Oil & the Urge to "Do Something"

There is a very interesting story on the front page of today's Wall Street Journal. Under a headline reading "Regulators Step Up Probes of Trading in Oil Markets" the article describes efforts by a newly-invigorated Commodity Futures Trading Commission* (CFTC) to get tough on alleged manipulations in the energy futures market.

While the article provides an interesting look at the latest effort by politicians to "do something" about the rise in oil prices, I think is important to understand that the massive run up in oil and gasoline prices probably has very little to do with chicanery or fraud or manipulation (though bubbles always bring out the worst of these sorts of things.) It is much more likely that the ballooning price of energy is simply a product of the same dynamics that caused the other bubbles in recent memory: big money, small market, and no diversity of opinion. When these factors are in place, you can bet there will be a bubble.

These three factors appear to be in full force in the oil market right now. As I discussed in my last post, the influx of levered financial players into the oil market has resulted in huge increases in demand for oil futures. While oil is hardly a "small" market, it has traditionally been narrow, meaning it was typically dominated by oil industry players with a few intrepid speculators mixed in. In recent years, however, large financial players have moved into the oil patch. Pension funds, hedge funds, and mutual funds have devoted very large portfolios to oil. Even non-specialty funds have moved into oil and other commodities to broaden out their asset allocation. The new financial players in the oil market do not bring a balanced set of opinions about oil. They are in oil only because they believe prices are going higher.

With this being the case, I'm not sure how effective the CFTC's latest actions will be at curbing the spiraling price of oil. In fact, if history is any guide, political efforts to tamper with markets are more likely to cause a host of unintended consequences much worse than the problem they were trying to solve. Remember the Nixon-era price controls?

A better approach is to let the market run its course. In time, the high price of oil will do three things: 1) it will make alternative energy sources look that much more attractive; 2) it will draw more oil supply onto the market; 3) it will encourage the development of new technologies that help us better use our existing resources.

As these three effects begin to take root and the price of oil stops going up, financial investors will likely decide it is time to move on. After all, oil produces no dividend and earns no interest. The only return a financial investor can expect comes from rising prices. Financial investors can be very fickle and impatient. They are driven by expectations about the future and when expectations for excess returns from oil evaporate, so will their demand for oil.

*The CFTC is the government regulatory watch dog commissioned with the the task of making sure that futures markets function properly and are free from fraud and manipulation.