Three Cheers for Oil Speculators!

Oil speculators are benefactors of humanity.  We should be very grateful to all of them.  Next time you see an oil speculator, thank him for what he is doing.  Most Americans would strongly disagree with me.  But they are wrong -- not morally wrong, but factually wrong.

One of the consequences of the recent increase in the price of gasoline has been the demonization of oil speculators.  Politicians, journalists, talking heads, bloggers, and agitators have been denouncing speculators and proclaiming that the general public has been harmed by their speculating.  Most of the anti-speculator rhetoric has been civil.  But some of it can be described only as hate speech: Google "speculator, bloodsucker" and you will be directed to 295,000 websites.  And this anti-speculator hysteria has not been confined to the usual suspects on the left.  For example, the normally sensible Bill O'Reilly has been bloviating about the wicked oil speculators. 

We now face an even more dangerous idea than the idea that speculation is harming the average American: the idea that the government should do something about it.  Many people, including the president of the United States, have called for the government to stop -- or reduce the amount of -- speculation in oil.  Vermont's socialist senator, Bernie Sanders, has announced that he plans to introduce a bill to do just that.

According to President Obama, "[w]e can't afford a situation where some speculators reap millions while millions of American families get the short end of the stick."  The president's assertion that some speculators have reaped millions is almost certainly true.  But his implication that the American people have been harmed by that is false.  Those who believe that speculation makes non-speculators like us worse off are factually incorrect.  Their mistake is the result of considering only one of the consequences of speculation, not all of the consequences.  Using that methodology, you can prove that anything is evil.

In all the ranting about oil speculators, there is one minor detail that never gets discussed.  That detail is this: if it is true that speculators are causing the present price of oil to be higher than it otherwise would be, then it is also true that speculators are causing the future price of oil to be lower than it otherwise would be.  It is not possible for speculators to do the former without also doing the latter.

Thus, speculation has two effects.  One of them -- raising the current oil price -- is bad.  The other -- lowering the future oil price -- is good.  Determining whether speculation is good or bad for society amounts to determining which of the two effects is larger.  The anti-speculator crowd hasn't gotten to step one in thinking seriously about the question: step one is recognizing that there are two effects.  Virtually everyone who has seriously considered this question has come to the conclusion that the benefits of lower future prices outweigh the costs of higher current prices, and therefore, speculation makes the world better off.  Some of the gain goes to the speculators

The fact that speculation has two effects, not one, is obvious.  After all, what is a speculator?  An oil speculator is someone who believes that future oil prices will be higher than the current oil price and who tries to profit by buying oil now at a lower price, storing it, and then selling it later at a higher price.  If his belief is correct and future oil prices are higher than the current price, he will make money; if his belief is incorrect, he will lose money.  By buying oil now and storing it in a tank -- instead of making it available to consumers -- he is decreasing the present supply of oil, and thereby increasing the price.  By selling the stored oil at a future time, he is increasing the supply of oil at that time, and thereby decreasing the price.  That is what a speculator does, and that is the only thing he does.  (What may be confusing to some is that, most likely, the speculator does not physically store the oil himself, but instead pays somebody else to store it for him.  This is, of course, irrelevant.  Or the speculator might purchase a futures contract.  Purchasing a futures contract is an indirect way of buying oil now at today's price, selling it at a fixed future date at that date's price, and paying somebody else to store the oil between now and then.)

The fact that consumers benefit from the activity of speculators is not obvious, but it is true.  Before explaining this, I must clarify whom I mean by speculators.  Oil producers can, and do, speculate.  If they believe that future oil prices will be higher than the current oil price, they simply leave their oil in the ground.  But these are not the people we call speculators.  By a "speculator," I mean a non-producing speculator -- that is, a middleman speculator.

Let us divide the population into three groups: oil speculators, oil producers, and oil consumers.  Suppose that in the absence of speculation, today's market price is $100 per barrel, and next year's price will be $150 per barrel.  Since the market price is $100 per barrel, a marginal consumer personally values a barrel of oil at $100; he would gladly buy one for less than $100, would refuse to buy one for more than $100, and is indifferent to buying a barrel for exactly $100.  Now suppose a middleman speculator enters the picture and buys one barrel from a producer for $110 and stores it for a year.  One marginal consumer -- call him Consumer A -- must buy one less barrel today.  Next year the speculator sells the barrel of oil to Consumer B for $140, making a profit of $30 minus expenses.  There are three non-speculators who are directly affected.  Clearly, the producer gains $10 and Consumer B gains $10.  Consumer A neither gains nor loses; he has to do without one barrel of oil, but he has an extra $100 in his pocket, and he is indifferent to that trade-off.

Those are the direct effects.  The indirect effect is that there is a supply decline of one barrel today and increase of one barrel next year, resulting in an (incredibly small) increase in today's price and decrease in next year's price.  The indirect effects produce no net gain or loss to non-speculators (producers and consumers); the effect is a redistribution among non-speculators.  The increase in today's price means that today's consumers lose and today's producers gain -- but the loss to the consumers is exactly equal to the gain to the producers.  Similarly, next year, there is a gain to the consumers which is exactly equal to the loss to the producers.  So when all of the effects, direct and indirect, are taken into account, the non-speculators (producers and consumers) benefit.

There are three cases to consider.  Case 1: Both consumers and producers gain.  Case 2: Consumers gain and producers lose.  Case 3: Producers gain and consumers lose.  They can't both lose.  In case 3, the consumers are, indeed, harmed.  But neither case 1 nor case 3 is likely to occur.  If speculation benefits the producers, some of the producers will decide to do the speculating themselves and eliminate the middleman.  If middlemen speculators are active at all, we must be in case 2.

There are people who take oil off the market now without putting it back on the market at a later time.  That is, these people are responsible for decreasing the current supply and thereby increasing the current price, without increasing the future supply and thereby decreasing the future price.  The behavior of these people has only one economic effect, which is a harmful effect.  But these people are not the people we call speculators.  They are the people we call environmentalists.

(See also: Obama and the Oil Speculators)