Why regulation doesn’t work, part n

Via Tyler Cowen, Paul Krugman attacks libertarianism:

Thinking about BP and the Gulf: in this old interview, Milton Friedman says that there’s no need for product safety regulation, because corporations know that if they do harm they’ll be sued.

Interviewer: So tort law takes care of a lot of this ..

Friedman: Absolutely, absolutely.

Meanwhile, in the real world:

In the wake of last month’s catastrophic Gulf Coast oil spill, Sen. Lisa Murkowski blocked a bill that would have raised the maximum liability for oil companies after a spill from a paltry $75 million to $10 billion. The Republican lawmaker said the bill, introduced by Sen. Robert Menendez (D-NJ), would have unfairly hurt smaller oil companies by raising the costs of oil production. The legislation is “not where we need to be right now” she said.

And don’t say that we just need better politicians. If libertarianism requires incorruptible politicians to work, it’s not serious.

This spill is evidence that regulation doesn't work. This doesn't mean a libertarian system would have prevented the spill, but it's pretty solid evidence that regulation didn't prevent it. Those oil rigs were regulated. They were Obama's regulators, too. After 15 months in office, he can't pass the buck to George Bush.

In case anyone gets the wrong idea, let me also point out that Sen. Lisa Murkowski is not a libertarian. As a representative of an oil state, she's basically practicing crony capitalism.

And don’t say that we just need better regulators. If progressivism requires incorruptible regulators to work, it’s not serious.

The effect of lower oil prices on future oil exploration

From CNN Money:

"Drill-baby-drill!"

With the price of oil falling below $75 a barrel Wednesday — down about 49% from last summer's highs — the industry's battle cry is sounding less and less convincing.

But falling oil prices are not the only reason why the air is coming out of the drilling balloon. The credit crunch has hampered oil company's ability to fund big-ticket drilling projects. Meanwhile, the prices that producers pay for raw materials and labor remain high.

"Any project that assumed oil would average $100 over the next 10 to 20 years is being seriously reconsidered at this time," said Richard Ward, senior cost analyst at IHS Cambridge Energy Research Associates (CERA).

As recently as July, tapping deep water sources and extracting crude from Canadian oil sands - two very expensive production methods - were seen as economically viable ways to deal with the energy crisis. At that time, the price of oil was above $140 a barrel.

Now that the price has fallen below $75 a barrel, and could go even lower, many experts say the future of these projects is uncertain.

Oil companies are quick to point out that big drilling projects are long-term investments, which are not based on today's oil price, but on what they think the price will be in the future.

Indeed, some deep water projects have a life span of 20 to 30 years. And some producers expect to be mining Canada's oil sands for up to 40 years.

AP: Oil was just another bubble

From the Associated Press, via MSNBC:

As oil prices zoomed toward an unheard of $147 a barrel this summer, it seemed every analyst prediction that oil would approach $200 was a self-fulfilling prophecy, until suddenly it was not.

Instead of $200 oil, oil is now $80. Instead of going up, U.S. demand has fallen at the steepest rate since the oil-shocked 1970s. Americans have dramatically cut down on driving over the past year.

Soaring prices for oil and other commodities this summer have turned out to be nothing short of another classic bubble, and the bursting may not be over, one analyst said Monday.

"It's just amazing that the market gets suckered into this," said analyst Stephen Schork of the Schork Report, who called the idea of $150 a barrel oil "an obscene number, a perverted, illogical number." ...

"We clearly underestimated the depth and duration of the global financial crisis and its implications on economic growth and commodity demand," analyst Jeffrey Currie said in a report.

David Fyfe, an analyst with the International Energy Agency in Paris, was a bit less critical, avoiding the word "suckered." "To be fair, there is always a tendency in parts of the analyst community to look at short-turn trends and assume it's something that will continue in perpetuity," he said.

As recently as July the price of oil was rising based on strong global economic growth, especially in China and India. Now that the financial crisis is threatening to push the entire world into a recession, global economic weakness is likely a major cause of the drop in oil prices.

Also, $4 per gallon gasoline seems to have been the tipping point that encouraged many Americans to cut back on driving and stop buying SUVs. Americans consume roughly 25% of all the world's oil, despite the fact that we make up only about 5% of the world's population.

Now let's see when the gold bubble bursts.

More on Financial Speculation and Oil Prices

Two new reports contradict each other regarding whether financial speculation was behind the rising price of oil earlier this year.

Conventional wisdom in Washington holds that speculative money flooding into the market from index funds pushed up oil prices earlier this year.

But a regulatory report released Thursday shows that those funds actually were cutting their stake in the oil market as prices were soaring.

That data, based on private trading data gathered by market regulators, contradicts parts of a report released by Washington lawmakers on Wednesday.

That earlier report, by Michael W. Masters and Alan K. White, blamed high commodity prices on the growing role of institutional investors, specifically index funds. It was cited by several lawmakers as proof that new rules were needed to curb the impact of speculation on commodity prices.

But the new 69-page study, by the Commodity Futures Trading Commission, shows that, rather than rising, the stake of index funds in the oil market actually declined in the first half of this year.

Regarding the Masters report, you should know that Princeton economist Paul Krugman has taken Michael Masters to task in the past:

Some correspondents have asked me what I think about the Congressional testimony of Michael Masters, who told a Senate subcommittee that “index speculators” — institutions that buy commodity futures as an investment — are responsible for the price surge.

The short answer is that I think his testimony is just stupid. Here’s what he says:

Index Speculators’ trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.

That quote pretty much epitomizes what’s wrong with a lot of what people say about speculation. Buying a futures contract for oil does not reduce the quantity of oil available for consumption; there’s no such thing as "virtual hoarding".

And Masters really is confused about the difference between paper contracts and physical stuff. He compares the growth in the futures market with increased consumption from China, and says

The increase in demand from Index Speculators is almost equal to the increase in demand from China!

Again, the fact that someone bought a futures contract (which means that someone else sold one) doesn’t reduce the amount of oil available to consume.

I’m willing to listen to serious arguments about how speculation might be affecting the price, but you do see a lot of dumb stuff. And this is really, really dumb.

Krugman attacked Michael Masters' reasoning in a bit more detail here.

OPEC, not speculators, is responsible for rising oil prices

From Fortune Magazine:

The leaders of OPEC have a long list of culprits for high oil prices: the falling dollar, U.S.-Iranian tensions, and shady speculators.

Here's one they seem to forget: OPEC.

The Organization of Petroleum Exporting Countries consistently claims that supply is not a problem - that there's plenty of oil to meet demand.

But last year, as the price of oil nearly doubled, OPEC was actually cutting production. The cartel produced 1.5% less last year despite adding two countries, Angola and Ecuador, to its ranks. That cutback at a time of growing demand helped drive prices up.

"They made a mistake," says Adam Sieminski, chief energy economist for Deutsche Bank, who thinks OPEC's drop in production last year is the No. 1 reason for today's prices. "The Saudis are responsible for trying to manage the world market. They underestimated demand and they overestimated non-OPEC supply."

Newsweek: Speculators not causing rising commodity prices

Robert J. Samuelson of Newsweek weighs in to say that financial speculators are not causing the increase in commodity prices. Instead, he properly puts the blame on increased global demand and harmful government policies.

Tired of high gasoline prices and rising food costs? Well, here's a solution. Let's shoot the "speculators." ... Gosh, if only it were that simple. Speculator-bashing is another exercise in scapegoating and grandstanding. Leading politicians either don't understand what's happening or don't want to acknowledge their complicity. ...

A better explanation is basic supply and demand. Despite the U.S. slowdown, the world economy has boomed. ... When unexpectedly high demand strains existing production capacity, prices rise sharply as buyers scramble for scarce supplies. That's what happened.

"We've had a demand shock," says analyst Joel Crane of Deutsche Bank. "No one foresaw that China would grow at a 10 percent annual rate for over a decade. Commodity producers just didn't invest enough." In industry after industry, global buying has bumped up against production limits. ...

But "speculators" played little role in the price run-ups. ... These extra funds might drive up prices if they were invested in stocks or real estate. But commodity investing is different. Investors generally don't buy the physical goods, whether oil or corn. Instead, they trade "futures contracts," which are bets on future prices in, say, six months. ...

Futures contracts enable commercial consumers and producers of commodities to hedge. Airlines can lock in fuel prices by buying oil futures; farmers can lock in a selling price for their grain by selling grain futures. What makes the futures markets work is the large number of purely financial players—"speculators" just in it for the money—who often take the other side of hedgers' trades. But all the frantic trading doesn't directly affect the physical supplies of raw materials. In theory, high futures prices might reduce physical supplies if they inspired hoarding. Commercial inventories would rise. The evidence today contradicts that; inventories are generally low. World wheat stocks, compared with consumption, are near historic lows. ...

Politicians now promise tighter regulation of futures markets, but futures markets are not the main problem. Physical scarcities are. Government subsidies and preferences for corn-based ethanol have increased food prices by diverting more grain into biofuels. ... Restrictions on offshore oil exploration and in Alaska have reduced global oil production and put upward pressures on prices. If politicians wish to point fingers of blame for today's situation, they should start with themselves.

Hat tip to Greg Mankiw.

CNN Money's take on oil speculation

CNN Money on oil speculation:

There's no question money from investment banks, pension funds, hedge funds and others that don't ultimately use oil has been pouring into oil markets over the last few years.

But whether they are chasing a trend — and actually helping keep prices lower by adding liquidity — or driving up prices in their own right is a matter of debate. So far, most experts say speculators are not to blame for the high prices, but many of them agree that the system is very opaque.

The New Yorker: Speculators not causing high oil prices

The New Yorker defends financial speculators from politicians' attacks, saying they are not responsible for the high price of oil:

When bad things happen, it’s always nice to have a scapegoat. So, with Americans furious about soaring oil prices, Congress has gone in search of someone to blame. There are a number of usual suspects to choose from, depending on your politics—OPEC, greedy oil companies, lily-livered environmentalists opposed to oil drilling—but now Congress has seized on another set of villains: commodity speculators. ...

Congress is not, though, just attacking illegal market manipulation; it’s also taking aim at perfectly legal speculation, namely the buying and selling of futures contracts, which are effectively bets that oil prices will go up (or down). Futures contracts can be used by oil sellers (like OPEC) or oil buyers (like the airlines) to hedge their risks by agreeing to sell or buy oil in the future at a set price. Speculators, by contrast, mostly use futures contracts to gamble on oil prices, and have no interest in buying or selling real barrels of oil. These gambles can be tremendously lucrative, but they don’t directly determine the real (or “spot”) price of oil. That’s set by the people who are buying and selling actual barrels of petroleum. Although speculators could directly distort oil prices by turning their futures contracts into oil and then taking it off the market to drive up prices, a look at oil inventories shows no sign that this is happening.

If speculators aren’t at fault, why have oil prices spiked so high? Fundamental reasons aren’t hard to find. Between 2000 and 2007, world demand for petroleum rose by nearly nine million barrels a day, but OPEC has been consistently unable, or unwilling, to significantly increase supply, and production by non-OPEC members has risen by just four million barrels a day. The prospect of military action against Iran, which would disrupt global supply, seems greater than it did a few years ago. And the plunging value of the dollar has meant that the cost of oil has jumped more in the U.S. in the past year than it has in countries with healthier currencies. ...

But there’s also something else at work, which the oil guru Daniel Yergin calls a “shortage psychology.” The price of oil—more than that of many other commodities—isn’t based solely on current supply and demand. It’s also based on people’s expectations about future supply and demand, because those expectations determine whether it makes sense for oil producers to sell their oil now or leave it in the ground and sell it later. ...

The difficulty for Congress, of course, is that none of the problems that have driven up the price of oil lend themselves to a quick fix, and most, like the boom in global demand and the inaccessibility of certain oil fields, aren’t under our control at all. That’s what makes speculators a perfect target: by going after them, Congress can demonstrate to voters that it understands their pain, and at the same time avoid doing anything that might require real sacrifice from Americans.

Hat tip to Greg Mankiw.

More on why speculators aren't causing rising oil prices

More from economist Paul Krugman on why speculators aren't causing rising oil prices. Joe Lieberman, my good friend, are you listening?

First of all, I don’t have a political dog in this fight. I’m happy to believe that crazy speculation distorts markets. And I do think it’s likely that oil prices will come down, for a while, once consumers have a chance to respond more fully to high prices by changing their driving habits, switching to smaller cars, etc..

But the mysticism over how speculation is supposed to drive prices drives me crazy, professionally.

So here’s my latest attempt to talk it through.

Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil — the actual price people pay to have a barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference.

Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. And that’s true no matter how many Joe Shmoes there are, that is, no matter how big the positions are.

Any effect on the spot market has to be indirect: someone who actually has oil to sell decides to sell a futures contract to Joe Shmoe, and holds oil off the market so he can honor that contract when it comes due; this is worth doing if the futures price is sufficiently above the current price to more than make up for the storage and interest costs.

As I’ve tried to point out, there just isn’t any evidence from the inventory data that this is happening.

And here’s one more fact: by and large, futures prices over the period of the big price runup have been slightly below spot prices. The figure below shows monthly data from the EIA; as the spot price shot up, the futures price (that’s contract 4, the furthest out) actually lagged a bit behind. In other words, there hasn’t been any incentive to hoard.

Why speculators are not to blame for high oil prices

This was a follow up by Princeton economist Paul Krugman to his original oil non-bubble article.

If the price is above the level at which the demand from end-users is equal to production, there’s an excess supply — and that supply has to be going into inventories. End of story. If oil isn’t building up in inventories, there can’t be a bubble in the spot price.

Now it’s true that oil supply responds very little to price, and that empirical estimates of the short-run price elasticity of demand, like this one, suggest that it’s low — say -.06. But even so, the math of a sustained, large bubble quickly becomes daunting. Say the demand elasticity is -.06, and that you believe that the current price is 40% above the level at which end-use demand equals supply. Then you have to believe that 2 million barrels a day is disappearing into secret hoards somewhere — secret, because it’s not showing up in the OECD inventory data. That’s a lot of oil. And bear in mind that people have been claiming that there’s an oil bubble for years.

You liar, Krugman! We all know Big Oil is hiding it with the UFOs in Area 51.

The flaws in blaming oil "speculators"

From CNBC, Vince Farrell defends commodity futures traders from the politicians' attacks:

I would like one of our fine, financially knowledgeable, market savvy politicians to define "oil speculator" for me. I know, there is no politician that fits the aforementioned description, but I would like someone to tell me who "they" are. I suppose Morgan Stanley would qualify since they are not in the oil business and trade oil futures.

So "they" are evil and to blame for the high price of oil. Except Morgan handles all the hedging business for United Airlines. The trades appear as Morgan trades but they are for an airline that critically needs to try to hedge its exposure to the volatile price of oil. Who gets outlawed?

Those being called "speculators" are players in the futures market. If they were to be the drivers of the price of oil, they would have to take possession of the commodity and hoard it. As it is they buy a piece of paper and for every buy decision there is going to have to eventually be a close out sell decision. They do not buy the physical product. When a "speculator" buys a futures contract, there has to be a seller and that's what free markets are all about.

Congress should know the price of oil has been driven primarily by the fact that more than 2 billion people in the Far East have been rushing into a more modern world and are demanding their share of the good life that is powered by oil. Demand is up, therefore the price is up. Also, since oil is priced in dollars, the precipitous decline in the value of the dollar due to the twin budget and trade deficits, has raised the price of oil. In 2002 one euro equaled one dollar. Today it costs about $1.55 to buy one euro. If the one-to-one ratio was still true, oil would be around $80.

Institutional investors that now consider commodities to be an asset class to invest in don't hoard the commodity and should have every right to be buying at the top of a bubble like they did in the internet boom. If investors like these were creating a bubble by buying futures contracts, how then to explain the soaring prices of potash and iron ore. These commodities don't have futures to trade!

But it's so easy to blame people, especially during an election year. Don't try to figure a solution. Just assign the blame and maybe get re-elected.

Farrell echoes the argument of Bush-bashing economist Paul Krugman. This is not a left–right issue. This is a fact vs. fiction issue.

Commodities speculation: A comparison of oil with onions

Fortune Magazine compares oil and onions to show how commodities speculation is not responsible for volatile prices:

Before the U.S. Commodity Futures Trading Commission starts scrutinizing the role that speculators may have played in driving up fuel and food prices, investigators may want to take a look at price swings in a commodity not in today's news: onions.

The bulbous root is the only commodity for which futures trading is banned. Back in 1958, onion growers convinced themselves that futures traders (and not the new farms sprouting up in Wisconsin) were responsible for falling onion prices, so they lobbied an up-and-coming Michigan Congressman named Gerald Ford to push through a law banning all futures trading in onions. The law still stands.

And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings. Since 2006, oil prices have risen 100%, and corn is up 300%. But onion prices soared 400% between October 2006 and April 2007, when weather reduced crops, according to the U.S. Department of Agriculture, only to crash 96% by March 2008 on overproduction and then rebound 300% by this past April.

The volatility has been so extreme that the son of one of the original onion growers who lobbied Congress for the trading ban now thinks the onion market would operate more smoothly if a futures contract were in place.

In fact, the entire reason commodities speculation exists is to reduce volatility and allow farmers to guarantee the future price of their crops.

High oil prices are good

The EconoSpeak blog speaks the truth:

The strategy of choice right now seems to be “blame the speculators”, and Obama has jumped on this bandwagon. Not a good idea, in my opinion, for two reasons. First, there’s not much evidence that speculators are the cause of this price runup. Second, high oil prices—in fact, much higher oil prices—are good. They will combat climate change...

5 Reasons to love $4 gasoline

From Foreign Policy, here are five reasons to love $4 gas:

1. The mass transit boom


2. Lower obesity rates


3. Fewer accidents


4. Shorter commutes


5. The biofuels craze

Hat tip to Greg Mankiw.

Financial speculation not responsible for high oil prices

Paul Krugman says today's high oil prices are based on actual supply and demand, not financial speculation:

Are speculators mainly, or even largely, responsible for high oil prices? And if they aren’t, why have so many commentators insisted, year after year, that there’s an oil bubble?

Now, speculators do sometimes push commodity prices far above the level justified by fundamentals. But when that happens, there are telltale signs that just aren’t there in today’s oil market.

Imagine what would happen if the oil market were humming along, with supply and demand balanced at a price of $25 a barrel, and a bunch of speculators came in and drove the price up to $100.

Even if this were purely a financial play on the part of the speculators, it would have major consequences in the material world. Faced with higher prices, drivers would cut back on their driving; homeowners would turn down their thermostats; owners of marginal oil wells would put them back into production.

As a result, the initial balance between supply and demand would be broken, replaced with a situation in which supply exceeded demand. This excess supply would, in turn, drive prices back down again — unless someone were willing to buy up the excess and take it off the market.

The only way speculation can have a persistent effect on oil prices, then, is if it leads to physical hoarding — an increase in private inventories of black gunk. This actually happened in the late 1970s, when the effects of disrupted Iranian supply were amplified by widespread panic stockpiling.

But it hasn’t happened this time: all through the period of the alleged bubble, inventories have remained at more or less normal levels. This tells us that the rise in oil prices isn’t the result of runaway speculation; it’s the result of fundamental factors, mainly the growing difficulty of finding oil and the rapid growth of emerging economies like China. The rise in oil prices these past few years had to happen to keep demand growth from exceeding supply growth.

Saying that high-priced oil isn’t a bubble doesn’t mean that oil prices will never decline. I wouldn’t be shocked if a pullback in demand, driven by delayed effects of high prices, sends the price of crude back below $100 for a while. But it does mean that speculators aren’t at the heart of the story.