Ifo Viewpoint No. 109: Good and Bad Speculation
Munich, 25 August, 2009
Many see speculation as the reason for the recent capricious movement in the oil price. Since the volume of trade on the futures markets can be ten times greater than production – so a frequently voiced assertion – the oil price today is purely speculative, and neither the producing countries nor the end users are able to influence it much. Gamblers at their terminals destabilise the markets and thus the whole world. They must be reined in.
But it is not quite so simple. For one thing, futures speculation is the necessary correlative of hedge transactions, which an economy needs in order to establish longer-term planning security. Forbidding this speculation would do great damage to the real economy. For another, futures speculation has, as a rule, no influence on current prices, because the transactions balance out on the spot market. If, for example, oil traders sell on the futures market, they normally do not purchase the oil until the agreed delivery date. They divert a portion of the production for their transaction and return precisely this amount to the market. In this way they influence the futures price but not the spot price, i.e., the current market price.
In order to influence the current market price, the speculators must withdraw the oil prior to delivering it, but to do this they need physical storage capacities. Only to the extent that they have these capacities can they influence the price. Mere on-line speculation is irrelevant.
Or course there is much speculation involving fluctuations in storage. The large oil companies have extensive storage that they can speculate with, and also the ships on the oceans are gigantic storage tanks. Currently many fully laden oil tankers are roaming the seas and are not delivering their shipments because the owners of the oil are waiting for higher prices.
This speculation, however, is not bad but good. In the normal case it helps to smooth spikes in prices, since speculators only make a profit if they buy the oil cheaply and sell it at a higher price. If the price is low, as it is today, they buy the oil and in so doing increase the price. And if the price is high, as it still was a year ago, they sell the oil and lower the price. The greater the profits of the “storage speculators”, the stronger the stabilisation effect that they induce.
Included among the speculators that act this way is above all OPEC, which has gigantic storage capacities in the form of the oil reserves themselves. The recession has reduced the demand for oil dramatically, and before the producers were able to adjust output, prices fell. Once the oil producing countries reduced their supply, prices picked up again in spring 2009. OPEC too is among the stabilising speculators. The representative of the United Arab Emirates at OPEC, Ali Obaid Al Yabhouni, made the observation in May at the Munich Economic Summit that OPEC should be regarded as an institution like a central bank that stabilises the world economy. This observation is not far from the truth.
Of course there is also a destabilising speculation. This always involves speculators borrowing cash or the object of speculation in order to be able to exert a much greater leverage effect on the market. This is problematic for two reasons. The speculators as a rule assume risks that they themselves cannot bear if their speculation goes awry. The major institutional speculators are mostly undercapitalised institutions with limited liability that in the case of failure can indeed go bankrupt but can themselves only bear a fraction of the losses that they cause. Secondly, the leverage effect is problematic, because in this way individual speculators wield market power by themselves being able to influence the price level of the market. If the traded quantities are so large that an individual speculator can change the prices something must be wrong. Others are cheated, and the market fails in its task of producing economic efficiency and stability.
Clear examples of market failure have become evident in connection with short selling. Large quantities of securities are borrowed, thrown onto the market, depressing the price and touching off panic sales via herd effects, which depress the price even more; then the securities are bought back and returned to the lender including a rental fee. This is what led to the collapse of Lehman Brothers and is how Georges Soros broke the British pound. Such activities are detrimental for the stability of an economy. They must be restrained. Short selling should be strictly limited if not forbidden. The most effective approach, however, is to force all speculators to shore up their transactions with much more equity capital than has been necessary up to now so that they can also pay for the possible losses. That would limit the market power traders exert through leverage and make them more cautious, reducing the risk of negative externalities on other market agents. Casino capitalism was able to spread because the legal instrument of limited liability by way of minimising the capital-assets ratios led to an overblown appetite for risk. This effect must be reined in, but we should not throw out the baby with the bathwater. Speculators are more useful than many think.
Professor for Economics and Public Finance
President of the Ifo Institute
Published as “Gute und schlechte Spekulation”, Wirtschaftswoche, No. 30, 20 July 2009, p. 36.