NCPA - National Center for Policy Analysis


August 24, 2006

Inexperienced institutional investors have been blamed for driving up oil futures prices, and spot prices along with them. But in reality, recent price gyrations show how financial markets and commodity markets interact, says Hal R. Varian, professor of business, economics and information management at the University of California, Berkeley.

Recent editorials have posited that speculation in the oil futures market is driving up spot prices. But as long ago as 1953, Milton Friedman argued that speculation normally helps to stabilize prices rather than destabilize them.

According to Friedman:

  • If speculative trading tends to push prices higher when they are already high and lower when they are already low, then traders must be buying high and selling low, meaning that traders have to lose money on average — which does not seem very likely.
  • In reality, speculative traders try to buy low and sell high, activities that by their nature tend to push prices up when they are too low and down when they are too high.
  • Ultimately, speculators who bought high and sold low would be driven out of business.

The real reason behind the quick price change is a phenomenon known as storage arbitrage, says Varian.  This argument follows that anticipation of rising prices will cause people to store, in order to realize greater gains in the future.  This reduces supply which will also drive up the current price.

However, if speculators start to worry that the price of oil could soon be significantly lower, some of that stored oil would come back on the market, pushing spot prices down, and offering welcome relief to consumers. 

Whatever the result on the price may be, says Varian, it is the product of market forces, not inexperienced speculation.

Source: Hal R. Varian, "The Rapidly Changing Signs at the Gas Station Show Markets at Work," New York Times, August 24, 2006.   

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