Why There Should Be More Oil Speculation, Not Less

Why There Should Be More Oil Speculation, Not Less

We need more — not fewer — oil traders. After a rollercoaster ride that has sent oil prices from a record high of $147 per barrel last July to below $35 in December and back to around $60, there’s been a clamor to clamp down on speculators—those investors who trade oil but don’t ultimately supply it or use it, the way airlines do for instance. The economic disruption caused by oil’s volatility has been so vexing that the Obama Administration believes it can stabilize prices by regulating speculators out of the market. It can’t.

So much money has piled into oil that there’s a belief that there are too many people involved in the futures market. In fact, the opposite is true. The participants are so few that a couple of major players can, if they choose, garner absolute control, cornering the market and creating a price bubble for their own benefit.

Currently, with virtually no regulation, the oil futures market — given that it drives the price of oil worldwide— is very small. Dangerously small. To limit trading would make it smaller still. If the government decides to curb trading in the oil futures market, it would limit trading by purely financial speculators. Instead, the government should focus on trade activity by oil companies, oil suppliers and oil hedgers like airlines. Yes, you read correctly: Oil traders with physical ties to crude represent the greatest threat for another price hike.

The oil futures market is tiny compared with the physical oil market: Less than 3% of the world’s oil consumption over the next year is accounted for in the open interest — the contracts currently being traded — at the New York Mercantile Exchange . To put it in perspective, Saudi Arabia alone produces four times that much oil. Consider the leverage that the futures market allows — you can trade more than 10 times your money in oil — and suddenly every dollar you put in the futures market controls well over $300 of oil. We can put a price tag on the whole market: For a mere $4 billion, you can easily control the fate of the entire multi-trillion dollar industry. Goldman Sachs pays out more than that in annual bonuses.

Most disturbingly, the U.S. government cannot possibly regulate the global market. Oil is an international commodity, traded by Americans and non-Americans alike on both American exchanges and exchanges overseas. The U.S. should not outsource markets by placing a divide between America and the rest of the world. Do regulators hoping to ease oil prices really want the dollar price of oil determined in Dubai, the backyard playground of the largest oil exporter With the proposed regulation, foreign oil suppliers will have a greater futures market share. The oil market will become more susceptible to manipulation by these suppliers.

Another common misconception is that speculators only buy and hold assets. More accurately, speculators try to benefit from fluctuations in prices. In other words, speculators cannot profit from sustained high prices; they can only profit from changing prices. So, yes, the recent volatility in the oil market can certainly be attributed to speculation, but speculation cannot support an extended price rally. Major players like banks, on the other hand, are more than just pure speculators, having the resources to drive prices up.

The same banks that we bailed out are major players in the energy markets: Citigroup, through its Phibro commodities trading subsidiary, and Goldman Sachs, through its own energy trading desk. Banks are likely playing a key role in the current run, by putting the bailout money to good use: to continue the bid for oil. Again, just a fraction of the bailout is enough to corner the market and rig the price of crude— not that any of these players would dare to do so.

There is no doubt that the banks and other speculators need accountability and transparency. But smaller speculators — like hedge funds and other trading firms — play a role in maintaining liquidity and reducing the impact that oil suppliers have in participating in the market. Those speculators might benefit from volatility, but without them, there would be even more volatility, resulting from radically rising prices.

While speculators affect the market in both directions, commercial participants tend to put upward pressure on prices. If airlines fully hedged themselves in the futures market, the price of oil would jump enormously. The futures market cannot support hedging for energy, let alone for other things; for example, investors might buy oil to hedge against losses in other investments, like stocks. With speculators out of the market, an airline’s hedge would have an even bigger impact, further raising the global price for oil.

What if we took out all the traders who had nothing to do with the oil market That would leave oil suppliers and oil hedgers: those trying to sell oil, and those trying to buy oil, respectively. Suppliers benefit from higher prices and so would not be willing to sell. Hedgers, afraid of soaring prices, would buy oil futures, driving the price to unheard of levels. Worse still, we have to worry about the oil suppliers themselves getting in on the futures price action. They can afford to take on huge risks in the oil futures market because they make such large profits by comparison.

Since an oil supplier has more freedom than an oil hedger — after all, a supplier sits on oil with no rush to sell it, as a hedger attempts to curb real risk — a supplier can squeeze prices higher by refusing to sell on the futures market. The supplier will just sell oil through private deals, whose prices are determined by the futures market — and not the other way around. This catch-22 represents the systemic flaw in the global oil market.

Technically, NYMEX has placed limits such that no one firm can control more than 20 million barrels of oil. Then again, a previously unknown energy trading company called Vitol controlled 11% of the open interest on NYMEX at one point last summer, which amounted to four times that! Around the same time, SemGroup, a large oil distribution company, filed for bankruptcy after losing $2.4 billion on a short position that also dwarfed the supposed limit.

Position limits at some threshold might be a good idea, but they must apply to all institutions — especially those dealing with physical oil. And they cannot be too small, or else loopholes through subsidiaries will become viable means to corner the market, for instance, by using subsidiaries.

The government has to avoid regulating the wrong participants, thereby pushing the price discovery mechanism for oil out of the hands of Americans and into those of foreign oil suppliers. Do we want the government punishing some financial investors while letting others — the ones who have the strongest motive to raise prices — continue business as usual That’s what could happen if the government regulates the oil market.

Oil trading does not need to be regulated so much as monitored. We can assume that corruption exists, but the government does not yet understand the business; officials only recently even admitted that the price does not reflect supply and demand. If we dig deeper, we might find the foreign oil suppliers themselves, posing as speculators, to be the true villains. And deeper still, we will certainly find that the very system is flawed: In a world where hedging against high prices fulfills its own prophecy, we can be sure that prices will never be stable.

Ari J. Officer, a regular contributor to TIME.com, works at a Chicago-based proprietary trading firm.

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