Managing Future Price Bubbles in Crude Oil Markets

Munir Quddus
July 9, 2009

Federal regulators, including the Commodities Futures Trading Commission (CFTC), are considering new restrictions on “excessive speculation” in markets for oil, natural gas and other energy products. Similar regulations already exist in markets for agricultural products such as wheat, corn and soybeans to preclude manipulation by large players.

These efforts has gotten some folks roiled up.  Critics have claimed that any attempt to regulate speculative trading would be anti-free market.  Others have noted that speculation is an essential force that moves markets towards equilibrium.  Therefore, any attempt to reduce speculation will retard market innovations and 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 traders and speculators markets cannot function efficiently, too excessive speculation can be fatal to market stability and efficiency.  The recent painful collapse of the housing bubble which led to the global financial meltdown should at the minimum serve as a stark reminder of the dangers inherent in markets that sometimes spin out of control. Markets do not always move towards an equilibrium.

Last year, the price of crude oil soared to an all time high of $147 per barrel, more than a 200% increase in less than a year.  The sustained rise in crude price was unexpected but convincing.  Numerous industry experts and economists concluded that price spike was indicative of fundamental changes in market demand and supply, and not caused primarily by self-fulfilling expectations of higher prices otherwise called a bubble. 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 is a crucial ingredient 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 escalating price of rice and other essentials.

Fortunately, most experts were wrong.  The spectacular increase in crude oil price was in fact caused by excessive speculation, or a 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, in a classic manner 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 reaching the true equilibrium.

Those who oppose the proposed CFTC legislation 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 state that since speculation is a market force, it must be allowed unimpeded.  Third, the argument is made that speculation is harmless.  Fourth, an argument is heard that regulation impedes markets and is anti-capitalistic, and harmful. One hears that yes, market gyrations can be painful, but attempts to control the fluctuations can be even more harmful.

None of these arguments stand up to close scrutiny.  The case for judicious regulations can be made relatively easily. 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 done in other countries and in US agricultural markets. Second, economists who have studied speculative price bubbles realize that at some point retail investors who are generally unsophisticated wade in creating greater instability. Third, even though normally speculative forces, through arbitrage, lead to improved market efficiency, these markets can spin out of control if excessive speculative funds come in.  According to 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.

Free markets were never meant to be free of all rules.  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 fall of the 2007-2008 crude oil bubble.  This would have been justified on national security grounds, and would have been good for consumers and investors in America and globally.  A bubble creates and feeds on artificial scarcity – by giving appropriate signals can influence expectations and puncture a growing bubble. As a result of cutting edge research, policymakers now have a number of additional tools in their arsenal to identify and stamp out 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.

By moving to curb excessive speculation, while preserving the ability of traders to conduct the normal transactions for risk sharing, CFTC and other Federal regulators are moving in the right direction.  Excessive speculation leading up to a price bubble can be absolutely toxic to the long term safety and health of markets.  To prevent the next bubble, it is crucial that regulators and politicians learn the right lessons from recent business history such as the bubble, and the more recent housing and financial markets (derivative) bubbles.  Clearly, these regulations must be placed in a coordinated fashion to close potential loopholes.


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