Speculation About Equilibrium

I got this "open letter" in my e-mail today, from United Airlines. It would seem that the airlines are calling for regulation of the oil market in an effort to reduce the skyrocketing cost of their fuel. If I've uploaded the picture right, you should be able to click on it and read the whole thing. Of course, you may have got an e-mail very similar to mine. Particularly because I don't think the letter is aimed at a narrow target of a select group of people, I think this letter can stand up to a bit of bullshit detection.

Now, I hadn't ever really considered "oil speculators" as being particularly evil or doing anything particularly harmful to the economy. And no one ever complained about them before. What, exactly, is "oil speculation" and why is it so bad? Why do the airlines want us to think that this practice is responsible for increased fuel costs which lead to rising airfares, less airline service, and repeated calls for government bailouts of these businesses?

"Speculation" is, in essence, buying something now in the hopes that it will increase in value later. You buy something -- a widget, a plot of land -- for $100 today, and hope that in the future, someone else will buy it for $110. Or, more realistically, for $100 plus the transaction costs of buying and selling it, adjusted for inflation at the time you sell it.

It can happen with anything for which there is a market -- oil is of interest today but other kinds of things have been the subject of speculation in the past. Notably, land speculation was responsible for a lot of economic activity, some of which was tumultuous and some of which was quite beneficial, in our nation's history.

Adding to this are things called "futures markets" in which you buy today the right to receive a product tomorrow, which makes speculating in a commodity very easy. You can buy one ton of pork bellies for $1,335.60 at today's commodities market closing prices. That means the market price for pork bellies is $.6678 per pound. You can also buy a future in pork bellies at the same price today -- meaning that you can buy a farmer's promise to give you 2,000 pounds of bacon in one month for $1,335.60 today. In one month, if the price of pork bellies has risen to $.70 per pound, you can sell those pork bellies and make a profit of $64.40. That would be a profit margin of 4.82%, before transaction costs like commissions.

Clearly, speculators are hoping to make more profit than 5% on their transactions. And like anything else in the market, there is a level of art to it, a level of science to it, and a level of luck to it. Some speculators hit it big when they bought oil futures for $60 a barrel and now it's selling for more than $100 a barrel.

What I don't understand is why this is a bad thing. Yes, traders are in business to make a profit. But commodities future speculation typically stabilizes market prices by buying and selling at points when enough profit has been earned that the speculator wants to lock in the money, and by cutting their losses when the price falls too far below the purchase price -- dampening the effects of market fluxuations. The speculator who initially buys a future guarantees that the commodity will continue to be produced, because that money goes to the producer who is looking to reduce his risk, too.

The advocates of oil market regulation will tell you that speculators bid up the price of oil, adding nothing but financial transaction costs, and would have you believe that because they do this, they have inflated the price of oil and are therefore at least partially to blame for the pain you feel at the pump these days -- and the increasing price of air travel, which is what these particular advocates are concerned with. But here's the part of that story they don't want you to remember -- a futures trader cannot successfully sell a commodities future for more than the real market price. The reason for that is that no one will buy what she is selling. "Speculators," then do nothing more than bid up the producer's lower sale price of a commodity to the true market price. Oil is as competitive a market as pork bellies, and you don't hear anyone complaining about the price of bacon being jacked up by a bunch of commodities traders. The reason is not that pork belly futures are less economically sensitive than oil futures. The reason is that the commodities traders in the pork belly market, like the commodities traders in the oil market, must work within the boundaries imposed by market conditions.

So a call for "regulation" of the oil market is not intended to take money out of the pockets of commodities traders, but rather to depress the price of oil below what the market would reach by its own equilibrium. An unregulated market reaches the equilibrium price for the commodity -- the point at which the price curve meets the quantity curve along the supply-demand axis. Regulation can take only one of four forms: artificially restricting supply, artificially restricting demand, artificially increasing price, or artificially depressing the price. (No amount of government regulation will increase supply or inflate demand.) Regulation of oil to make it cheaper for the airlines (and other consumers) therefore means doing something to keep the price low. This can mean restricting demand or supply through rationing. I don't think that's what anyone has in mind.

So by process of elimination, we're talking about price caps. Why does that leave a sour taste in my mouth? Why shouldn't I want something that will make oil cheaper?

The reason is because price caps don't work and are not sustainable in the long run. The market demands value in exchange for value; that is the definition of equilibrium. When a product is sold at an under-equilibrium price, even if that price is still very profitable for the producer, demand pressure is increased for that commodity in the short run, and supply pressure is decreased in the long run.

In the short run, people will find ways to cheat to buy the below-market price oil. Then, soon enough, there will be no more below-market oil to be bought because people will have bought it all and the gas stations will be dry. The extra cost could take many forms -- increased "user fees" for airplane transportation, for instance, or bribes to the gas station attendant to cut in line, or "gas club membership dues," or things like that. But there will be indirect costs that consumers pay that will sneak in to the market in order to buy petroleum products if the market is regulated in the manner considered.

If price caps are sustained for a long period of time, someone in the oil production infrastructure will not be paid what they know perfectly well they could be for their product or their labor. So they will quit working because it's better to not work at all than to work and not get paid. Oil supply will decrease. Demand will not, however, which will further distance the market price of oil from its equilibrium price. Eventually, producers of oil -- the people who pump it out of the ground and the people who refine it into gasoline and other usable products, will find the regulated price to be so distant from what they know they could get that they will also withdraw from the market. This will continue until supply reaches a low enough point that the government relents and raises the artificially capped price to more closely approximate the price that the real demand and real supply curves would indicate.

So what will happen is that the true price of oil will not decrease -- part of the price will become hidden, and the real price will not go down, but in the long run, supply will decrease and there will simply be less oil to be had at any price.

Now, that's not to say that a little regulation will go that far. The scenario I describe is only if there is a fairly aggressively regulated market. But I go as far as I do because I think people are reacting viscerally and not rationally to the rapidly-changing market conditions, and will call for stern levels of regulation. Now, maybe you think that overall, the market needs regulation despite everything I've said. And I'll allow that it's possible for light regulation, theoretically, to have a beneficial effect in keeping the quality or quantity of a product within levels that are beneficial to society at a whole. But I am very skeptical of direct price regulation which is what we're talking about here. I do not see in the CEOs' open letter a call for moderate, careful, and restrained levels of price regulation that closely tracks prevailing global market forces. And that is why we should be very cautious about what the CEOs have suggested to American voters.