Wired Web Press Net

Oily Speculation - part 1

by Glenn Caleval

Gas could fall to $2 if Congress acts, analysts say - MarketWatch

Many reports are now coming that over 70% of the trading on energy commodity markets is being conducted by “speculators.” In the above cited MarketWatch story Neal Ryan, manager at Ryan Oil & Gas Partners, says

Speculation is the root of capitalism

This kind of speculation however is actually what I call “casino capitalism.”

The most powerful force for producing material well-being in the history of humanity is Capitalism in the form of markets free to balance supply and demand through transparent price discovery and unrestricted competition. An economics professor of mine described it thus

A free market is the only real means of efficiently allocating scarce resources.
Dr. Gordon Church

The reason capitalism has been so successful is that it has come closest to directing, according to their supply, scare resources (land, labour, capital) to their end uses, according to their demand.

For it to operate, a market has to actually be allocating something. Even currency markets are (or should be) trading in the real world money of various countries, demand for which moves with trade and other real world factors.

Speculation like we’ve seen in oil markets is gambling pure and simple. It is not trading in anything other than the mere abstract desire to win big, precisely the same way someone engaged in a round of Texas Hold ‘em wishes to win.

The difference is that the card player can only attempt to manipulate and influence the others at the table who want to win equally badly. There is no large group dependent on what happens in the game, so there are no others affected by the outcome.

With casino capitalism the gotchya is that the bets are not determined by the people playing the game. Rather it is a vast group of “others” wholly unconnected to the game that are manipulated and influenced to increase the size of the bets.

Now, there is a real factor of increasing demand for energy. But the value of that increase is dwarfed by the jumps in the price of oil. The fact is that oil, very much like the fertilizer and chemical industries, has not been a free market for a very long time. What traders like Neal Ryan want is not free markets but markets they are free to manage or run like a casino.

Traders play a critical role in our economies. That role is to match suppliers and buyers to facilitate an exchange. Over time some traders have learned that they do not need to fill this particular role. Instead they have adopted a posture of creating trades for the sake of the trades themselves. The traders earn commissions and buyers and sellers are left to wonder at the vagaries of free markets.

To further hinder the energy market, the oil industry has been almost completely vertically integrated with a small number of players controlling the market from the raw material stage to sale to the final consumer.

Free markets were never understood to operate this way. At their foundation free markets depend on competition. Competition requires many suppliers competing to meet the demands of many consumers.

Where there are few suppliers public policy has always sought to impose disciplines, particularly price disciplines, to compensate for the deviation from the free market. Most commonly known are the variety of utility price review agencies in countries around the world. A public agency would require oligopolistic suppliers in electricity or water, for example, to justify their prices and those prices could not be increased without such approval.

This is not a measure against a free market, but one to compensate for the absence of a free market.

The second solution public policy has brought to bear in the past has been to forcibly break up oligopolies and to legislatively require competition. This has happened in the telecom industry to fantastic results for the world economy, not just for the United States where the move for telecommunications competition first took root.

The concept has not however, been properly applied to the most insidious oligopolistic economic arrangements such as characterize the oil industry. That arrangement is to ensure the ownersof the raw materials companies also own the refining companies which also own the retailers. With such a high degree of vertical integration combined with such a concentration of ownership, the free market barely wheezes, forget about breathing a full life.

Consider this: the principle usually enunciated for allowing rampant gambling in equity markets is based on the need to efficiently allocate capital, which is itself a scarce resource. The quite sound underlying principle suggests that if operating in a free market, then returns to capital will reflect the real world supply and demand for capital by various suppliers and consumers of capital. As more and more investment is needed in a particular business or industry, the need to provide increasing incentives rises. The incentives (i.e. the price of capital) will rise to a point where rational investors will flock to supply the need. As more and more suppliers prove more and more willing to invest, each supplier becomes more willing to accept less reward (profit). This occurs until the amount of capital required is being provided at what is called the “equilibrium price.” This is the price at which just enough supply is being provided at the right price that other investors are not encouraged to jump in (else the price would fall) and at which the buyer feels the need is being met optimally such that the buyer will not bid a lower price (else supply would go down).

All that seemingly complicated stuff is in fact the heart and soul of real capitalism. Let’s test it against the oil industry.

The industry has been making wild profits. Indeed the industry has been making the greatest profits in the history of the world.

If free markets are in play two things should be happening: first, investors should be falling all over themselves to get into the oil business and second, existing players should be making massive investments in creating more supply.

What do we have? Well, it appears that investors are indeed trying to buy oil — at least paper oil. But where is the flush of new entrants to the industry? Where is the market response that brings in transformative players until an equilibrium is found? No one can find it.

In the face of continuous profits, how many new refineries have been built? None.

With competition natural forces require businesses to share gains from productivity and technology with their customers. This is so because if I find a better, more efficient way of doing things, I can lower my price and take significant market share from you. If I refuse to share part of those gains with the customer then when my competitors achieve the same or different gains, they will wreak havoc on my market share.

So where have we seen any differentiation at the retail level that would reflect any sharing of any productivity gains?

Are we to believe that absolutely everyone in the oil industry has exactly the same cost structures, technological prowess, logistics efficiencies, transport costs? All of them? Exactly the same?

Obviously this is not the case. The fact that what the market is provided is a set of identical prices for retail products indicates that there is little to no competition at the retail level. It is in fact likely that the industry itself suffers, because the absence of competition means little pressure to innovate or invent.

It is such a heavily warped market that at the retail level, the owner-operators are expected to make their money selling chocolate bars and soda while saying “Thank you, sir” to the refinery for the privilege of selling its gasoline. So we have a phenomenon where retail gas stores represent an expropriation of labour by the big oil companies. Literally mom and pop teams buy into a franchise and then spend their lives working 18 hour days with little or no compensation from the gasoline. This is not the result a free market would produce.

In part two we’ll look at some solutions.

Glenn Caleval is a consultant and entrepreneur who writes widely. This article is distributed by The Wired Web Press Network. All Rights Reserved. Permission for reuse is granted provided that this attribution paragraph, with the link, is included.

Technorati Tags: oil industry, gas prices, free market, commodity market, monopoly