Tuesday, July 22, 2008

Speculating about Speculation

I haven't said much about the search for a scapegoat on which to blame the rise in energy prices. Congress has held endless hearings and have alternately blamed oil companies and the undefined "speculators", but frankly I figured that the price would drop before our politicians did something stupid. That might not be a good bet in an election year. The Senate is considering a bill called the Stop Excessive Energy Speculation Act of 2008 and if it is enacted there will be negative consequences.

In futures markets there are two kinds of traders. Commercial traders are those who are using the futures market to minimize risks to their business by locking in the future price of energy. This allows them to plan their business with known costs rather than being subject to the wide swings sometimes seen in the price of commodities. Examples of commercial traders could be airlines or oil companies. Speculators are traders who are betting on the price of the underlying commodity for a financial gain. They are also often the traders who take the other side of the trade from the commercial hedgers. Without the speculators, commercial hedgers will find it more expensive or impossible to lay off their risks. So speculators play an important role in the markets - specifically they provide liquidity to the market for the commercial hedgers.

The bill under consideration will give the CFTC (Commodity Futures Trading Commission) the authority to end "excessive speculation". As with many bills passed by Congress, the definition of excessive speculation will be left to the regulators. How will they determine what constitutes excessive speculation? Is there any such thing as excessive speculation? In the futures market if one person wants to sell there needs to be someone else who wants to buy. It is a zero sum game. And it is voluntary. So what is excessive? The only thing that defines excessive in my mind is if someone wants to buy and there is no one to sell, but in that case the buyer will adjust his price until he finds a willing seller. Again, this is a voluntary transaction. No one is down on the floor forcing traders to take positions they don't want. Why should Congress be concerned with voluntary transactions among willing participants?

Speculators are not to blame for the rise in oil prices. Oil prices have risen because the demand for oil is greater than the supply. That is the only reason. The question of why there is an imbalance between supply and demand is a different question altogether. It could be because China is growing rapidly along with other emerging markets. Or it could be because investors are looking for ways to hedge against the inflation caused by the Federal Reserve. Or it could be because OPEC is withholding oil from the market. Or it could be because we've been pouring oil into the SPR. But this much is certain - the reason is irrelevant.

As an investor I believe that commodities are in important part of my portfolio because they are the best hedge against inflation. And that inflation is something that has existed since the day the Federal Reserve Act was passed. As long as we have a central bank with the ability to print unlimited quantities of money and politicians willing to spend it, we will have inflation. I believe it is my fiduciary duty to my clients to protect them from the devaluation of their assets through monetary manipulation. And the best way to do that is by owning real things such as commodities. Am I a legitimate hedger? Apparently Congress doesn't think so.

If this bill is passed it won't end "excessive" speculation. The speculators will just move to overseas markets with more friendly regulations. Futures markets are not some high tech item that only Americans can produce. In fact, they are pretty simple to operate since all that is really needed is a place for traders to exchange information. You don't even need a trading floor anymore. The victims of this bill will be the legitimate hedgers and the US futures exchanges. And the price of oil will not be affected one bit.

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