Speculators Aren't the Problem, Policy Is

Jeff  Carter
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Posted: Mar 06, 2012 12:01 AM

Here we go again. Some lawmakers want to enact stricter position limits on speculators to try and stem the oil price rise. It’s stupid logic that won’t go away. Bart Chilton advocated for position limits on all commodities and by a 3-2 margin, the CFTC enacted them. Recently, Morningstar analyst Adam Bailin confirmed my supposition that the position limits were bad for markets.

For the untrained in the market place, position limits are hard and fast rules that regulate how many contracts you can buy or sell in commodity marketplaces. The incorrect supposition is that speculators are buying and holding thousands of contracts that drive the price of oil higher. What regulators and lawmakers forget is that it’s a zero sum game. For every buyer, there is a seller. All positions net out and open interest is never an odd number when you include options positions.

When a regulator artificially curbs the amount of trading that can take place, bad things happen. First, there is less liquidity in the marketplace. Commodity marketplaces exist to transfer risk from one party to another. Speculators help to transfer that risk. They are the grease that lubricates the engine. Having transactions occur in a transparent marketplace like an commodity exchange($CME, $ICE, $NYX) is good! Regulators can see who is doing what, positions are margined so there is actual cash behind the activity. If there is a problem, they can spot it almost immediately and in real time since all trades are cleared that day. All accounts get debited and credited each and every day, sometimes in volatile markets twice a day. Speculation is actually a good side effect of a healthy marketplace because of the extra price transparency it provides.

What happens to the market when speculation is checked? The risk of undertaking business still exists and needs to be managed. Risk is ever present. Government regulators may be able to stop trading, but they can’t stop the cycle of risk that happens when companies do business.

Companies make a decision. If it becomes too expensive to hedge their risk, they simply stop doing business. This hurts GDP because if if people stop doing business they aren’t producing. Second, they begin hedging their risk in the over the counter market (OTC). The OTC market is far less transparent and liquid than the exchange markets. They may pay more to hedge. Many of the hedges don’t have adequate cash to support them. The concept of counter party risk is introduced into the transaction, so trades might happen slower-slowing down the entire economy in the process. Prices can be obfuscated, with different markets trading different prices. Worse yet, risk free arbitrage might take place and customers might even get a worse deal. Position limits are very damaging to free markets.

When risk is heightened in a market, prices move higher. Existing position limits are putting money in the pockets of the Middle East oil barons that produce the oil. The way to change that is to end position limits and increase production. Change the supply line in the economic graph.

In this day and age, we ought to be encouraging more transparency rather than pushing it underground. The real culprit to the high oil price caper is anyone that is limiting the exploration for new energy resources, and anyone/anything that is limiting the building of new capacity to turn those raw resources into productive energy. Mostly it comes down to the federal agencies over seeing energy, and the President of the United States that believes algea, wind and solar are competitive alternatives to what we are using today.

As an angel investor, I have looked at several business plans for solar and wind energy. They never work without government subsidies. It didn’t take a real life experiment to prove it, but we had one with Solyndra. Spain and Germany lost billions when they tried to embrace solar power, and hurt their domestic economies in the process. If your legislator is supporting position limits, they are supporting the regression of the American and world economy.