PDF _ RL34555 - Speculation and Energy Prices: Legislative Responses
6-Aug-2008; Mark Jickling, Lynn J. Cunningham; 38 p.

Update: Previous Editions:
August 6, 2008

Abstract: While most observers recognize that the fundamentals of supply and demand have contributed to record energy prices in 2008, many also believe that the price of oil and other commodities includes a “speculative premium.” In other words, speculators who seek to profit by forecasting price trends are blamed for driving prices higher than is justified by fundamentals.

In theory, this should not happen. Speculation is not a new phenomenon in futures markets — the futures exchanges are essentially associations of professional speculators. There are two benefits that arise from speculation and distinguish it from mere gambling: first, speculators create a market where hedgers — producers or commercial users of commodities — can offset price risk. Hedgers can use the markets to lock in today’s price for transactions that will occur in the future, shielding their businesses from unfavorable price changes. Second, a competitive market where hedgers and speculators pool their information and trade on their expectations of future prices is the best available mechanism to determine prices that will clear markets and ensure efficient allocation of resources.

If one assumes that current prices are too high, that means that the market is not performing its price discovery function well. There are several possible explanations for why this might happen. First, there could be manipulation: are there traders in the market — oil companies or hedge funds, perhaps — with so much market power that they can dictate prices? The federal regulator, the Commodity Futures Trading Commission (CFTC), monitors markets and has not found evidence that anyone is manipulating prices. The CFTC has announced that investigations are in progress, but generally manipulations in commodities markets cause short-lived price spikes, not the kind of multi-year bull market that has been observed in oil prices since 2002.

Absent manipulation, the futures markets could set prices too high if a speculative bubble were underway, similar to what happened during the dot-com stock episode. If traders believe that the current price is too low, and take positions accordingly, the price will rise. Eventually, however, prices should return to fundamental values, perhaps with a sharp correction.

One area of concern is the increased participation in commodity markets of institutional investors, such as pension funds, foundations, and endowments. Many institutions have chosen to allocate a small part of their portfolio to commodities, often in the form of an investment or contract that tracks a published commodity price index, hoping to increase their returns and diversify portfolio risk. While these decisions may be rational from each individual institution’s perspective, the collective result is said to be an inflow of money out of proportion to the amounts traditionally traded in commodities, with the effect of driving prices artificially high.

This report summarizes the numerous legislative proposals for controlling excessive speculation, including H.R. 6604 and S. 3268, which received floor action in their respective chambers in July 2008. It will be updated as events warrant.

 [read report]

Topics: Energy, Legislative, Economics & Trade

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