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Speculation NOT the primary cause of the decade-long oil price increase

April 24, 2012

Despite the claims of various politicians, speculation and the financialization of the oil markets are likely not the greatest causes of the steep rise in oil prices since 2003.  In a recent op ed, former Congressman Joseph Kennedy III made the claim that up to 40% of the price of oil is the cause of speculation in the commodity markets by oil traders.  Kennedy’s argument is little more than a base appeal to populist resentment and is neither well reasoned nor well researched.  Indeed, Kennedy points to a working paper from the St. Louis Federal Reserve to buttress his argument.  However, the paper by Luciana Juvenal and Ivan Petrella (link will open a pdf file) actually arrives at the opposite conclusion:

On balance, the evidence does not support the claim that a sudden explosion in commodity trading tectonically shifted historical precedent: Global demand remained the primary driver of oil prices from 2000 to 2009. That said, one cannot completely dismiss a role for speculation in the run-up of oil prices of the past decade. Speculative demand can and did exacerbate the boom-bust cycle in commodity prices. Ultimately, however, fundamentals continue to account for the long-run trend in oil prices.

Indeed, the data analysis in this paper concludes that no more than 15% of the overall price rise since 2003 can be attributed to speculation.   Fifteen percent, if correct, is a significant contributor, but other researchers cast doubt on that figure.

More recently, Bassam Fattouh and Lavan Mahadeva of Oxford’s Institute for Energy Studies and Lutz Kilian at the University of Michigan’s Center for Economic and Policy Research examined the same topic.  In a review of recent research on speculation and financialization in the oil markets, Fattouh, Kilian and Mahadeva found that

the existing evidence is not supportive of an important role of speculation in driving the spot price of oil after 2003.  Instead, there is strong evidence that the co-movement between spot and futures prices reflects common economic fundamentals rather than the financialization of oil futures markets.

Now, a 15% price cut would be a significant savings for most drivers, to be sure, but attempting to ban oil market speculation would simply move the practice off shore.  There are bigger and better ways to attack the price of oil – primarily by attacking the cartelization of supply by leveraging other liquid fuel substitutes, as we have noted many times in the past.

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