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Tuesday, August 12, 2008

Oil Prices and Speculators

The mainly Liberal Democrats who are excoriating speculators for the high price of oil are notorious for their diligence in the search for scapegoats rather than solutions.

While it is possible to explain the movement in oil prices, from under $70 per barrel at the end of September 2007 to over $113 today, as the market's belated reaction to the reality of supply and demand, it is hard to see the recent price spike - from $110 in early May to $146 in July and, within a month, back to $113 - as anything other than speculative froth. Supply and demand simply do not change that rapidly in the real world - absent an earth shaking event such as a [new and major] war or natural disaster.

Speculators generally perform a useful function. They provide liquidity to markets - allowing both producers and buyers to take out insurance on prices. That service, however, comes at the cost of speculative excess. The result is that prices consistently overshoot - on both the high and low sides - before settling down to the level dictated by supply and demand.

Although the cost of speculative excess is particularly noticeable, the services provided by speculators are valuable enough that we should be cautious in our attempts to regulate them. Chastising them is certainly useful - thank you Liberal Democrats.

Ill considered - even well considered - regulation, however, is likely to run up against one of the guiding principles of the Universe: The Law of Unintended Consequences.

Caution should be our watchword but the almost irresistible need for politicians to be seen to be doing something is a danger. If we are lucky, the election year urge to leave Washington in order to ensure re-election will keep then from hasty action. If we are not lucky, that same imperative will result in poorly crafted legislation which will only result in further economic dysfunction.

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