Bipartisanship has its advantages. A bipartisan process is more likely to get policy based on values that Americans broadly agree on, and a bipartisan process is less likely to accept mistaken evidence because many eyes will have examined the evidence from different perspectives.

But we need to remember, especially at Across the Aisle, that bipartisanship should rarely, if ever, be a goal for its own sake. The United States in recent years has made all sorts of “bipartisan” foreign policy errors.

And we’re on our way to another one, if the House-led effort to crack down on oil market speculators makes it into law.

In recent years as a New York Times columnist, Paul Krugman has often opined based on his values, and his columns can sometimes seem partisan and shrill. But when he writes as an economist, he is almost always sharp and clear and insightful (who am I to offer broad criticism of one of the leading international economists of our time? I once tried to get him to join my committee of advisors on my Ph.D. dissertation, but since I studied graduate international economics at MIT when he was on leave, meaning that I took the class with another great contemporary international economist, Avinash Dixit, Krugman demurred.  Bottom line: I have my personal views about Krugman’s economics writings, but a dispassionate observer would be perfectly justified in taking his views much more seriously than mine.).

Krugman’s column in today’s Times about speculation in the oil market seems solidly on point, based on well-argued economics. And he offers much more detailed analysis on his blog (here is the most recent post in a series, which started here). Blaming “speculators” for the run-up in oil prices and passing bipartisan legislation to crack down on speculators in hopes of driving down the price of gas in the U.S. is misguided.

I don’t have much to add to the specifics of the oil discussion. Krugman posts lots of detail and some useful graphs. The bottom line is that “paper barrels” traded by financial speculators rarely affect the price that consumers of oil pay for the ability to burn petroleum (whether in their cars or somewhere else). Financial speculators who never physically possess the oil both buy and sell in the market. They increase the number of trades, but they don’t change overall supply and demand. Every “paper” speculator who buys a futures contract then sells that same contract before the delivery date. So the added demand for purchases is exactly compensated by the added supply offered for sale within the lifetime of the contract.

Of course, if the speculator does actually take delivery of the oil and decides to hold it in inventory, then his purchase in fact reduces the supply available to people who want to take the oil and burn it. So if inventories rise along with “speculative” trades, then speculation can drive up the consumer price of oil, at least until the speculators decide to sell from their inventories (e.g., when tanks get so full that the rental cost of storage capacity is high enough that it’s no longer profitable to hold the oil hoping for a higher consumer price in the future).

The thing is that oil inventories have not been rising in this fashion, and the relationship between the futures price and spot price of oil does not appear to support the hypothesis that this hoarding dynamic is going on.

Of course, producers of oil may be speculating by leaving oil in the ground, and the fact that producers are organized into a cartel (OPEC) makes it more plausible that they might be do this. Whatever the level of demand (which surely has been rising in recent years), a working cartel will withhold some measure of supply, selling less than the amount at which price equals marginal cost. And it’s hard to tell today whether OPEC is pumping at full capacity and investing as fast as it can to increase its future ability to pump oil (that is, trying to “catch up” to rising demand), or whether OPEC is acting like a working cartel. We just don’t know enough about what’s going on inside OPEC’s fields, because they hold their technical data very close to the vest.

But if OPEC “speculation” is the problem, then the issue for U.S. policy is with OPEC not with financial speculators regulated by the CFTC. Directing the CFTC to limit the ability to trade oil futures will just reduce trading volume and create market rigidities that in principle may create losses in the American market.

For me, though, the real thing to consider is what makes someone a “speculator” (hence the quotes throughout this blog entry). No one ever seems to define carefully who the “bad guys” are in this plot. Definitions of speculation are hard to come by, and they are even harder to operationalize.

In my courses, I try something relatively simple, and although it is imperfect, I think it helps make some points: a speculator is someone who hopes to make a profit by buying an asset (e.g., a futures contract) and selling it to someone else at a higher price even though he has not taken any action to increase the value of the asset. A speculator’s goal is to profit by taking money from some other buyer rather than by creating additional value. If the speculator correctly buys “low” and sells “high” at the “right” price in each transaction, the speculative purchase has not created any new value; it has simply transferred the profit from the previous owner (who sold to the speculator) to a new owner (the speculator himself).

This definition is not too far from the one offered in Benjamin Graham’s classic business book, The Intelligent Investor, which seeks to differentiate between “investors” and “speculators” and to convince readers to be the former rather than the latter. Graham doesn’t include as clear a statement of the definition as I would like, but Jason Zweig’s commentary in the 2003 revised edition comes close: “An investor calculates what a stock is worth, based on the value of its businesses. A speculator gambles that a stock will go up in price because somebody else will pay even more for it.” The definition of an investor presumes what seems to me an unreasonable ability to calculate the true value of a business (and that the current owners won’t be able to calculate that same value), but again, Zweig is getting at something meaningful.

So what’s the implication of this investment? Speculators may or may not make money on particular trades, but it seems that their success depends more on luck than on reasoning — or perhaps on understanding human nature and animal spirits of other speculators more than on understanding the underlying business.  But the worst that speculators can do is lose their own money rather than change the underlying value of the asset. Their demand for the asset — and their money flowing into the market for the asset — is only a temporary aberration. The recent run-up in oil prices has extended over several years, which is a pretty long time to blame on purely financial speculation.

If OPEC suppliers are holding oil in the ground rather than pumping as fast as they can, are they speculating? Probably not. For one thing, they are taking direct action to increase the price of the asset (that is, they are constraining supply).  Is that good behavior, from the perspective of the United States and American consumers? Probably not (unless you really believe the climate change story that says we’re better off with much higher energy prices). But it’s a different problem from the one that the bipartisan consensus in the House of Representatives diagnosed this week.

Begging our friends in the Persian Gulf to pump more oil doesn’t seem very productive (as in the Bush administration’s recent effort), because Saudi Arabia and the other producers will decide what’s in their interest and what they are capable of doing in terms of investment and exploitation of existing fields. Our ability to tell them what to do is, well, limited. But the begging policy is based on a logic that is closer to the right way to think about the causes of current high oil prices than Congress’ anti-speculation jag.

 

So this post mostly has been about what is not causing high oil prices. I recently was interviewed at length about oil by the Romanian magazine Revista 22 (of all places — I have no special ties to Romania), and if anyone has the stamina to read on, here is the English version of a couple of my thoughts about what is causing oil prices to rise:

1.     What has triggered the current oil crisis-the post 9/11 price spikes? Which were the structural forces that shaped these trends? Which are the key factors that affect oil supply and prices? Which was their role in shaping these trends?

Many things affect oil prices. The market is incredibly complex, especially at the detailed level of trying to explain individual trades, as particular deliveries of crude oil depend on variations in the quality of the oil, the exact timing of deliveries, the number of oil tankers available to compete for the business, etc. But for broad understanding of the environment rather than an effort to make money on particular futures contracts, we can explain the run-up in oil prices in the past few years based on a couple of key factors.

The first big factor is that demand is rising around the world.  Economic growth in China and India have received a lot of attention in the press, and those countries are big factors to be sure, but demand has also soared in other countries, notably including the United States. Comparing to the immediate aftermath of 9/11 is a bit unfair, because the economic troubles at that point artificially depressed demand (so of course demand looks like it is “up” since then), but even comparing to the late-1990s, demand has increased worldwide. And that demand increase has helped raise oil prices, partly because it takes a few years for investment in production and distribution capacity to catch up and partly because the higher level of production to meet the demand involves exploitation of more expensive marginal resources. But I should stress that increases in the cost of producing oil cannot explain the run-up to a $130 per barrel price: there’s a lot of oil available that’s economically viable to produce at a price of $50 per barrel – for example, in Canada – that just takes a few years to get on line. 

Along with the increase in demand (relative to the rate of investment in supply), the second big factor in the rising nominal price of oil to the vicinity of $130 per barrel is the drop in the value of the dollar. If we monitor the price of oil in dollars, and each dollar is worth less, then the reported number for the price needs to increase just to maintain the same level of true cost for the oil. The drop in the value of the dollar relative to other currencies is not caused by anything in the oil market: the United States runs a trade deficit, and over time, economists expect that long-term exchange rates should adjust to bring that deficit back into balance. Indeed, at some point, the U.S. will run a trade surplus again. But because oil prices reflect a combination of the real cost of production and, probably more importantly, the real value of oil to consumers, when the numerical representation of that value changes because the value of what we use to measure prices – the value of the dollar – changes, then the nominal price of oil must change, too. This would be true even if the real value of oil stayed the same. One effect of this is that the real increase in the cost of oil for consumers in the United States has increased more than the real increase in costs for consumers in countries whose currencies have appreciated relative to the dollar (e.g., for European consumers).

 

2.     We live today in a global oil market that has become very tight on supply. The real issue seems to be a supply issue. So, in this context (of a very tight supply) has the market the capacity to respond to some major oil supply shocks caused by political disruptions (wars, terrorism)? In the past it seems to have a market pattern capable of dealing with major disruptions in the oil supply by compensating increases elsewhere. Has the today’s market enough slack production capacity in order to increase the output for dealing with a price spike triggered by political disruptions?

 

It is hard to divide the causes of the rising price into the “supply side” and the “demand side” of the oil market. The price is determined simultaneously by the amount of oil on the market at a particular moment (supply) and how much people want to use that oil (demand). You can only talk about “tight supply” in comparison to demand conditions. What we see today is that demand has broadly increased, and the amount of oil pumped into the market has increased, too, by a few million barrels a day – say, from 80 million barrels a day to 86 million barrels a day worldwide. Right now, people are willing to pay more than $130 for the marginal barrel of oil, given that 86 million barrels or so are on offer, but suppliers are not willing to reduce inventories or pump faster right now for a marginal price of only $130. There’s a lot of oil inventory around the world – in private and public stocks, owned by oil producers and by middlemen and by consumers – and all that oil could be additional “supply” tomorrow, if people thought that it was worth it to sell at the current price. 

Trying to trace a particular price or a particular restraint on selling to “supply-side” political disruptions like wars or terrorist attacks or fires or natural disasters is a mistake. Most supply disruptions are very small compared to the overall size of the market, and many market participants have opportunities to compensate for the disasters.  Iraq’s contribution to oil on world markets dropped after 2003 for several years, but the net drop of a few hundred thousand barrels of Iraqi oil did not cause the market price to double.  Supply disruptions have been one factor, but a relatively small one. The market generally over-reacts to news of an attack on oil supplies: most of the time, when pipelines are damaged or a tanker is attacked, the damage is minor and the asset gets back on line promptly.  It is hard for terrorists or even militaries to cause a lot of damage to such a large and diverse infrastructure of oil supplies. If one tanker does not make its scheduled delivery, some oil comes out of the market that day, but there is plenty of oil available in inventories to compensate – and the tanker will eventually make its delivery, a bit behind schedule, so the inventories can later be refilled. The only supply disruptions that really should affect oil prices are sustained disruptions that affect a lot of oil (millions of barrels per day) for a long time (weeks). 

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