Betting on the Bubble

By the St. Louis Post-Dispatch | Jun 9, 2008 at 18:53:45

Here's a way to get oil prices down, at least by a little: Take a regulatory whip to the speculators who've been bidding prices up.

The Commodity Futures Trading Commission - the somewhat toothless federal watchdog over oil markets - needs to tighten its rules on speculative trading, both in oil and agricultural products. If the CFTC won't act, Congress should.

Oil prices have risen 39 percent so far this year. Indeed, on Friday alone, the price of a barrel of crude rose $11 to a record $139. Most of that is for a very basic reason: Demand is up around the world, especially in Asia, and supply isn't keeping pace.

But as prices went up, a new crowd of players jumped into the oil markets. Pension fund managers, hedge fund operators and other big investors shifted money from the stock and bond markets - where they were losing their well-tailored shirts - into commodities.

Investment in commodities index funds grew from $13 billion to $260 billion in five years. Oil futures trading on the Intercontinental Exchange quintupled over two years to a paper value of $8 trillion in 2007, reports the British newsmagazine The Economist.

George Soros is an investor of legendary savvy who last year earned more than $200 million per month. Last Tuesday, he went before the Senate Commerce Committee to warn of a speculative bubble building in oil.

"The bubble is superimposed on an upward trend in oil prices that has a strong foundation in reality," Soros said. "The rise in oil prices aggravates the prospects for a recession."

Players in the commodities markets come in two basic types. Some actually plan to use the commodity. For instance, a refinery might buy a contract for oil to be delivered in the fall. Then there are those who buy futures contracts betting that the price will go up.

The speculators, Soros said, are misjudging the basic supply-demand equation, and pushing oil prices too high. Bubbles eventually burst, but Soros sees no sign that this one will burst soon.

How much of the price of a barrel of oil can be attributed to speculation? Mark Cooper, research director at the Consumer Federation of America, says it may be as much as $40 per barrel. Others, including Soros, think it's considerably less. Some estimates say speculation adds just a few dollars to the price of each barrel.

Whatever the figure, it should be eliminated. High oil prices slow the economy and cost jobs. Should the bubble grow too large, a sudden pop could weaken workers' pensions and cause more strain in our weakened credit system. Soros said the commodities market today reminds him of the stock market before the 1987 crash.

So where's the CFTC watchdog in all this? It's chasing the wrong rabbit. The commission recently revealed that for the last six months, it's been investigating manipulation in the energy markets.

Manipulation is different from speculation. Manipulation means taking action intended to raise prices, rather than simply jumping aboard for the ride. It's hard to imagine traders manipulating the world price of oil. A conspiracy would require too many conspirators.

The watchdog agency has taken a few steps in the right direction, sharing information with European regulators and requiring more transparency from American market players. But it should go further:

- Raise margin requirements to make it harder to speculate with borrowed money.

- Revise rule changes enacted in 2000 that made the market more speculator-friendly.

- Close loopholes that let speculators skirt trading limits.

- Impose greater limits on the ability of pension fund managers to speculate with money that workers will need when they retire.

Tighter rules in the United States could simply move trading overseas, but the United States is a big and influential player, to say nothing of it being the world's biggest oil consumer. It should lead by example.

Reprinted from the St. Louis Post-Dispatch.