On May 24 the Commodity Futures Trading Commission (CFTC) filed lawsuits against oil traders, alleging that they manipulated the oil markets in early 2008 while harming consumers and personally pocketing $50 million. The case is unusual because the CFTC usually goes for the easier route of charging attempted manipulation of markets; actual manipulation has only been successfully proven on one previous occasion.
I am an economist, not a legal expert. In the present article I won’t comment on whether the individual traders “manipulated” markets in violation of the Commodity Exchange Act. Rather, I will argue that penalizing “manipulation” of markets is actually economically counterproductive. Furthermore, even if these allegations are true, these particular traders had little to do with the huge run-up in oil and gasoline prices in the first half of 2008. As the government’s case itself alleges, the defendants pushed oil prices up and then back down a few weeks later.
As reported by the New York Times:
The suit says that in early 2008 [the defendants] tried to hoard nearly two-thirds of the available supply of a crucial American market for crude oil, then abruptly dumped it and improperly pocketed $50 million.
In the case filed Tuesday, the defendants — James T. Dyer of Australia, Nicholas J. Wildgoose of Rancho Santa Fe, Calif., and three related companies, Parnon Energy of California, Arcadia Petroleum of Britain and Arcadia Energy, a Swiss company — have told regulators they deny they manipulated the market.
The commodities agency says the case involves a complex scheme that relied on the close relationship between physical oil prices and the prices of financial futures, which move in parallel.
In a matter of a few weeks in January 2008, the defendants built up large positions in the oil futures market on exchanges in New York and London, according to the suit….At the same time, they bought millions of barrels of physical crude oil at Cushing, Okla., one of the main delivery sites for West Texas Intermediate, the benchmark for American oil, the suit says. They bought the oil even though they had no commercial need for it, giving the market the impression of a shortage, the complaint says.
At one point they had such a dominant position that they owned about 4.6 million barrels of crude oil, estimating that this represented two-thirds of the seven million barrels of excess oil then available at Cushing, according to lawsuits.
The traders in mid-January cashed out their futures position, and then a few days later began to bet on a decline in oil futures, with Mr. Wildgoose remarking in an e-mail about the “inevitable puking” of their position on an unsuspecting market, the federal lawsuit says.
In one day, Jan. 25, they then dumped most of their holdings of West Texas Intermediate oil, and profited by the drop in futures.
The traders repeated the buying and selling in March 2008, and were preparing to do it again in April but stopped when investigators contacted them for information,the suit says.
What Goes Up, Must Come Down
The most obvious problem with blaming these particular traders for any large moves in the oil market is that they held their position for less than a month. Even if the allegations are perfectly accurate, then the traders began accumulating the physical crude for a few weeks in January, reversed their position in the futures markets (to position themselves to profit from a fall in price), and then dumped most of their physical holdings on January 25. They apparently repeated the process in March, and shied away from trying again in April because of heat from investigators.
The crucial point about the alleged scheme is that it was self-reversing. The strategy worked by (a) buying futures contracts at low prices, (b) hoarding physical oil in order to drive up the futures price, (c) cashing out the futures contracts and even taking a net negative position, and finally (d) driving the futures price back down by dumping the physical oil. In other words, the traders allegedly made money both driving oil prices up and then back down. Since they had more insight into the large swings in inventory to which other traders would react, these particular traders were allegedly able to make money both ways.
Therefore, even if these traders behaved just as the government claims, their actions can’t possibly explain the jump in crude prices from about $92 per barrel in December 2007 to a whopping $134 per barrel (average monthly price) in June 2008. Hoarding and then dumping physical oil—in bursts of a few weeks—at worst can make oil prices more volatile; it can’t drive them systematically higher for months at a time.
If anything, these lawsuits demonstrate just how difficult it would be for speculators to drive up oil prices significantly above the level justified by the “fundamentals,” especially if they wanted to make it a “sure thing.” Even though they apparently gained control of two-thirds of the excess Cushing inventory, these traders only made $50 million from the scheme. That’s a lot more money than I made in 2008, to be sure, but it can hardly explain giant movements in the world price of oil.
Speculators Perform a Useful Function in Markets
As I have explained in previous posts, speculators perform a useful function in markets. To the extent that they correctly anticipate future price movements, they actually dampen the volatility in the spot price. This is obvious: Speculators earn profits when they buy low and sell high (or short-sell high and cover low). So if a commodity such as oil will have a price rise in the near future, speculators start pushing up the price now in anticipation. Conversely, if a commodity is current overvalued (in the sense that it will drop in the near future), then successful speculators start the process right away by selling.
The twist in the current story is that (allegedly) the traders were dabbling in both the physical and futures markets. So it’s true, their “speculative” trades smoothed out prices. However, one could argue that their buying and selling in physical crude actually introduced far more volatility in the spot price than their futures trading softened.
This may seem a pedantic point, but it’s important for people to understand the role of futures markets. To say it in other words: It was not their “speculating” on futures prices that actually caused the volatility in oil prices, but rather their accumulation and then dumping of the physical crude. (Of course, the reason they allegedly acted this way in the physical market, was because it allowed them to earn speculative profits in the futures market.)
Now for the tough question: Was there something illegitimate economically about hoarding and then dumping physical crude inventories? According to the various press accounts, I have not seen any allegations of actual fraud on the part of the traders. For example, they didn’t buy the oil, blow up one of their warehouses, and then falsely tell the police, “We lost all of our oil in the blaze.”
No, it appears (on the basis of the press accounts) that they simply purchased large holdings of physical crude, and others in the market assumed that the oil was being used for refining or other purposes. It was thus a surprise when the oil was dumped back into the market at the end of January, a few weeks later.
To repeat, to the extent that this “trick” really worked, it didn’t change the long-term price of oil (or gasoline). The $50 million profit reaped by these traders would have come largely at the expense of other oil traders (not average consumers) who were caught with their pants down both on the way up and on the way down in the futures market.
Going forward, savvy competitors presumably would have tried to avoid such a trick in the future. If they saw an apparent tightness in the Cushing physical market, they would think twice before pushing up the futures price, since it might come crashing down a few weeks later. People can’t simply make $50 million automatically, month after month, in the commodities and futures markets, the way the critics seem to think. Other speculators would adapt and quickly stamp out such opportunities.
The problem with giving government regulators the task of stamping out such “anti- social” trading is that they will mute the ability of the market to respond to genuine threats of crude shortages. Because of the lawsuits, oil traders will be less willing to acquire physical inventories even if they believe the fundamentals justify a rising price over time. Such traders would be afraid that the government would accuse them of causing the movement in prices, even if they were genuinely just trying to anticipate it.
So long as they don’t use violence or fraud, people in a market economy generally make profits by serving others. This is easy to see in the cases of successful entrepreneurs like Bill Gates or Oprah Winfrey. It’s not as easy to understand when it comes to successful traders in the futures market, but the presumption is still present. Whether or not the defendants in the recent CFTC case actually broke the law, the charges against them will weaken the market’s ability to adapt to future supply and demand conditions in the oil industry. Finally, people should always keep in mind that speculators drive prices down in response to good news. When President George W. Bush announced the end of the Executive Branch moratorium on offshore drilling, oil futures prices fell $9 during the speech.