Think Speculators Cause High Oil Prices? Don’t Bet On It

Americans are spending more money at the pump than ever before. According to a recent estimate by the Energy Department, the average U.S. household spent nearly $3,000 on gasoline last year. Earlier this month, the U.S. Energy Information Administration forecast that the price for regular gasoline will average $3.63 a gallon this summer — a slight decline from last summer, not far from the record levels set in 2008. Why do oil prices remain so stubbornly high?

According to some in Washington, the blame lies with “speculators” — investors who buy and sell oil futures contracts to bet on the price of oil. As they see it, these scheming speculators — which may be individuals, but can also be mutual funds, hedge funds, or other investment institutions — inject billions of dollars into commodity exchanges in pursuit of a limited number of barrels, which in turn drives up the price of oil. Speculators, critics say, rake in piles of money at the expense of ordinary people who are going broke fueling their cars and heating their homes.

More than other commodities, sharp increases in oil prices are often blamed, at least in part, on speculators.

President Obama has called for restrictions on oil speculation, as have other influential figures in the policy and business community. In an op-ed in The New York Times last year, Joe Kennedy II, a former Massachusetts congressman who is the founder of Citizens Energy Corporation, said that speculators “should be banned from the world’s commodity exchanges.”

The problem with this view is that it ignores other important long-term shifts in economic fundamentals that contribute to the supply and demand — and therefore the price — of oil. Chief among them: the rise of China and India, whose growing thirst for petroleum drives up the price. Consider this: In the late 1960s, the U.S. used a third of the oil consumed in the world, while China consumed less than 1 percent, according to the International Energy Agency (IEA). In 2011, the U.S. accounted for less than 22 percent of world oil consumption, while China’s share was 11 percent.

This increase in demand has already had a big impact on the price of oil. Until mid-2004, the price of crude oil in the U.S. had never exceeded $40 per barrel. By 2006, it reached $70 per barrel, and in July 2008 — when the economy was going gangbusters and China and India were the two fastest-growing countries in the world — it reached a peak of $145. By the end of 2008, the beginning of the global financial meltdown, the price had plummeted to about $30. The price of oil reached about $110 in 2011, and today it hovers around $90.

Back to those pesky speculators for a moment: surely their bets on oil have had at least some effect on prices?

According to our latest research, the answer is: not really. In our recent paper, we explore the link between speculation and inventory changes. We calculate a series of speculation-free prices by creating a stable inventory of oil, providing us with a picture of what the market might look like in the absence of speculation. We focus on inventory for a simple reason: If oil prices are changing because of speculators, then there would have to be commensurate changes to inventories — a build-up when prices are increasing, and a draw-down when prices are falling.

But when the economy was strong and oil prices were increasing, we didn’t see large increases in inventories. In fact, they fell somewhat. This means that peak prices would have actually been higher if you take away any effects of speculation.

Investors buying oil contracts, the so-called speculators, are simply making a bet on supply and demand conditions in the future. And they are just as likely to be wrong as they are to be right.

More than other commodities, sharp increases in oil prices are often blamed, at least in part, on speculators. (Interestingly, however, speculators are rarely blamed for sharp decreases.) But they are not actually at fault. Oil price speculation is just an investment designed to pay off if the price of oil goes up (or alternatively, if it goes down), but it can do little or nothing to affect global prices.

Investors buying oil contracts, the so-called speculators, are simply making a bet on supply and demand conditions in the future. And they are just as likely to be wrong as they are to be right. Those who profit are either very lucky or they have better information than the market does. (They may have a better model for forecasting Chinese growth, or more reliable predictions about Middle East supply disruptions.) Either way, their activities will have little effect, if any, on prices and volatility.

This piece was co-authored by Robert Pindyck, Bank of Tokyo-Mitsubishi Ltd. professor in finance and economics and a professor of applied economics at the MIT Sloan School of Management.

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