President Obama Doesn’t Understand Oil Markets

Money Morning Article of the Week

by Keith Fitz-Gerald, Chief Investment Strategist, Money Morning

If you think gasoline prices are volatile now, stay tuned. President Obama’s plan to clamp down on oil speculators is going to make things worse.

I’m sure you’ve seen the news by now. The president wants to clamp down on so-called “oil price manipulation” and has proposed a $52 billion plan to increase federal supervision of oil markets.

What the president doesn’t understand is that the oil markets already have this function built in. Speaking from the Rose Garden last Tuesday, President Obama noted specifically that we can’t afford to have “speculators artificially manipulating markets buy buying up oil, creating the perception of a shortage and driving prices higher – only to flip the oil for a quick profit.” Evidently, the president hasn’t passed Econ 101. If he had he would know that prices on everything from eggs to houses are by their very definition self regulating.

Speculation, as opposed to manipulation, is a vital part of the markets – they are not the same thing despite the fact that the president is interchanging the terms. If prices are too high, people stop buying. If prices are too low, they stop selling. By authorizing $52 billion in oversight, he’s chasing a ghost that he’ll never catch.

The Real Problem with Oil Prices

The real problem is that the United States consumes 20% of the world’s crude but only produces 2%. It comes a time when oil demand is expected to rise more than 25% (to 105 million barrels a day) by 2015, according to a new report titled Oil and Gas: A Global Outlook by Global Industry Analysts, Inc. If you want the biggest piece of the pie from the deli, you have to pay a premium.

There is no hocus pocus and there’s no additional oversight necessary. Rather, we need to enforce the laws we already have on the books. Sure the $10 million fines he’s jawboning about (up from $1 million) sound great but they’re really a non-starter. In fact, given that Exxon Mobil Corporation (NYSE: XOM) alone generated an average of $1.33 billion a day in 2011, they’re little more than an acceptable cost of doing business. Nice try.

Take gasoline, for example. Prices have jumped 78.2% since the p resident took office and that doesn’t sit well with the party faithful who are convinced that evil oil price speculators are responsible. They are distraught that traders put hundreds of billions of dollars into energy every month because that may cause prices to rise.

This is not complicated. Any time there are more buyers than sellers, prices go up. Any time there is more demand than supply, prices go up.

Contrast what’s going on in the oil markets with what’s happening in natural gas. Prices for natural gas are at ten- year lows. Demand has risen but supply has risen faster. There are more suppliers than buyers. So natural gas prices drop. Natural gas, by the way, is traded by many of the same traders who trade oil.

Oil Price Manipulation, Gas Prices and the Free Market

Gasoline prices at the pump have never been proven to be a direct consequence of oil price manipulation. But it’s widely conjectured. Believe me, I hate paying more just as much as the next person, but get over it.

Geopolitical tensions, supply constrictions, war, tyrants with spigots and other buyers are the real factors at work and they always have been. When risks go up, so do prices – that’s the way free markets work.

Apple didn’t produce nearly 115 million iPhones and iPads in 2011 for kicks. They did it because there’s huge demand for their products and they can make big bucks.

Things are just more critical now because we’ve failed to develop a comprehensive energy policy over the past 50 years at a time when global demand is increasing rapidly in absolute terms. The president wants votes in an election year; this is pure political pandering. For example, China’s per capital oil consumption has increased by 350% since the early 1980s. The International Energy Agency estimates that China alone will account for 42% of global oil demand by 2015.

And they’re one of the slow growers with consumption rising a mere 100% in the last ten years. Other countries like Malaysia have seen per capita usage quadruple since the 1960s. Brazil and Thailand have seen oil demand double to 5.7 barrels/year and 4.8 barrels/year per capita.

And don’t forget the weak dollar. Because oil is generally priced in dollars, Bernanke’s weak zero interest rate policies are helping drive prices higher. Producers have to compensate with higher prices to make up the reduction in margin being forced upon them by greenbacks that have diminished purchasing power. Speaking of which, the Beltway Boys, in their infinite wisdom have got it in their heads that margined trading – meaning you can borrow money to control more of the underlying asset – gives too much power to financial investors aka the speculators.

What they don’t realize is that:

•Even if you tighten up margin requirements, traders will shift to derivatives like options, swaps and other so-called exotics.

•Higher margin requirements lead to less liquidity which, in turn, actually exacerbates the speculative volatility they’re trying to control.

Think about it. Futures markets like those which drive oil and gas prices are a function of two groups of market participants – hedgers and speculators. Those, incidentally are the CFTC’s terms so don’t confuse them with the politically charged versions the p resident is using.

Hedgers are farmers, importers, exporters and manufacturers who depend on consistent pricing to make, sell or otherwise produce something using oil. They participate in the markets in order to keep prices stable to protect against pricing risk. But they can only buy or sell so much. They are actually interested in delivery of the oil or gas they need. For example, McDonald’s wants to hedge against rising potato costs that could affect the profitability of its world famous f rench fries. The farmer who sells them potatoes normally wants to hedge against falling potato prices so as to maximize crop prices and his profit margin.

The position is much the same for Starbucks and coffee just as it used to be for dentists and the silver they used for fillings, for example.

Speculators , on the other hand, are those who profit from the price changes against which hedgers are trying to protect themselves. They are not interested in taking delivery. Speculators serve a very important function in that they bridge the gap between higher and lower prices often buying and selling when hedgers can’t or won’t. If speculators are taken out of the picture, prices become less liquid and more jumpy.

Instead of moving smoothly from $100 to $120 a barrel, for instance, oil prices might simply gap higher because hedgers will be forced to trade directly with each other or through intermediaries who have effectively got their financial hands tied. This would back all the way through the gasoline refinery process to the pump. And investors who are dumfounded by the price increases we’ve seen so far, may be absolutely gob fobbed when things jump $1 or more at a time. Then there really would be a link. Shutting down speculators would be like banning ice cream delivery trucks in July.

The President is Chasing a Ghost He Can’t Catch

To think that oil companies will not shift to other pricing mechanisms is naïve. If U.S. markets are restricted, traders will simply shift to London or Shanghai and conduct business as usual using new contracts structured specifically to avoid additional U.S. regulation. They will also create trading entities that act as a proxy for the “speculators” the White House has targeted in this latest gambit. This is exactly what many did with credit default s waps after the United States clamped down on them.

Why do you think funds shunted to London are at the heart of the MF Global fiasco or Goldman’s most aggressive traders are located there? Because money goes where it’s treated best. There are more accommodative regulations in the land of crumpets.

We don’t need more regulation. We need to enforce what we have. This is another misguided political con job drawn from the well of bad ideas. The p resident says he wants cheap gas, yet he kills the Keystone Pipeline, stymies drilling and allows the Fed to engineer a bailout of that put trillions into the system over the past four years – every dollar of which makes gas more expensive. He says he wants to rein in speculators while not drawing a line between what constitutes legitimate speculation (as a function of free markets) and already illegal manipulation. If anything, the f ederal government is the biggest manipulator in the history of manipulators.

Quantitative easing has done more damage to gas prices and the wallets of millions of consumers than a few speculators ever could. Frankly, it’s a miracle prices aren’t $10 a gallon at the pump by now.

I say let the markets work. Prosecute the true oil price manipulators but otherwise quit meddling. Piling on more regulation will only detract from economic activity, not create it.

Oh…and by the way, investors need to stay long energy especially in growing economies using more fuel. Higher oil prices mean higher oil profits and there is a link between rising fuel consumption and GDP growth.

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