Wednesday, July 02, 2008

Krugman On Oil, Iron Ore & Speculators

Congress has always had a soft spot for “experts” who tell members what they want to hear, whether it’s supply-side economists declaring that tax cuts increase revenue or climate-change skeptics insisting that global warming is a myth. Right now, the welcome mat is out for analysts who claim that out-of-control speculators are responsible for $4-a-gallon gas.

Back in May, Michael Masters, a hedge fund manager, made a big splash when he told a Senate committee that speculation is the main cause of rising prices for oil and other raw materials. He presented charts showing the growth of the oil futures market, in which investors buy and sell promises to deliver oil at a later date, and claimed that “the increase in demand from index speculators” — his term for institutional investors who buy commodity futures — “is almost equal to the increase in demand from China.”

Many economists scoffed: Mr. Masters was making the bizarre claim that betting on a higher price of oil — for that is what it means to buy a futures contract — is equivalent to actually burning the stuff.

But members of Congress liked what they heard, and since that testimony much of Capitol Hill has jumped on the blame-the-speculators bandwagon.

Somewhat surprisingly, Republicans have been at least as willing as Democrats to denounce evil speculators. But it turns out that conservative faith in free markets somehow evaporates when it comes to oil. For example, National Review has been publishing articles blaming speculators for high oil prices for years, ever since the price passed $50 a barrel.

And it was John McCain, not Barack Obama, who recently said this: “While a few reckless speculators are counting their paper profits, most Americans are coming up on the short end — using more and more of their hard-earned paychecks to buy gas.”

Why are politicians so eager to pin the blame for oil prices on speculators? Because it lets them believe that we don’t have to adapt to a world of expensive gas.

Indeed, this past Monday Mr. Masters assured a House subcommittee that a return to the days of cheap oil is more or less there for the asking. If Congress passed legislation restricting speculation, he said, gasoline prices would fall almost 50 percent in a matter of weeks.

O.K., let’s talk about the reality.

Is speculation playing a role in high oil prices? It’s not out of the question. Economists were right to scoff at Mr. Masters — buying a futures contract doesn’t directly reduce the supply of oil to consumers — but under some circumstances, speculation in the oil futures market can indirectly raise prices, encouraging producers and other players to hoard oil rather than making it available for use.

Whether that’s happening now is a subject of highly technical dispute. (Readers who want to wonk themselves out can go to my blog,, and follow the links.) Suffice it to say that some economists, myself included, make much of the fact that the usual telltale signs of a speculative price boom are missing. But other economists argue, in effect, that absence of evidence isn’t solid evidence of absence.

What about those who argue that speculative excess is the only way to explain the speed with which oil prices have risen? Well, I have two words for them: iron ore.

You see, iron ore isn’t traded on a global exchange; its price is set in direct deals between producers and consumers. So there’s no easy way to speculate on ore prices. Yet the price of iron ore, like that of oil, has surged over the past year. In particular, the price Chinese steel makers pay to Australian mines has just jumped 96 percent. This suggests that growing demand from emerging economies, not speculation, is the real story behind rising prices of raw materials, oil included.

In any case, one thing is clear: the hyperventilation over oil-market speculation is distracting us from the real issues.

Regulating futures markets more tightly isn’t a bad idea, but it won’t bring back the days of cheap oil. Nothing will. Oil prices will fluctuate in the coming years — I wouldn’t be surprised if they slip for a while as consumers drive less, switch to more fuel-efficient cars, and so on — but the long-term trend is surely up.

Most of the adjustment to higher oil prices will take place through private initiative, but the government can help the private sector in a variety of ways, such as helping develop alternative-energy technologies and new methods of conservation and expanding the availability of public transit.

But we won’t have even the beginnings of a rational energy policy if we listen to people who assure us that we can just wish high oil prices away.


Tony said...

Our local politicians also firmly believe in the speculation theory. Mukhris Mahathir has suggested that direct deals between countries will bring down prices although he did not explain if Petronas should export its oil at USD70 to friendly countries when it can sell its oil for 140 in the open markets. Or whether we should curb CPO trading and sell CPO at Rm 1500 instead of speculative rates of 3500.

mantua said...

At last, I'm hearing an economist who makes sense.

Over-consumption, wasteful practices plus under-invesment in oil exploration & development in the last few decades means that the world is finding it difficult to meet the increasing demands from newly developing countries.

The quicker we accept this simple fact, the quicker will we adapt more sensible lifestyle practices & more realistic energy prices.

And don't forget that other vital resource we take for granted - clean drinking water.

rask3 said...


If we compare the average standard of living at the beginning of the twentieth century with that at the end of that century, there is a multifold increase. Explosion of population growth too has accompanied this increase. This was made possible partly by the consumption and exploitation of all natural resources, including oil.

Since natural resources have been over utilised to meet unlimited wants of humans, we are in the midst of a reality check. Put another way, the available natural resources can no longer match the needs of the world and the status quo standard of living can no longer be maintained in the long run.

In the long run we are all dead, lol.


pamina said...

hard times ahead...i guess its hard to admit that we are at fault after all, no matter how simple is the whole thing actually is.

mantua said...

While acknowledging that current high oil prices are caused by increasing world demand & diminishing oil reserves, I am not totally pessimistic about the long-term prospects.

1) High oil prices are already having an effect in curtailing demand. The US has just reported a sharp drop in sales of trucks, SUV's & other gas guzzlers. (Why in the world would one drive a truck anyway?!) In the long run, this change in consumer sentiment would be good for the environment.

2) There are many ways in the world's major cities can further reduce oil consumption with minimal impact on living standards e.g. improvements in public transport services - Bandaraya pls note.

3) High oil prices will encourage the development of alternate fuels such as solar, wind, hydro & nuclear power. The latter two are already well proven & economic options, albeit with some environmental concerns. I believe the latter concerns can be managed appropriately.

4) The biggest usage of petroleum is currently for internal combustion engines, particularly in cars. This could drop dramatically (in decades to come) with the successful introduction of battery-powered cars.

5) I forsee Brazil becoming the next major energy supplier once it harnesses the vast expanses of the Amazon Basin for large-scale biofuel production. Brazilian cars already use a mixture of gasoline & methanol, produced from cane sugar.

The human race has always adapted to changing circumstances. The current high oil price is no different, provided we first recognise the roots of the problem & stop blaming greedy speculators & producer nations for our problems.