Beating the Oil Barons

Over the past eighteen months, oil prices have more than doubled, inflicting huge costs on the global economy. Strong global demand, owing to emerging economies like China, has undoubtedly fueled some of the price increase. But the scale of the price spike exceeds normal demand and supply factors, pointing to the role of speculation – and underscoring the need for policy action to clean up the oil market.

Reflecting their faith in markets, most economists dismiss the idea that speculation is responsible for the price rise. If speculation were really the cause, they argue, there should be an increase in oil inventories, because higher prices would reduce consumption, forcing speculators to accumulate oil. The fact that inventories have not risen supposedly exonerates oil speculators.

But the picture is far more complicated, because oil demand is extremely price insensitive. In the short run, it is technically difficult to adjust consumption. For instance, the fuel efficiency of every automobile and truck is fixed, and most travel is non-discretionary. Though higher airline ticket prices may reduce purchases, airlines reduce oil consumption only when they cancel flights.

This illustrates a fundamental point: in the short run, reduced economic activity is the principle way of lowering oil demand. Thus, absent a recession, demand has remained largely unchanged over the past year.

Moreover, it is relatively easy to postpone lowering oil consumption. Consumers can reduce spending on other discretionary items and use the savings to pay higher gasoline prices. Credit can also temporarily fill consumer budget gaps. Although the housing boom in the United States – which helped in this regard – ended in 2006, consumer debt continues to grow, and America’s Federal Reserve has been doing everything it can to encourage this. Consequently, for the time being the US economy has been able to pay the oil tax imposed by speculators.

Unfortunately, proving that speculation is responsible for rising prices is difficult, because speculation tends to occur during booms, so that price increases easily masquerade as a reflection of economic fundamentals. But, contrary to economists’ claims, oil inventories do reveal a footprint of speculation. Inventories are actually at historically normal levels and 10% higher than five years ago. Furthermore, with oil prices up so much, inventories should have fallen, owing to strong incentives to reduce holdings. Meanwhile, The Wall Street Journal has reported that financial firms are increasingly involved in leasing oil storage capacity.

The root problem is that financial markets can now mobilize tens of billions of dollars for speculative purposes. This has enabled traders collectively to hit upon a strategy of buying oil and quickly re-selling it when end users accommodate higher prices – a situation that has been aggravated by the Bush administration, which has persistently added oil supplies to the US strategic reserve, further inflating demand and providing additional storage capacity.

Absent a change in trader beliefs, the current oil price spike will be broken only by a recession that exhausts consumers’ capacity to buffer higher prices, or when the slow process of substitution away from oil kicks in. Thus, economic fundamentals will eventually trump speculation, but in the meantime society will have paid a high price.

Whereas oil speculators have gained, both the US and global economies have suffered and been pushed closer to recession. In the case of the US, heavy dependence on imported oil has worsened the trade deficit and further weakened the dollar.

This sobering picture calls for new licensing regulations limiting oil-market participation, limits on permissible trading positions, and high margin requirements where feasible. Sadly, given the conventional economic wisdom, implementing such measures will be an uphill struggle.

But some unilateral populist action is possible. A major form of gasoline storage is the tanks in cars. If people would stop filling up and instead make do with half a tank, they would immediately lower gasoline demand. Given lack of storage capacity, this could quickly lower prices and burn speculators.

By Thomas I. Palley, Copyright Project Syndicate

10 Responses to “Beating the Oil Barons”

  1. Paul Cox Says:

    As an economists I thought you would have heard what the price of oil is telling the market. This is not due to speculation. I wonder what people will say when the price hits $650.00, my calculated price of a barrel of Starbucks.

    The price may be high in comparison to the past, however, it is the volume of consumption that needs to be addressed.

    I think that we can all clearly see the energy related problems of today. What are we going to do about it. The only plan of action that I see is what I have been writing about on my blog. (

    Professor Ludwig von Mises suggested that the industrial revolution was the solution to over population and hunger. The Information Technology revolution now has a purpose to step in and solve the energy and related problems of today.

  2. Jakub Segen Says:

    If the number of people involved in such action is enough
    to affect the price, a much bigger effect will be if
    they request their representatives to restrict speculation.

  3. J. Pierre Loebel, MD Says:

    The half a tank idea sounds intriguing. But wouldn’t there simply be a doubling (or whatever) of fill-up frequency?

    How can we speculate on the speculators?

  4. John Colm Says:

    I don’t think driving half full (empty?) will do the trick…but cutting your miles driven by half would. Can a meaningful number of Americans find a way to do that?

  5. Interfluidity Says:

    The convenience yield…

    If a commodity is in “backwardization”, that is, if futures prices are lower than current prices, does that imply that futures markets are discouraging storage (encouraging disgorgement)? Paul Krugman makes the case, …

  6. peatey Says:

    I appreciate this blog. Thank you. That said,

    But some unilateral populist action is possible. A major form of gasoline storage is the tanks in cars. If people would stop filling up and instead make do with half a tank, they would immediately lower gasoline demand. Given lack of storage capacity, this could quickly lower prices and burn speculators.

    You mean if people would stop speculating (with their gas tanks) then we wouldn’t have speculation anymore? Kind of assuming the conclusion, is it not?

  7. Ron Patterson Says:

    Ironic, if the half tank of gasoline scheme worked, lower prices by lowering demand, it would prove it was all about supply and demand, not speculation.

  8. Juan Says:

    A backwardated forward curve inhibits the storage trade which was not insignificantly profitable during the relatively long period during which the market was in contango.
    This was brought up in a 6 October, 2007, WSJ article by Ann Davis. See:

  9. Eleanor Says:

    Filling the tank half just means more trips to the gas station. Missed that Mr. Palley?

  10. Kevin Says:

    For people who want to see a good explanation of the basic economics of speculation, there is an excellent slide presentation by the International Energy Agency. It is sad that they had to begin by reminding even sophisticated audiences about elementary economics. However, the first few slide do it very well.