CAP’s Daniel J. Weiss and Valeri Vasquez explain strategies for minimizing speculation in this CAP repost.
The oil shock of 2008 helped drive the U.S. economy into the Great Recession. Oil at that time cost a record $147 per barrel, and gasoline prices surged to $4.11 per gallon in July 2008″”the highest price ever. This squeezed families’ budgets because it is very difficult for most people to significantly reduce driving in the short run when prices rise. And the U.S. Commodity Futures Trading Commission, or CFTC, found that the 2008 oil record was partly driven by speculators driving up prices to make a quick killing.
This year “it’s like d©j vu all over again.”
Oil prices are rising to heights not seen since 2008. Oil rose from $85 per barrel to $112 per barrel in a little more than two months””a whopping one-third leap. Gasoline prices have followed along, rising by 70 cents per gallon“”or 23 percent””during this same time. As our economy struggles to recover from the Great Recession, Americans are again forced to pinch pennies to afford their commute to work, school, and worship. Meanwhile, oil companies prepare to reap record profits in the first quarter of 2011.
As in 2008, there are serious indications that speculators are driving up oil prices. CFTC Commissioner Bart Chilton released data that found that:
Hedge funds and other speculators have increased their positions in energy markets by 64 percent since June 2008 to the highest level on record.
Similarly, a dozen U.S. senators wrote to CFTC Chairman Gary Gensler that “speculators are seizing on recent political turmoil in North Africa and the Middle East to drive energy prices to unwarranted levels,” citing numbers from the CFTC’s weekly “Commitment of Traders Reports” that indicate since January 25:
Money managers have increased their long positions in NYMEX West Texas Intermediate crude oil futures contracts by more than 35 percent, or the equivalent of 75 million barrels of oil.
According to Investopedia, a long position in a commodity futures contract is made when an investor “enters a contract by agreeing to buy and receive delivery of the underlying [commodity] at a set price – it means that he or she is trying to profit from an anticipated future price increase.” By buying oil futures long, speculators are betting that they expect oil prices will increase over the life of the futures contract so the oil is more expensive at delivery time compared to the original purchase price. Political instability in an oil-producing nation or region often leads end users and speculators to increase their purchase of long oil positions due to the anticipation that future prices will be higher. The fear that prices will continue to rise leads oil end users to pay more now for future delivery of oil to lock in a lower price than the one they expect upon delivery.
Indeed, two weeks ago Goldman Sachs & Co. researchers caused a stir in the commodities trading world when it named “excessive speculation” the culprit for inflating oil prices “$20 higher than supply and demand dictate,” and advised its clients to sell off their oil-related assets because they were being overvalued due to speculation.
Oil market analysts note turmoil in the Persian Gulf as a factor for higher oil prices, beginning with a small price bump around the January democracy protests in Egypt. The uprisings soon spread around the region.
Prices then took another leap up when regional political unrest hit Libya, disrupting its production of 1.8 million barrels per day, or about 2.1 percent of the world’s daily production. A decline in Libya’s prized sweet crude (the best for refining into gasoline) certainly rattled Europe and its market for crude oil. But market fears about potentially declining global oil supplies should have been ameliorated when Saudi Arabia used its vast reserves to fill the supply gap. But as Marcela Donadio, Americas Oil and Gas Leader for Ernst & Young, observes:
When Saudi Arabia increases production, as they just did, it is clear that oil supplies are plentiful and that the current pricing volatility is driven by market psychology and not necessarily real-time fundamentals.
The United States, too, has relatively ample domestic reserves“”enough to reasonably allay fears of an immediate supply disruption. And then there is the question of relatively static demand. Daily energy and environment news service Greenwire noted that:
Current U.S. crude oil inventories are roughly 12.6 million barrels larger than the past five-year average levels. Demand for gasoline from U.S. drivers has barely budged from where it was a year ago.
Although there are ample international and domestic supplies, analyst Donadio notes that “driven by angst over broad geopolitical concerns, markets are proactively reacting to a potential supply problem.” This reaction to Persian Gulf instability makes it relatively easy for speculators to bid up prices because of fear of potential supply disruptions and price increases. Oil end users and other traders buy more future contracts. This, in turn, leads to price increases and the cycle repeats. Indeed, Reuters reported that political unrest in the region drove investors “to accumulate the equivalent of almost 100 million barrels of oil between mid-February and late March on top of their existing positions, adding approximately $10 to the ‘risk premium.’”
Oil speculation has real costs to oil prices and to the overall economy. According to an estimate released by Goldman Sachs, “every million barrels of oil held by speculators contribute[s] to an 8 to 10 cent per barrel rise in the oil price.” Reuters reported:
Using Goldman’s 8- to 10-cent estimates and data on speculators’ positions from the U.S. Commodity Futures Trading Commission, Reuters calculated that as of last Tuesday, the total speculative premium in U.S. crude oil was between $21.40 and $26.75 a barrel, or about a fifth of last Tuesday’s price.
Such an increase would have a real drag on the U.S. economy. Analysts project that a sustained $10 increase in the cost of a barrel of oil can reduce our gross domestic product by up to 0.2 percentage points this year alone. In addition, a sustained $20-per-barrel increase in oil prices could yield at least a 50-cent-per-gallon hike in gasoline costs.
Speculators playing the oil market to make a fast buck are not the only factor contributing to high oil prices. Because oil is priced in dollars, the relatively weak value of the dollar makes oil an attractive purchase for speculators because oil is also priced in dollars but also rising in value. And the greater demand for oil, the higher the price.
What to do about oil-and-gas speculation?
Politico reports that “Republicans are getting ready to capitalize on record prices at the pump with a May focus on oil and gasoline.” But what will they point to? After all, House Republicans voted twice to make it significantly harder for the CFTC to establish and enforce safeguards that reduce speculators’ ability to drive up prices to make quick bucks. In February House Republicans voted nearly unanimously to pass H.R. 1 to fund the government for the remainder of fiscal year 2011. It cut the CFTC budget by nearly one-third.
Fortunately, President Barack Obama and Senate Majority Leader Harry Reid (D-NV) made sure the CFTC received more, not less, money to police commodity markets in the final legislation that funded the government through September of this year. It boosted the CFTC budget by $34 million, a 20 percent increase over FY 2010 levels. The Senate Appropriations Committee says the extra funds will “provide critical funding to better protect the average investor and increase safeguards against excessive speculation.”
But House Republicans came back at the CFTC just weeks later. On April 15 the House passed Budget Committee Chairman Paul Ryan’s (R-WI) budget proposal for FY 2012 that begins October 1, H. Con. Res. 34, by 235-193. All but four Republicans voted for it while all Democrats opposed it. In addition to many other draconian cuts, it chainsawed the CFTC budget by 34 percent, which would compel the agency to cut its staff by two-thirds. This would destroy the CFTC’s ability to police oil markets and would instead let speculators run wild””free to bet with abandon on oil prices, making it impossible for everyday Americans to budget for their driving costs””oftentimes (like now) at a huge cost to their wallets..
So what’s the most effective solution? The CFTC and other federal agencies must promptly develop and enforce safeguards that reduce the impact of speculators on oil prices. Specially, the CFTC should:
- Investigate speculative fraud. On April 21 President Obama directed Attorney General Eric Holder to create an Oil and Gas Price Fraud Working Group to “monitor oil and gas markets for potential violations of criminal or civil laws to safeguard against unlawful consumer harm.” The group will function as a subset of the Financial Fraud Enforcement Task Force Working Group and include representatives from the Department of Justice, the Commodity Futures Trading Commission, the Federal Trade Commission, the Department of the Treasury, and other essential federal agencies.
- Raise margins on speculative oil contracts. Investors who want to buy an individual stock must provide 50 percent of the value of that stock up front. Oil speculators, on the other hand, only have to provide 6 percent for an oil futures contract. In other words, one must provide $500 to buy $1,000 worth of a single stock, while only $60 up front is required to purchase oil futures.
- The CFTC should heighten margin requirements for speculators to safeguard the market’s financial integrity as authorized by Section 736 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The law’s emphasis on “protect[ing] the financial integrity of derivatives clearing organizations” makes heightened margin requirements permissible for “risk management purposes to protect the financial integrity of transactions.” As recommended by Sens. Bill Nelson (D-FL), Maria Cantwell (D-WA), and 10 other senators in their March 16 letter to the CFTC, these “higher margin levels would reduce incentives for excessive speculation by requiring investors to back their bets with real capital. The margin increase should only apply to speculators, not true hedgers.” Dodd-Frank specifically allows the CFTC to differentiate between speculators and true hedgers (p. 90). This margin increase should apply strictly to speculators, not the actual merchants and producers who are oil end users and are using future contracts to hedge against higher prices.
- Establish “position limits” to reduce potential for abuse. “Position limits” are an important safeguard that restricts the size of the bets investors can make on commodities. The Dodd-Frank law provides the CFTC with the ability to set such limits but it has not yet acted. Dennis Kelleher, a former securities lawyer who now heads the financial reform advocacy group Better Markets, urges the administration to “impose position limits, which would stop excessive speculation now.” He believes the CFTC has “the power to do this quickly.”
- Appoint a CFTC commissioner who advocates strong speculator limits. The CFTC’s mission is to protect both “market users and the public from fraud, manipulation, abusive practices and systemic risk.” Five CFTC commissioners fill staggered five-year terms and are central to this mission. One of the commissioner seats expires in June 2011. President Obama should take this opportunity to appoint a new commissioner that is pro-middle class and pro-American family, and supports the aforementioned measures to reduce the impact of speculators on oil prices.
- Charge a fee for speculator trades. Another way to limit the potential for speculators to manipulate the market would be to charge a small transaction fee for oil speculators. People who oil need must buy it””and hedge it””long term, which is why oil end users, such as airlines, should be exempt. Only serial speculators churn contracts daily, sometimes hourly. The fee per contract should increase as the speculators’ volume of futures contracts increases. The funds levied could pay for more CFTC oil-market cops to police trades and prevent the market manipulation of prices that can devastate middle- and low-income Americans, and oil-dependent businesses.
These solutions will rein in speculators and lessen the high gasoline prices that place a financial burden on American families.
What to do about our oil addiction?
But to ultimately solve the problems the surging cost of oil gives this country, we must make fundamental changes in our energy policies. This means building cars that are able to attain 60-plus miles per gallon by 2025. It means cutting foreign oil use by 5 percent annually in order to reach an end goal of slashing these imports in half by 2022. And it means ending billions of dollars of tax giveaways to Big Oil companies, using those funds to diversify transportation choices and finance advanced vehicle technologies. Only by using less oil, reducing imports, and investing and using clean energy technologies can we diversify our sources of energy and lower the cost of oil and gasoline. We need to start now.
Daniel J. Weiss is a Senior Fellow and Director of Climate Strategy at the Center for American Progress. Valeri Vasquez is a Special Assistant on the Center’s Energy Opportunity policy team. And thanks to David Min, Associate Director for Financial Markets Policy at the Center, for his help on this column.