Evan Soltas
Mar 4, 2012

Speculative Understanding

Economists ought to call out political illogic

"[S]peculators are driving up the cost of oil, hurting consumers and potentially damaging the economic recovery. Wall Street profiteering, not oil shortages, is the cause of the price spike," House minority leader Nancy Pelosi said in a Feburary 22 press release. "We need to take strong action to protect consumers from this speculation."

Pelosi isn't the only one who's blaming speculators in financial markets for recent increases in the price of gasoline at the pump (see graph above). Both Democrats and Republicans, to some degree, have bought into the logic -- specious, as we will soon see -- that speculation, and not the economic forces of supply-and-demand, is responsible.

In a way, I agree strongly with Pelosi: we economists need to take strong action to protect consumers from this speculation. But not Wall Street speculation on oil prices. Political speculation on the cause of oil price changes.

Economists have largely rejected the idea that speculation in any market can worsen price volatility, or that it imposes large costs on market participants.

(Admittedly, there are some asterisks and footnotes from Baumol and DeLong, but the rule of thumb stands that speculation tends to stabilize prices. Krugman also notes that the mechanism for how speculation in futures markets, as "Wall Street" implies, affects actual supply and spot prices is not clear.)

Why? Speculation that prices will increase in the future should encourage the accumulation of inventories, and when these inventories are released into tighter supply conditions, it should prevent prices from increasing. Conversely, speculation that future prices will be lower should encourage the reduction of inventories.

This matters because there is a certain validity to blaming speculators for recent increases in the price of oil, but perhaps not what Pelosi intended. Events in the Middle East are raising fears of a coming supply disruption. What is the rational response? Store oil -- accumulate inventory.

This is what has been going on. Crude oil inventories in the US jumped 4.2 million barrels last week, to 344.9 million, which the Energy Information Administration characterized as "in the upper limit of the average range for this time of year."

So speculation is driving prices up. But it's not the kind one should fight, with, say, opening the SPR, unless one wants to increase price volatility in the future, or unless one is clairvoyantly sure that Iran will not jeopardize oil supplies. This is inventory accumulation out of the legitimate, albeit politically inconvenient, fear of a supply disruption.

As a note, "speculation" is the go-to explanation whenever prices increase, even when inventories haven't. That should stop.