When Goldman Sachs Warns That Speculation Drives Oil Prices, Listen Up

Goldman Sachs (GS) fears that speculation is causing a dangerous spike in the price of oil. In fact, the head of commodities trading at the investment bank is so worried that he advised clients this week to cash in their profits before the bubble pops, noting in a report that the sector shows "record levels of speculative longs [trading] in crude."

This is, to put it mildly, an unusual admission from Wall Street's preeminent casino. The official position of securities traders, hedge funds and other market players has been that speculation doesn't affect oil prices, including prices at the pump. That's the line the industry has taken in enlisting key lawmakers on Capitol Hill to quash rules proposed under the Dodd-Frank financial reform law aimed at curbing wild swings in the price of oil.

As Goldman makes clear, this view is implausible. Mounting evidence -- and recent history -- suggest that crude oil prices are increasingly determined by investors betting on which way prices are moving, rather than on economic fundamentals.

Shortly before the financial crisis in 2008, for instance, the cost of oil soared more than 125 percent, pushing gas prices to more than $4 a gallon and badly denting the global economy. The run-up couldn't be explained in conventional economic terms, since global oil supplies at the time exceeded demand. Prices, too, whipsawed, shooting from $65 a barrel in June 2007 to $147 a year later, before diving to $30 in late 2008 and back up to $72 the following summer. Meanwhile, the supply of crude in the U.S. was hitting a 20-year high, while the deep economic recession cratered demand.

What oil speculation costs
In wake of this surge, the House of Representatives passed legislation that would've curbed speculation in crude oil derivatives. But it later died in the Senate under pressure from Wall Street and other derivatives users.

It's not only U.S. lawmakers who perceive the threat of oil speculation -- so do the countries that benefit most from high oil prices. Said the Saudi Arabian oil minister at a 2008 meeting of oil-producing countries:

I believe that there has been a parting of the ways when it comes to oil supply-demand balances and other industry fundamentals on the one hand, and the price behavior and market volatility on the other. Industry fundamentals cannot account for today's high prices, nor for the enormous degree of market volatility that we have experienced of late.

Financialization: The tipping point
Speculation is, of course, a normal and useful feature of markets. The danger is when a market that is ordinarily governed by supply and demand becomes increasingly hostage to speculators. Why? Because they have no financial stake in whether a barrel of oil, bushel of wheat or mortgage-backed security is correctly priced. Their only interest is whether the price of that asset goes up or down. And when speculators begin to crowd out other types of investors -- including companies wanting to hedge their risks and even the kind of high-rollers served by investment banks -- it can fundamentally disrupt that market.

Compounding that threat is the growth in recent years of new investment products and strategies that has resulted in what former CFTC staffer and now University of Maryland law professor Michael Greenberger calls the "financialization of the oil industry." And other industries, too. For instance, the Goldman Sachs Commodity Index, which the company launched in 1991, includes some two dozen commodities, including oil, coal, metals, corn and wheat.

Such markets can be useful to, say, airlines interested in hedging against sudden hikes in the price of jet fuel. But they have also attracted a wave of speculators eager to bet on a range of commodities. And sure enough, prices in these "financialized" sectors have become alarmingly volatile over the years.

With oil, such volatility in wealthier countries can result in slower GDP growth and higher unemployment. With wheat, it has caused starvation in poor countries. And political turmoil here in the U.S., it's worth adding. Statistician Nate Silver has shown that high gas prices can severely damage the incumbent party's electoral chances.

Gaming the game
The most obvious solution is to establish "position limits," which cap the number of futures contracts a trader can hold. Dodd-Frank gives the CFTC the power to establish these limits as a way to diminish excessive speculation and ensure that markets function well. For now, however, exactly how those rules will be implemented or enforced is unclear. Why? Because companies like Goldman are lobbying against them.

If that sounds like the same recipe that helped trigger the financial crisis -- economic and political interests aligning to fight regulation -- that's because it is. Or to put it another way, Wall Street and its clients create markets where speculation can flourish. They reap enormous profits from that trade, calling in their chits on Capitol Hill to fend off efforts to restrict it. Perhaps bankers can also claim to serve as a voice of prudence in openly warning about an overheated market.

And when the stakes get too high, they take their winnings and go home.

Image from Wikimedia Commons user Flcelloguy
Related:

• The Four Biggest Lies About Gas Prices
• Priming the Pump: How Wall Street Boosts Gas Prices
• Why Big Oil is Fighting a New Disclosure Proposal From the SEC
• Why Wall Street May Yet Win the Derivatives War
• Financial Reform: Why Shielding Energy Firms From Derivatives Rules May be Nuts