Good and bad speculation

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"Many see speculation as the reason for the recent capricious movement in oil prices," writes Professor Hans-Werner Sinn, president of the Ifo Institute for Economic Research at the University of Munich, in a July paper. But the reality is a little more complicated, he suggests.

Despite the public perception that “the oil price today is purely speculative” and “gamblers at their terminals destabilise the markets and thus the whole world,” speculation is for the most part not a malign force, Sinn argues. 

Speculating over the future price of oil has “no influence on current prices, because the transactions balance out on the spot market,” the professor writes, explaining that banning such speculation would pose problems. Futures speculation is part of hedging transactions, which companies need “to establish longer-term planning security”. 

To influence current market prices, speculators must “withdraw the oil prior to delivering it,” which requires having the capacity to store it, Sinn points out. Speculators can hoard and sell huge stocks of oil, claims the academic, explaining that “large oil companies have extensive storage that they can speculate with, and also the ships on the oceans are gigantic storage tanks”. 

Sinn argues that such speculation is good because it normally “helps to smooth spikes in prices”. When prices are low, those with capacity will buy up oil, causing prices to rise, he explains. When they are high, then “they sell the oil and lower the price”. The greater the profits for such “storage speculators”, “the stronger the stabilisation effect they induce”. 

Chief among these storage speculators is the Organisation for Petroleum Exporting Countries (OPEC), which Sinn describes as having “gigantic” storage capacities. “OPEC should be regarded as an institution like a central bank that stabilises the world economy,” he suggests. 

Although ‘storage speculation’ is mostly benign, he cites “destabilising speculation” which “always involves speculators borrowing cash or the object of speculation,” so that they can “exert a much greater leverage effect on the market”. This is facilitated by “limited liability,” which allows bankrupt speculators to bear only a fraction of the losses they cause. 

This presents a problem for two reasons, Sinn argues: speculators “assume risks that they themselves cannot bear if their speculation goes awry,” while the leverage effect allows “individual speculators [to] wield market power by themselves being able to influence the price level of the market”. 

The professor denounces short selling, a type of speculation which he says leads to “clear examples of market failure”. He blames short selling for the collapse of Lehman Brothers, arguing that the practice is “detrimental for the stability of the economy” and “should be strictly limited if not forbidden”. 

Sinn calls for action to be taken to “force all speculators to shore up their transactions with much more equity capital than has been necessary up to now”, and in doing so ensure that “they can also pay for the possible losses”. 

He concludes by declaring that “casino capitalism” must be “reined in”, but carefully, because “speculators are more useful than many think”. 

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