Article published Sunday, March 11, 2012 at Philadelphia Inquirer.

Speculators smooth out the rough spots

By John R. Lott, Jr.

With regular gas prices topping $3.70 last weekend, angry politicians are blaming the higher prices on speculators and greedy oil companies. On Monday, The Hill newspaper reported that 23 senators and 45 congressmen, all Democrats except for one independent, called for urgent action against the "speculators" they hold responsible. Sen. Bob Casey of Pennsylvania demanded, "Consumers shouldn't be forced to pay higher prices at the pump because of speculative bets on Wall Street."

These politicians want the Commodity Futures Trading Commission to use its new regulatory powers under a law signed by President Obama two years ago to limit the amount of oil that speculators can buy.

This isn't a new concern. Last April, when regular gas prices hit $4 a gallon, the president launched a Department of Justice investigation into what he called "manipulation in the oil markets that might affect gas prices."

Unfortunately, neither the Democrats in Congress nor Obama appear to have a clue how markets work. The policy reminds one of Richard Nixon's attacks on speculators during the 1970s.

Everyone wants lower prices, but many politicians seem unable to understand that speculators actually smooth out wild swings in prices. Speculators make profits by buying oil when the price is low and selling when it is high. When prices are expected to rise in the future, they buy oil today and sell it when they think the higher price occurs. They will keep doing this until the gap between today's prices and tomorrow's expected price virtually disappears.

Tensions have risen over the last few weeks as Iran threatens to block oil shipments through the Strait of Hormuz if Israel attacks its nuclear facilities. With up to 20 percent of the world's oil supply at risk - an amount equal to the entire production from Saudi Arabia, Kuwait, Qatar, and the United Arab Emirates - steep price increases are a real possibility.

The risk immediately increased oil prices. Speculators aren't waiting for Israel to actually attack. By buying oil now in order to set it aside if supplies are interrupted if a conflict occurs, consumers are actually protected. Storing oil for this possible crisis will prevent what would have been even higher prices.

The Democrats obviously think speculators are unjustified to start bidding up prices. And, indeed, Israel's attack might never occur. Yet, if speculators didn't do that and oil shipments were halted, the much bigger increase in oil prices would surely cause these very same politicians to call for the scalps of everyone in the oil business.

Speculators are taking a real risk with their own money. If no attack occurs and prices fall, few in Congress are going to shed tears over the money that the speculators would lose. If the attack takes place and prices only rise a fraction of what they otherwise would have gone up, who is going to thank the speculators for a job well done?

Higher oil prices today reduce consumption and increase inventories and thus reduce how much prices will rise if disaster strikes. The possibility of higher prices when disasters strike also gives oil companies an incentive to put aside more oil to cover those emergencies. All this ensures that the overall increase in price will actually be less.

Still, government policies can help lower gas prices today. Democrats and even some conservatives, such as the National Review's Rich Lowry, claim that there is nothing that can be done immediately to reduce oil prices. After all, they argue, even if the go-ahead were given today to drill for more oil, it would take years before we would actually see it. But lower future prices do lower current prices. Just as speculators save oil for future consumption if they think that prices will rise, lower future prices mean that they won't keep their inventories, and selling them off now will lower today's prices.

Unfortunately, this crazy political attack on speculators is all too typical of the regulations that we are seeing imposed on other industries. No matter how well-meaning, politicians who don't understand how markets work can do real damage to the economy.

High gas prices have long been in the making. Punishing speculators may be politically popular, but it will only hurt consumers.

John R. Lott Jr. is a contributor. He is an economist and co-author of "Debacle: Obama's War on Jobs and Growth and What We Can Do Now to Regain Our Future.".

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