The Oil Future

Wednesday, June 18, 2008

ADEMOCRATIC energy bill has died in the Senate -- and it's probably just as well. For the most part, it was election-year symbolism. Several provisions, such as a Justice Department investigation of the Organization of the Petroleum Exporting Countries, a windfall profits tax and an end to certain oil industry tax breaks, might have stuck it to alleged culprits, but they would have had little or no impact on prices at the gas pump.

Congress cannot repeal the law of supply and demand. In real terms, the price of crude oil has topped the postwar record set in 1980. Between these two peaks, oil was cheap -- encouraging Americans to adopt fuel consumption habits that are painful to sustain now. And we were not the only ones gassing up; India, China and other rapidly growing developing nations began consuming more as well. Especially in the past two years, global demand has begun to outstrip supply -- as production stagnated or declined slightly in Mexico, Venezuela, the North Sea and even Saudi Arabia. According to BP, the international oil company, global oil production fell by 126,000 barrels a day in 2007, while consumption grew by a million barrels a day. Notably, all of last year's increase came in countries other than the United States and Europe, where demand actually went down a bit. Prospects are for more of the same, and the commodities markets reflect that.

Still, market fundamentals cannot explain sudden, dramatic recent price movements, such as the $11 a barrel spike on Friday, June 6. In that sense, Democrats in Congress have a point: The froth in the oil market stems at least in part from financial factors -- a.k.a. speculation. According to Michael Masters of Masters Capital Management, hedge funds and other institutional investors boosted their investments in commodities such as food and crude oil from $13 billion at the end of 2003 to $260 billion as of March 2008. The Federal Reserve's recent interest rate cuts have contributed a fresh supply of cheap dollars to this tide. Commodities markets can be wonderfully efficient at helping producers and purchasers of raw materials hedge against supply disruptions. When they function as designed, society benefits. Current events suggest, however, that the exchanges are becoming a repository for "hot money."

Government could do something about this. One provision of the doomed Senate bill would have discouraged speculation by requiring commodities traders to put up more cash. This might help, if applied to institutional investors. The independent Commodity Futures Trading Commission (CFTC) already has the authority to take such a step in a declared "emergency." The CFTC could also rescind its current policy of "no action" on lightly regulated exchanges that are nominally based overseas -- but whose infrastructure is partly located in the United States. The CFTC said yesterday that the London-based ICE Futures Europe has agreed to adopt position limits used in the United States for trading West Texas intermediate crude oil contracts, which are tied to similar contracts on the New York Mercantile Exchange. Foreign officials also will share trading data with U.S. authorities daily rather than weekly. The CFTC has promised a broader interagency study of speculation; that is a reasonable idea given the paucity of hard information on the commodities markets. Unless underlying economic forces can tame excessive speculation, regulators may have to do more.

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