Up popped deregulation. (Speculators - part 3)

In yesterday's post, we saw that "supply and demand" could not account for the spike in oil prices, and we learned about the basic operation of the commodities markets and the function of "speculators" in those markets.


The commodities markets functioned nicely for 50+ years after the creation of the Commodity Futures Trading Commission in the 1930's. Speculators were limited by regulation to a small fraction of the market. 


According to Mat Taibbi, in his July 9, 2009 article in Rolling Stone titled "The Great American Bubble Machine": "In 1936, however, Congress recognized that there should never be more speculators in the market than real producers and consumers. If that happened, prices would be affected by something other than supply and demand, and price manipulations would ensue." 


By 1990, most of the allowed speculator seats had been purchased by large banks such as Goldman-Sachs. In 1991, a Goldman-owned speculator (J. Aron) wrote to the CFTC and asked for an exemption to the speculation rules. The CFTC granted this request to be treated as a producer/consumer rather than a speculator, escaping the limits placed on speculators.


A subsidiary of a large and powerful bank received a favorable ruling from a government agency. How on Earth did this ever happen? Who would have expected such a thing?


In short order, the CFTC granted the same exemption to 14 other speculators, and we were off to the races. According to the McClatchy article referenced yesterday: "Prior to the 1990s, speculators made up about 30 percent of the futures market. In the latest reporting period, the ratio on May 3 stood at 68 percent speculators to 32 percent users of oil. Meanwhile, the volume of total reported trades has grown five-fold since 1995, underscoring the impact of speculation on futures markets."


Taibbi says: "So what caused the huge spike in oil prices? Take a wild guess.... the root cause had almost everything to do with the behavior of a few powerful actors determined to turn the once-solid market into a speculative casino. Goldman did it by persuading pension funds and other large institutional investors to invest in oil futures — agreeing to buy oil at a certain price on a fixed date. The push transformed oil from a physical commodity, rigidly subject to supply and demand, into something to bet on, like a stock. Between 2003 and 2008, the amount of speculative money in commodities grew from $13 billion to $317 billion, an increase of 2,300 percent. By 2008, a barrel of oil was traded 27 times, on average, before it was actually delivered and consumed.... By the middle of [the summer of 2008], despite rising supply and a drop in demand, we were paying $4 a gallon every time we pulled up to the pump."


Tomorrow: Turn off the bubble machine!