Oil Prices Are Rigged?
MAY 21, 2009 by ROBERT P. MURPHY
Even though oil prices have fallen and quieted the price-conspiracy mongers, you can bet that when prices go up again, they will be back in force. It happened last time. For example, in an article for Time last August, Ari Officer and Garrett Hayes ask, “Are Oil Prices Rigged?”. Our cynical authors—who are Stanford graduate students in financial mathematics and materials science/engineering respectively—answer in the affirmative, but their arguments are shockingly ignorant of how markets work.
Officer and Hayes admit up front that oil speculators aren’t the ones manipulating oil prices. Rather, they blame the oil producers for rigging the market, allegedly through the use of futures contracts:
The price of oil reported in the news is actually the price of oil in the futures market. In this market, traders do not exchange physical barrels of oil, but instead trade contracts which obligate them to exchange oil at a quoted price at a specific date in the future. . . . Such a contract allows companies to hedge positions by locking in prices early. . . . It’s all about reducing risk and uncertainty. But what if oil suppliers were instead buying oil futures, compounding their own risk and reaping enormous profits from the explosion in the price of physical oil?
An interesting possibility, to be sure, except for one nagging problem: If an oil producer is buying a futures contract from himself, that is equivalent to taking future supply off the market. To use a simplistic example, suppose a major producer estimates that he can sell 100,000 barrels of January 2010 oil at $90 per barrel or raise the price to $100 per barrel if he restricts his output to 75,000 barrels. The authors want to argue that he has a third option: “selling” 100,000 future barrels at $100, holding the price up himself by entering the futures market and snatching up those excess 25,000 barrels of January 2010 oil.
But in this third approach the producer is still extracting the same deal from his actual customers: They are giving him $100 each for 75,000 barrels of January 2010 oil. Since the producer himself bought the other 25,000 barrels, it is rather irrelevant that he received a high price for them; he can “pay himself” $100 a piece, if it makes him feel rich, but that still leaves him just as wealthy—and with just as much oil—as if he had simply cut his January 2010 output to 75,000 barrels. The existence of the futures market doesn’t give our producer any more ability to gouge his customers than his ownership of the oil in the first place gives him.
Final Consumers Have the Final Word
There is no getting around this basic fact, try as the authors might to bring up subtleties of the futures market.
They argue, for example, that only “Hedge funds, oil companies, OPEC—the very people who profit from massive, consistent increases in prices,” have access to the futures market. From this they conclude that, “we as oil consumers don’t set the prices.”
That’s simply untrue. Hedge funds can’t force refiners to buy more oil than they want to at a given price. If the “fair” price of oil, as determined by the “fundamentals” of supply and demand, is $80 per barrel, but the greedy hedge funds and OPEC buy up futures contracts and push the price up to $120 per barrel, then there will be a glut. That is, more physical barrels of oil will come to market than the actual end users will purchase. Oil inventories would grow larger every day, as producers kept pumping more oil than consumers burned.
Incidentally, this outcome is certainly possible. For example, if a group of rich speculators foresaw an imminent attack on Iran, they could rush to buy up oil futures. This would push up the futures price, which would lead producers to lower current output and devote more of their finite supply to the future (where the new demand was). The reduction in current supply would drive up the spot price, forcing consumers to economize on oil in the present.
Maybe High Prices Aren’t Such a Bad Thing
Let’s carry this scenario just a bit further. Suppose the speculators were really convinced that war with Iran would happen within a few months and that the price of oil at that time would skyrocket to $200 per barrel. Then the speculators would continue buying futures contracts, so long as the futures price were below $200. Oil producers would be overjoyed at this incredible demand, and would gladly sell more and more futures contracts. At some point, the producers would realize that they had promised as many barrels in future months as they could physically pump. Then it would become profitable to pump oil in the interim and physically warehouse it.
Thus the speculators’ actions would a) drive up the spot price of oil to cause consumers to restrict their use of oil in the present, and b) induce stockpiling of oil. Notice that these effects are exactly what we want to happen. If the speculators were right and war broke out, the spot price would not jump as sharply because it would have been pushed up already. The larger stockpiles of physical oil would help ease the crunch when Iran stopped exporting.
Pumping Out Evidence to the Contrary
To return to the Time article, the authors have spelled out a mechanism through which rich institutions could push up the price of oil. But they haven’t followed out the implications of their thesis and checked to see whether this was actually happening. Unfortunately for their claim, oil inventories have been fairly constant over the last several years, and—most damning of all—world oil production increased from 2007 through 2008, exactly the period when prices skyrocketed. (See my article “Oil Speculators: Bad or Good?” for more details.)
To repeat: Consumers still decide how many barrels they want to buy at a given price. If outside parties push up the price (and they can, if they are willing to risk enough money), then consumers will buy fewer barrels. Therefore, if the high price of oil were due to manipulation, we would observe either a restriction in output and/or accumulating inventories. We see neither.
In reality, all prices are determined by supply and demand, properly defined. Outside investors with lots of money can certainly influence prices, but there are always risks. Funds that had large “long” bets on commodities took a bath as oil fell from its July 2008 high of $145 down to well below $50 a few months later. Futures markets allow producers and consumers to hedge against needless risk by locking in prices, and they allow speculators with superior foresight to improve the allocation of resources over time. Our Time authors think they’ve shown that the oil market is rigged, but it just ain’t so!