Large financial firms are contending with the oil industry right now for the title of ‘most hated business sector,’ so few in the general public will oppose a new initiative by the Commodity Futures Trading Commission to impose tighter regulation on trading oil futures. On the whole, the proposed changes are reasonable, but even much-maligned oil speculators have a role to play.
The CFTC proposes limiting the number of futures contracts any single “speculator” holds at one time. (Such limits already apply to agricultural commodities like corn or soybeans.) A speculator is someone who contracts to buy or sell a commodity for delivery in the future but who does not either produce or use the product in question. They are not oil companies trying to lock in a price for what they produce nor are they fuel users like an airline or railroad trying to set a firm price for the input they must buy to operate. Such producers, processors or users of a commodity seeking to reduce risk are “hedgers.”
Speculators instead contract to buy at a stated price, hoping prices will rise, or they contract to sell hoping prices will drop. Though they’ve been the target of much criticism of late, they perform a valuable service for society by agreeing to take on risk in return for possible reward, just as do insurance companies. And they provide liquidity, standing ready to buy whenever someone wants to sell or to sell whenever someone wants to buy. Such liquidity further reduces risk and generally makes prices less volatile.
The questions of how much speculation is needed and the negative consequences of excessive speculation are knotty ones. There clearly are periods when the risk-seeking speculator tail in futures markets wags the risk-shunning hedger dog. Many, including numerous industry insiders, think this happened in oil futures in 2008 when investment firms like Goldman Sachs and Morgan Stanley, hedge funds and commodity index mutual funds all poured in billions of dollars and prices rose to near $150 per barrel.
Many argue this speculation accentuated price swings and created greater uncertainty for the economy at a time when increased uncertainty was most destructive. So if excessive speculation exists and harms society as a whole, what should be done about it?
There are two approaches. One is to ban or limit speculative trading. The other is to force greater public disclosure of who is trading what. The CFTC apparently is considering both types of measures.
The benefit of some speculation is so great that an outright ban is out. But limiting the number of contracts for any one trader is likely. While the CFTC itself does not currently impose such limits, individual exchanges do. The New York Mercantile Exchange, for example, limits any one trader’s total positions to 20,000 contracts, or 20 million barrels. This is about as much oil as the United States uses in one day. Exactly what limit the CFTC may impose is up in the air.
The fact that buying and selling for future delivery need not take place on an organized exchange complicates the CFTC’s task. So does the danger that tighter regulation in our country will simply drive the business to London or other jurisdictions with less-restrictive rules. The fact that analogous limits have applied to agricultural commodities for decades without the Chicago trading floor losing its dominant position to other countries indicates that such fears may be overblown. But no rules about short-term trading can change long-term factors of supply and demand that determine long-term price trends.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.