble in oil prices in the recent past does not diminish my concern about the economic costs associated with the peaking of global oil production.  Increasing the regulatory oversight of energy markets now may in fact reduce those costs in the future by limiting market volatility.  While the U.S. responsibly develops its remaining oil and gas resources, bipartisan efforts to increase our long term energy security should focus on: 1) tuning up the efficiency of our economic engine to reduce wasted energy; 2) reducing our energy consumption and overall addiction to fossil fuels; 3) investing in a more energy efficient transportation infrastructure; and 4) diversifying our energy portfolio with renewable energy – all in anticipation of higher oil prices in the future that will ultimately be driven by the economic realities of peaking oil production.

Peter Morton is a Denver-based Senior Resource Economist for The Wilderness Society.. The opinions expressed in this commentary belong solely to the author and do not represent the views, the opinions, or policy recommendations from The Wilderness Society.

References

Cooper, M.  (2007) The Failure of Federal Authorities To Protect American Energy Consumers From Market Power and Other Abusive Practices.  Loyola Consumer Law Review.  Vol. 19:4

Federal Energy Regulatory Commission.  (2003)  2003 Natural Gas Market Assessment.  Winter 2002-03.

U.S Government Accounting Office.  (2002).  Natural Gas: Analysis of changes in market price.  GAO-03-46.

Category: Commentary, News Release, Peak Oil Review Extra