Commodity Online
MUMBAI: Should the speculator be blamed for the oil price hike? Some politicians, commentators and economists say speculators are the drivers who drive up the oil pries? Is it true?

Read below an interesting article by Jeffrey Frankel from Seeking Alpha about the goodness of speculators:

"In the 1955 movie version of East of Eden, the legendary James Dean plays Cal. Like Cain in Genesis, he competes with his brother for the love of his father, a moralizing patriarch. Cal “goes long” in the market for beans, in anticipation of an increase in demand if the United States enters World War I. Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father to make up money lost in another venture. But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and angrily tells him that he will have to “give the money back.”

Cal has been the agent of Adam Smith’s famous invisible hand: By betting on his hunch about the future, he has contributed to upward pressure on the price of beans in the present, thereby increasing the supply so that more is available precisely when needed (by the British Army). The movie even treats us to a scene where Cal watches the beans grow in a farmer’s field, something real-life speculators seldom get to.

Sure, speculators are important in the commodities markets, more so than they used to be. The spot prices of oil and other mineral and agricultural products — especially on a day-to-day basis — are determined in markets where participants typically base their supply and demand in part on their expectations of future increases or decreases in the price. That is speculation. But it need not imply bubbles or destabilizing behavior.

The evidence does not support the claim that speculation has been the source of, or has exacerbated, the price increases. Indeed, expectations of future prices on the part of typical speculators, if anything, lagged behind contemporaneous spot prices in this episode. Speculators have often been “net short” (sellers) on commodities rather than “long” (buyers). In other words they may have delayed or moderated the price increases, rather than initiating or adding to them.

One revealing piece of evidence is that commodities that feature no futures markets have experienced as much volatility as those that have them. Clearly speculators are the conspicuous scapegoat every time commodity prices go high. But, historically, efforts to ban speculative futures markets have failed to reduce volatility.

One can distinguish three kinds of speculation in the face of rising prices. First, there is the “bearer of bad tidings” like Cal in East of Eden. The news that, in the future, increased demand will drive prices up is delivered by the speculator. Not only would it be a miscarriage of justice to shoot the messenger, but the speculator is actually performing a social service, by delivering the right price signal that is needed to get real resources better in line with the future balance between supply and demand. Without him, the subsequent price rise would be even greater, because supply would be less. But it does not appear that speculators played this role in the commodity boom that started earlier this decade: as already mentioned they, if anything, lagged behind the spot price.

Second, when the price is topping out, stabilizing speculators can sell short in anticipation of a future decline to a lower equilibrium price. This type of speculator again adds to the efficiency of the market, and dampens natural volatility, rather than adding to it.

Third, in some cases, when an upward trend has been going on for a few years, speculators sometimes jump on the bandwagon. Market participants begin simply to extrapolate past trends. Self-confirming expectations create a speculative bubble, which carries the price well above its equilibrium. Examples of previous peaks in speculative bubble peaks include the dollar in 1985, the Japanese stock and real estate markets in 1990, the yen in 1995, the NASDAQ in 2000, and the housing market in 2005.

It is the third kind of speculation, the destabilizing kind (also called bandwagon behavior), about which people tend to worry. As noted, there is little evidence that it has played a role in this run-up of commodity prices. Just because the boom originated in fundamentals does not rule out that we could still go into a speculative bubble phase. The aforementioned bubbles each followed on trends that had originated in fundamentals (respectively: rising US real interest rates, 1980-84; easy money and rapid growth in Japan, 1987-89; US recession, 1990-91, and Japanese trade surpluses; the ICT boom in the late 1990s; and easy US monetary policy after 2001).

It is not hard to identify in economic fundamentals the origins of this decade’s boom in commodity markets: easy money in the US; rapid growth worldwide, but especially in China and India; instability among oil producers, especially in the Middle East; misguided ethanol subsidies; drought in Australia, etc. Even so, a bubble could take hold yet."

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