By Thomas I. Palley
WHILE oil prices were surging, debate raged about the relative roles of economic fundamentals and speculation in boosting oil prices. Although prices have now fallen back from their peak, that debate must not be forgotten, for it has profound policy implications that government officials would be derelict to ignore.
If higher prices are due to fundamentals, oil markets are working as they should. But if they are due to speculation, then policymakers must act to rein in behaviour that has imposed huge and needless costs on the global economy. When the evidence is confronted, it points to speculation as a culprit.
Whereas many oil market participants have blamed speculation, most economists point to economic fundamentals. One argument economists use is that higher prices are due to the weak US dollar. Because oil is priced in dollars, a weak dollar makes oil cheaper to users in other countries, which increases global demand.
A second argument is that higher oil prices are due to lower interest rates and anticipate higher long-term prices. That supposedly reduced supply by encouraging producers to store oil in the ground and pump it later.
A third argument is that if speculation were to blame for price increases, there should have been an increase in oil inventories, because speculators do not consume oil but instead store it for later sale. Since there has been no rise in inventories, there has been no speculation.
All three arguments are weak. The price of oil has risen far more than the dollar has fallen. That means oil prices should have reduced, not increased, demand. Moreover, it is high oil prices that weakened the dollar, not vice versa. This is because high oil prices raised inflation in the US, worsened the US trade deficit, and increased the likelihood of a US recession.
Nor have there been any reports of unusual production cutbacks - the linchpin of the second argument. Indeed, the spike in oil prices actually gives independent producers an incentive to boost production. The last time real oil prices reached current levels was 1980, which shows that hoarding oil in the ground can be bad business. The Organisation of Petroleum Exporting Countries also has a strong interest in maintaining production. It wants to keep prices lower to maintain the global economy's oil addiction and deter alternative energy sources.
Finally, the storage argument fails to recognise different types of inventory. Thus, record-high speculative prices have likely caused bunker traders to release inventory, but those releases may have been purchased by speculators who are now active lessees of commercial storage capacity. The implication is that speculators can drive up prices and increase their inventory holdings even as total commercial inventories remain little changed.
Additionally, oil market speculation may have induced 'echo speculation', whereby ultimate users buy refined products in advance to protect against future price hikes. They then take delivery on their premises so that overall refined inventories rise, but that increase is not part of reported commercial inventories.
Proving that speculation is responsible for higher prices is always difficult, because it tends to occur against a background of strong fundamentals. However, there is considerable evidence that strongly indicates rampant speculation in today's oil markets. One key sign is the documented change in the character of oil trading, with speculators (financial institutions and hedge funds) now accounting for 70 per cent of trades, up from 37 per cent seven years ago.
With regard to market fundamentals, there have been no changes in demand and supply conditions that explain the jump in oil prices. Moreover, the actual behaviour of oil prices is consistent with speculation. In June, oil prices leapt by US$11 (S$16) in one day, and in July they fell back by US$15 in three days. Such volatility does not fit a fundamentals-driven market.
Despite the oil market's size, speculation can move prices because of the inelasticity of demand and supply. Oil demand is slow to change because of behavioural inertia and fixed technology, while adjusting production takes time. These features make the oil market vulnerable to speculation.
With prices falling, the imperative to act inevitably tends to recede. That is the nature of the behavioural response to crisis and why a bad status quo can persist. But leaving the system unchanged will maintain the global economy's vulnerability to future bouts of speculation. Just consider how the current bout has raised global inflation, lowered incomes of the poor, weakened the dollar, aggravated global financial instability, and increased the likelihood of a global recession. That is an overwhelming indictment that merits urgent policy action.
The writer was chief economist with the US-China Economic and Security Review Commission.