In Praise of Oil Speculation

Dear Ed,

You've written some great columns for BusinessWeek.com about oil prices and speculation (BusinessWeek.com, 6/27/08), and you've gotten barrels of positive reaction from readers—one recent example: "Ed Wallace is my hero." I buy gasoline, too, so I sympathize with your impulse to get to the bottom of why we're suddenly paying over $4 a gallon. I even agree with you that speculation is probably playing a role in driving up prices, and we need smart regulation of the energy markets.

But I can't work up much passion for blaming speculators and manipulators for the predicament we're in. My faith in human nature, especially when it comes to energy traders, is shallow. However, my faith in the power of financial gravity is bottomless. If speculators and manipulators have somehow managed to get prices too high, then those prices will come back to earth as surely as apples fall from trees and meteors land in Arizona. The price decline will inflict billions of dollars of losses on those speculators and manipulators—just desserts.

On the other hand, if by some chance the speculators and manipulators are correct—that oil prices could go even higher, based on supply and demand—then they will have done all of us a favor by ringing the alarm bell. High prices today are inciting suppliers to produce more oil and consumers to use less, which will ease the transition to a future of costly energy.

On July 1, the International Energy Agency in Paris predicted that by 2015, the developing countries will equal the mature economies in their oil consumption. Nobuo Tanaka, the IEA's executive director, dismissed speculation talk as a distraction: "OPEC production is at record highs, and non-OPEC producers are working at full throttle, but stocks show no unusual build," he said, according to a press release. "These factors demonstrate that it is mainly fundamentals pushing up the price."

Either way, then, it's hard to see what the big problem is. Either the traders are wrong and they are setting themselves up to lose a lot of money, or they're right, they'll make money, and they're sending the proper market signals to the economy.

Financial Gravity and Smart Regulation

Here's why I believe in financial gravity: If the price is too high, you might not know it right away because supply and demand don't react quickly in the short run. But they surely do react in the long run. Oil fields that were once too costly to explore suddenly become economical. Drivers switch from Tahoes to Civics. The natural supply of oil starts to exceed the demand. At that point, the only way to keep the price from falling is to buy oil on the open market and put it in storage. But that gets expensive, and there are only so many places you can store oil. After you've filled up every last tanker, teacup, and cowboy boot, the price must fall. Absolutely must.

Granted, the cleverest speculators and manipulators just might manage to sell before the crash and get away with a fortune, inflicting the loss on others who are just as greedy but not as bright. There's also a risk that a big, underregulated trader could go bust on bad bets and cause collateral damage, as the hedge fund Amaranth Advisors did when it blew up in 2006.

Are Pension Funds Fueling High Oil?