President Barack Obama’s proposals this week to deal with the possible adverse effects of oil trading focus on two somewhat separate issues. The first is deliberate manipulation of prices for the benefit of someone in the petroleum industry or for some financial speculator. The second is the possible negative effects of excess speculation, per se, on oil prices and hence on the public, but ones that are merely the overall outcome of high-volume but uncoordinated speculation by many investors.
Two initiatives Obama called for address the first issue. One is increased funding for enforcement by the Commodity Futures Trading Commission, which oversees oil futures markets. Trading in these markets has burgeoned in the past 20 years, and funding for oversight has not kept up. So many economists will support the president’s call, although dyed-in-the-wool libertarians would prefer the abolition of the commission itself.
The second change sought from Congress is an increase in penalties for price manipulation. Penalties for violations of U.S. securities law have not kept up with inflation, either, so an increase would restore their inflation-adjusted value.
Besides, given the history of presidents appointing blue-ribbon panels, amid much publicity, to investigate gasoline price rigging only to have these bodies come back with negative reports, this is the measure with the least real-world relevance in the package. It may be a waste of time, but it won’t do any harm.
The remaining two important proposals have more substance and probably would raise sharper divisions within economics. Both deal with speculation rather than manipulation.
The first is tighter “position limits” on the number of futures contracts any single investor can hold. The idea is that if a single trader, particularly a speculator, is prohibited from holding a disproportionate fraction of the total quantity traded, the opportunity for market manipulation is lessened. This agrees with basic economic theory that the economy as a whole suffers when someone has even quasi-monopoly power.
One objection to this is enforceability.
Traditionally, participants in futures markets included hedgers, actual producers, processors or users of the commodity and speculators, typically individual traders or specialized firms. Large investment banks and investment funds stayed away. That has changed. These large investment firms now make up a significant and increasing fraction of total trading and are the target of the administration’s new initiative.
However, the Commodity Futures Trading Commission and U.S. law govern only U.S.-based exchanges. Those based elsewhere might quickly step in to fill the gap if new regulations made U.S. exchange-based trading less attractive to the big players. Furthermore, as the history of the “investment vehicles” formed to hold derivative mortgage-backed securities demonstrates, Wall Street is adept at establishing myriad shell companies. This might be a means to an end run around tight position limits.
The final element of Obama’s proposals is higher margin requirements for speculative trading of oil futures. Margin is a deposit held by the commodity exchange to cover any possible default on a contract. If prices move adversely for anyone, additional margin must be put down. But the fact that one can contract to buy or sell something by putting down only a fraction of its value allows a much higher value of financial leverage than if one purchased or sold actual oil.
Increase the amount of margin required, and you decrease the return on investment from any profit on the contract itself. Reduce potential profit, and you reduce the attractiveness of commodity futures to large investment funds.
Both of these measures, more restrictive position limits and higher margin, will result in lower fuel prices only if speculation itself is driving prices up. Economists are divided, but there is evidence that about 15 percent of price increases in the past couple years derive from speculative activity. That estimate is explained in a publication from the Federal Reserve Bank of St Louis. It can be found at research.stlouisfed.org/publications/es/article/9179. The authors note that fundamental factors of supply and demand remain the primary determinants of prices.
Most people citing this study fail to note that the same logic explaining higher prices in a rising market could lead to lower prices in a falling market. In other words, speculation may well accentuate market swings, but it doesn’t necessarily raise prices over the long term.
As many commentators have pointed out, the president’s proposals are largely political window dressing, since they don’t have much chance of getting past House Republicans. But the issue will arise again, regardless of who wins in the November election.