Everything from Oil to Silver: Are Speculators Causing Too Much Volatility?Published: May 25, 2011 in Knowledge@Wharton
Allegations that traders manipulated oil prices in 2008 are reinforcing the buzz -- at the gas pump and elsewhere -- that speculators are driving up the price of oil, triggering wild price spikes and nail-biting volatility. In a federal lawsuit filed on May 24, the Commodity Futures Trading Commission (CFTC) charged two traders from a Swiss firm with hoarding and dumping millions of barrels of oil to reap more than $50 million on derivatives contracts. The allegations come three weeks after President Barack Obama appointed a task force to investigate oil price fraud and manipulation, and just one day after the Democratic staff of a House oversight committee reported that "excessive oil speculation could be inflating prices by up to 30%."
Fingering speculators is a popular pastime these days, but experts at Wharton and elsewhere say the blame is often misplaced. Although speculation does exist and can affect prices, most of the recent price swings in oil and other commodities are happening for fundamental economic reasons. Speculation, a normal function of markets, is not the same as price manipulation, which is illegal. Attempting to control speculation could backfire, they warn. Speculators play an important role in keeping markets healthy by taking on risks and keeping prices fluid. And while speculators may sometimes drive short-term prices higher or lower, just as often they bring fluctuating prices back into line.
According to Wharton finance professor Krista Schwarz, the majority of oil price fluctuations in the last few years are due to supply and demand, not excessive speculation. "I don't know anything about the merits of this particular case that the CFTC is pursuing, but I would note that $50 million is a tiny amount relative to the size of the global oil market," says Schwarz, who has a forthcoming paper in the Journal of Futures Markets titled, "Are Speculators Informed?" Although speculators may have some influence on prices, world events are playing a much larger role, Schwarz notes. "Oil prices rose this spring as the possibility of a major conflagration in the Middle East loomed. The resolution of the crisis in Egypt, the stalemate in Libya, and the absence of trouble in Saudi Arabia have all caused these worries to ease for now. Also, the global economy looks a bit weaker, reducing oil demand. This has likely caused oil prices to fall back, which is all about supply and demand, not some special effect of speculators."
Roughly defined, a speculator tries to profit from an asset by anticipating how its price will change -- either by buying it in expectation that the price will rise, or selling short in anticipation that the price will fall. Speculators often focus on the short term rather than the long term, and may be willing to take on greater risk than a typical buy-and-hold investor. Some may borrow to increase the scale of their bets.
"Speculation has sort of become a derogatory term to describe investors who are acting recklessly," says Bernard Baumohl, chief global economist at the Princeton, N.J.-based Economic Outlook Group and author of The Secrets of Economic Indicators: Hidden Clues to Future Economic Trends and Investment Opportunities. "I think that is unfortunate because they do contribute to the market." Speculators may be less interested in the actual value of an asset and more focused on emotions and anxieties that drive the market, Baumohl adds. "I have a sense that speculators spend more time trying to understand the short-term psychology that affects trade than the underlying value of how something might perform." The purest example of this was the dot-com bubble of the 1990s, when investors poured money into Internet startups that had never made a penny in profit. "It was not really based on fundamentals," Baumohl says. "It was based on a prayer."
Blaming speculators for rising commodity prices is nothing new, says Craig Pirrong, a professor of finance and energy markets at the Bauer College of Business at the University of Houston. "These sorts of arguments are highly perennial. Whenever commodity prices go up, it has been conventional to blame the speculators." Pirrong agrees with Schwarz that recent movements in oil prices are based more on fundamentals than speculation. Likewise, he attributes price fluctuations in precious metals like gold and silver to genuine concerns about monetary policy, not an attempt by any one investor to corner the market.
Speculation Gone Wrong
Speculation differs from manipulation, says Pirrong, author of The Economics, Law, and Public Policy of Market Power Manipulation. Attempts to corner the market have happened in the past -- a phenomenon Pirrong calls "bad speculation." In one famous case, for example, the Hunt brothers in 1980 tried to corner the silver market, buying so much of the precious metal that the price soared to a high of $49.45 per ounce. Government regulators finally stepped in, and the Hunt brothers were convicted of manipulation.
When looking for signs of manipulation or "bad speculation," Pirrong pays attention to quantities rather than prices. If speculators are manipulating prices, quantities should reflect that. But in the case of oil, prices have risen when inventories dropped, and later fell when inventories rose. "If speculators were moving the market, prices and inventories would be moving in the same direction," he says. Recent speculative bubbles prove his point: The dot-com boom saw an explosion of Internet stocks as prices rose. And during the housing bubble, prices soared despite overbuilding in hot markets such as Phoenix and Florida.
The Dodd-Frank Act, passed in response to the financial crisis and the housing bubble that preceded it, includes provisions to counter excessive speculation. But Pirrong doubts that regulating speculators will work. "Generally, I'm very skeptical that there's any constructive policy that would serve to whittle out the bad speculation from the good speculation," he says. "Manipulation is best addressed the way the CFTC is trying to do [it] in this instance -- by imposing penalties on manipulators after the fact -- rather than by indiscriminate restrictions on the actions of market participants, virtually none of whom are manipulating or even can manipulate."
In most asset markets, it is very hard to draw any meaningful distinction between speculators and other investors, says Schwarz. "All investors care about is maximizing their returns while minimizing risk. Some may have a shorter horizon than others, but broadly [speaking,] all investors have the same basic objectives."
Hoping to Profit
To some extent, nearly any investor could be labeled a speculator since most people hope to profit from their investments and nobody really knows what future prices will be, says Wharton adjunct finance professor Christopher C. Geczy. "Every time you make an investment in the stock market, that's speculation. When you buy a car, if you're thinking about resale value, you're speculating. People who buy a house are speculating."
The definition of a speculator is more clearly spelled out in futures markets, where investors can lock in a future price for commodities such as grains, food, metals and fuel. Investors often use futures contracts to protect themselves against price fluctuations that could hurt their business -- a practice called hedging. For example, an airline might hedge to protect itself against rising fuel prices. A farmer might hedge against a drop in the price of wheat. On the flip side of the hedge is the speculator, who places a bet that fuel prices will fall or wheat prices will rise.
"The fact is, speculators provide a service," says Wharton finance professor Krishna Ramaswamy, who studies options and futures markets. By placing bets in the futures market, speculators take on risks that others don't want. A company like Hershey's, for example, needs to protect itself against rising cocoa prices. If there were no speculators in the futures markets, Hershey's would not be able to hedge that risk. "We call this 'the provision of liquidity,' which means that somebody provides the counter-side of the trade," Ramaswamy notes. "Liquidity is supplied by speculators, and they expect to make a return.... When [hedgers] need to sell and they need a counter party on the other side of the market to buy, it is the speculator that will fill the breach."
Investors with short-term objectives are often helpful to markets, points out Schwarz. "For example, the fraud at Enron was discovered because some investors wanted to short Enron stock. Likewise, the dot-com bubble was burst by short sellers. The bubble would have been worse and more destabilizing had it been allowed to last longer."
Despite the common view that speculators cause price volatility, they may sometimes stabilize prices or bring them closer to what they should be. There are two views on speculation, says Wharton finance professor Jeremy Siegel: "One side is that speculation can send the price far from the underlying true economic price of the asset or the stock. The other view is that some speculators know better than the people who are involved what the price actually should be.... Sometimes speculators from the outside can be very shrewd."
Last year, for example, speculators made bets that Europe was heading for serious financial trouble. At the time, European government leaders dismissed the dire predictions, but as the debt crisis unfolded, the world realized later that the speculators had been right. Siegel wonders if speculators, in similar fashion, could have played a positive role in the early stages of the financial crisis if credit default swaps had been traded more openly. "Speculators might have seen the problems coming," he says.
Regulators should enforce rules against illegal trading practices and maintain margin requirements to make sure that speculators gamble mostly with their own money, Siegel suggests. But banning speculation would create more problems than it would solve. "History has generally concluded that although speculators may occasionally send the price of an asset too high or too low, on balance speculators increase the amount of information in the market."
Geczy agrees, arguing that regulations should keep markets fair, not attempt to control speculators. "When gas prices are high, consumers are frustrated and regulators take notice," he says, but a cure for speculation could end up far worse than the disease. "There are always unintended consequences of regulation," he says. "Speculation is a fundamental way that economies work.... High prices may just be the rational, appropriate, ethical and moral clearing of supply and demand."