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<< Previous   of   Next >>   ADVERTISEMENT   CONTACT THE HERALD Mike Benbow, Business Editor benbow@heraldnet.com   Published: Sunday, June 29, 2008 Futures market in oil needs limits By James McCusker Congress is investigating the role that speculation plays in the run-up of crude oil prices, taking testimony during hearings from regulators as well as market participants. Maybe some good will come of it, but generally Congress is better at dealing with simple issues, where you have victims, accusers and perps, just like on TV. Unfortunately, market speculation is a lot of things, but simple is not one of them. Economic theory tells us that speculation can be very helpful in some markets, especially in agriculture, where it all began. And experience has confirmed this. Speculation is, in a very real sense, a form of time and risk management. Most organized speculation today -- the big money -- deals in what are called futures contracts, which divide up the unknowable future into manageable chunks of time. Since our uncertainty increases as we look further into the future, organized markets of futures contracts allow us to find the level of uncertainty we are comfortable with. The reason that speculation has generally worked so well in agricultural markets is that the costs, risks, uncertainties and demand are up front for all to see. Farming's risks, for example, have been recognized since the dawn of agricultural societies, and they haven't changed all that much since. With access to an organized futures market, a farmer can absorb the level of risk he is comfortable with. Instead of waiting four or five months to see if his costs are covered, he can sell his crop, or a portion of it, at a fixed price even before he plants it. That way he knows that his family won't be dining on his corn crop as the sheriff auctions off his house and land. In essence, and in fact, the farmer sold his crop to a speculator, someone who was willing to gamble on the future. When they are at their best, speculators tend to stabilize markets by redistributing the risk so that each participant takes on the amount he can handle. They also add liquidity to commodity production and consumption. Our exemplar farmer, for instance, has transformed his nonliquid investment of labor and capital into a highly liquid financial instrument he can sell at will. Speculators, of course, are not always at their best -- although that does not necessarily make them villainous. In most cases the participants in harmful speculation look and act pretty much the same as they do in helpful speculation. That is one of the things that make regulation difficult. From the simple beginnings of buying and selling farmers' crops ahead of the harvest, futures markets have come a long way. Today's futures markets have become marvels of math gone wild, with billions of dollars changing hands in transactions so complex neither buyers nor sellers understand them. There is no doubt that our futures markets support a level of high-stakes gambling that Las Vegas might envy. At their center, though, they still provide a way to redistribute risk among producers, investors and consumers -- at least when they are working right. What goes wrong in a futures market is the same thing that can go wrong in every market: The perception of risk disappears. Somehow, in ways we do not fully understand, buyers and sellers, lenders and borrowers all seem to lose the sense of uncertainty that created the market in the first place. The belief that prices will only go up overpowers the normally healthy market psychology and creates first the bubble and then its "Minsky moment" (named for economist Hyman Minsky, who described how a speculative investment bubble is eventually starved for liquidity and bursts). This change in the perception of risk was a factor in our housing bubble and mortgage mess, and it undoubtedly played a role in the run-up of crude oil prices. Will the crude oil market have its Minsky moment and collapse? It could happen, but today's crude oil price levels are more likely to produce adjustments than collapse. Attempts to regulate futures markets have had some modest success, mostly in two areas: excluding the outright crooks, scoundrels and manipulators; and providing cooling-off periods through trading session limits. Would either of these tools provide comfort in the crude oil markets? Probably not. Among other reasons, it simply is not a market controlled or even dominated by the United States. Congress hasn't done any real damage to the futures markets, at least not yet. But it should refocus its efforts away from market regulation and toward limiting participation. Those who represent their own interests should be allowed to speculate to their heart's content. Those who represent stockholders, pension funds or other third parties' money should be forced to behave themselves like responsible adults. James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.

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