Analysis
Managing price bubbles in crude oil markets
By Munir Quddus
Online Journal Contributing Writer


Jul 21, 2009, 00:13

The Commodities Futures Trading Commission (CFTC) is considering new restrictions on �excessive speculation� in markets for oil, natural gas and other energy products. It is about time they do.

Similar regulations already exist in markets for agricultural products such as wheat, corn and soybeans. The historical record shows that these have been relatively successful in preventing manipulation by a few large players and excessive speculation, without hurting market efficiency in agricultural products.

Predictably, the CFTC moves have some folks riled up. These critics claim that any attempt to regulate speculative trading would be anti-free market. Others have noted that speculation is an essential force that helps the markets move towards equilibrium. Therefore, any attempt to constrain speculation will retard market innovations and reduce benefits such as risk sharing, liquidity and efficiency.

These critics miss the point. Contemporary research by economists and study of business and economic history reveals that speculative trading can be both healthy and unhealthy for market integrity and efficiency. Although without a healthy presence of traders and speculators, markets cannot function efficiently, but excessive speculation can be problematic for market stability and efficiency.

The recent painful collapse of the real estate bubble in the United States which led to a global financial meltdown should, at the minimum, serve as a reminder of the dangers inherent in non-regulated markets that can spin out of control. Economists of all shades agree that markets do not always move towards an equilibrium. A growing group believes the assumption of equilibrium in economic models may have to be jettisoned for more realistic assumptions. It is time to question the conventional wisdom.

Last year, the price of crude oil soared to an all time high of $147 per barrel, more than a 200 percent increase in a relatively short time span. The steep and rapid rise in crude price came as a complete surprise to most experts. Nevertheless, numerous industry experts and professional economists concluded that the price spike was not a temporary aberration caused by a herd reaction of speculators, but was indicative of fundamental changes in market demand and supply. Factors such as high demand in India and China were mentioned. Even top-notch economists like the Nobel Laureate Paul Krugman ruled out the existence of a bubble, given the low inventory levels in crude oil.

The consequences of the sustained rise in crude oil prices were harsh on the global economy. Since crude oil and energy are crucial ingredients in the production of agriculture products, the impact on food prices was predictable and debilitating. Food riots broke out in many developing nations with millions of low income families squeezed in a vicious crisis from the escalating price of rice and other essentials.

Fortunately, most experts were wrong. The spectacular increase in crude oil prices was, in fact, the result of self-fulfilling expectations by traders that led to a speculative price bubble. Fundamentals such as a sustained increase in demand from economic growth in India and China played a relatively minor role. A market bubble is created and sustained by easy money and excessive speculation from an influx of unsophisticated traders. Traders who take long positions in markets infected by a price bubble are not acting irrationally, but the market outcome is highly inefficient. Rational traders can behave with a herd mentality, causing irrational outcomes. A bubble is not sustainable, and when conditions are right it collapses. Once the crude oil price bubble popped in 2008, prices fell rapidly until they were below $35 a barrel, a dizzying collapse of more than $111 dollars per barrel in a few months. Typically, a collapsing bubble overshoots before finding the true equilibrium.

Today, those who oppose the proposed CFTC regulations have presented various arguments. First, some argue that it is a mistake to try to separate the two types of traders, speculators from hedgers, since both add liquidity. Second, some hold that since speculation is a market force, it must be allowed unimpeded. Third, the argument is made that speculation is harmless. Another argument that is often heard is that regulation impedes markets, is anti-capitalistic and, therefore, is always harmful. Finally, some agree that market gyrations can be painful, but believe that attempts to control these fluctuations can be even more harmful.

None of these arguments stand up to close scrutiny. The case for judicious regulations is well established in economics. First, it is relatively easy to separate and regulate trading motivated by a desire to spread the risk, and trading for profit motive only. This is already achieved by appropriate regulations in the US agricultural markets, and in other nations. Second, economists who have studied speculative price bubbles realize that at some point retail investors who are generally unsophisticated wade into the market, creating greater instability. Third, even though normally speculative forces lead to improved market efficiency, these same forces can sometimes cause the markets to spin out of control, if excessive speculative funds come in. According to some estimates, at the peak of the crude oil bubble, demand was several times what could be justified by fundamentals. Contrary to the common view, speculation can be destabilizing eventually creating millions of victims including small businesses and retail traders.

Capitalism and free markets were never meant to be free of all rules. Adam Smith the father of modern economic science was well aware of the need for public sector controls of the private economy. After publishing his magnum opus, The Wealth of Nations, he served as a senior customs official. Good regulations play the same role in markets, as good traffic laws play in transportation. They ensure efficiency and safety of all participants. It makes little sense to allow price bubbles to grow unimpeded and wait to clean up the mess after the bubble pops. Good regulations can prevent bubbles from forming, and can pop these before they grow too big.

In case of the recent run up in the crude oil markets, by intelligently using the Strategic Oil Reserves, policy makers could have intervened to prevent the rise and collapse of the 2007-2008 crude oil bubble, saving the economy from much grief. This would have been justified on national security grounds (would have reduced the flow of dollars to unfriendly oil exporting nations), and would have been good for consumers and investors in America.

A market bubble creates and feeds on artificial scarcity -- by giving appropriate signals, policy makers can influence unrealistic expectations and puncture a growing bubble. Such aggressive and pro-active management of a bubble may save the economy billions. As a result of cutting edge research, policymakers now have a number of tools in their arsenal to identify and shoot down price bubbles. This includes reducing leverage by raising margin requirements, raising interest rates to reduce excessive liquidity, making fundamentals more transparent, and warning against the dangers of irrational exuberance. 

If only the Federal Reserve and regulators, such as the CFTC, had the necessary tools and the political will, perhaps today the US economy would not be in such serious trouble with over 12 million Americans unemployed. The mismanagement of our economy in recent years has seriously impacted our credibility as the leader of the world�s free market economies.

The CFTC and other regulators, by moving to curb excessive speculation while preserving the ability of traders to conduct their normal business, are finally moving in the right direction. Good regulations strengthen, not weaken, free markets. Excessive speculation leading up to a price bubble can be disastrous to the safety and health of markets and millions of participants. The simplistic choice between judicious regulations and market efficiency is a false choice. It is possible to regulate markets to prevent debilitating booms and busts, and preserve incentives for innovations and efficiency.

To prevent future bubbles, it is crucial that regulators and politicians learn the right lessons from recent debacles, such as the dot.com bubble and the collapse of the housing and financial markets (derivative) bubbles. Further, regulators in the United States must coordinate proposed new regulations with regulators in Europe and Asia for closing loopholes and maximum impact.