Restricting Speculators Will Not Reduce Oil Prices

For the most part, speculators do not demand physical oil the way thirsty Chinese refiners do. There is no evidence that speculators are accumulating large and rising inventories of physical oil. But to cause prices to be above their competitive level, speculators would have to take physical oil off the market -- the way that governments have done in the past with agricultural products, amassing mountains of grain and cheese to prop up their prices.

What some speculators do instead is trade futures contracts that entitle them to take delivery of physical oil at a future date (say next August) at a price negotiated in the marketplace. But they almost never exercise the right to take delivery when the contract matures.

A speculator who anticipates rising prices buys a futures contract at the prevailing market price. If he is right, and the futures price rises, he can sell the contract at the higher price before contract maturity and pocket a profit; if he is wrong, and prices fall, he sells the contract at a loss. Buyers and sellers of these futures contracts almost never take delivery of the oil to implement their trading strategies.

Restricting these speculators won't reduce the price of oil -- but they are likely to make consumers and investors worse off. Futures and swap markets facilitate the efficient management of price risks, and speculators are an important part of that process. For instance, a producer of oil may want to lock in the price at which he sells his oil in the coming months in order to hedge against fluctuations in its price. He can do so by selling a futures contract at the prevailing market price. Similarly, an airline can protect itself against price increases next summer by buying today a futures contract that locks in a purchase price for next July.

The unprecedented run-up in oil prices is painful for consumers around the world. But the focus on speculation is misguided, and represents a convenient distraction from an understanding of the real, underlying causes of high oil prices -- most notably continuing demand growth in the face of stagnant production, supply disruptions and the weakening dollar.

More restrictions and regulations of energy markets, in the vain belief that such actions will bring price relief, are counterproductive. They will make the energy markets less efficient, rather than more so.

Univ. of Houston Finance Professor Craig Pirrong, in today's WSJ