Speculation, Rumors of War and Intrinsic Value

If you pay attention to the financial news these days, you can’t help but hear about the “nasty” speculators in the oil markets and how many politicians in Washington, DC are blaming them for the high oil prices which are contributing to the declines in the stock markets. Both sides of the political spectrum are shouting, “Something must be done!” While most politicians are doing a lot of political grandstanding these days (it is an election year after all), we should not look to Washington, DC for answers.

First of all, it is important to acknowledge that I am potentially skating on thin ice from a political perspective. With that being said, it is also important to acknowledge that this post (or anything else that I write) is not written from a political perspective. I write from an economic – or even psychological – perspective.

A topic like this could be seen as political; but I am writing this using economic principles as my basis, not political opinion. They are called principles because they are the same today as they were 35 years ago and they will still be the same 35 years from now.

My last post was about oil. In it, I put the blame of the oil prices directly on our own behaviors. While I am a big proponent of the belief that the price of oil is being driven by market forces (that is, not enough supply and too much demand), I do believe that speculators are playing their part. However, this does not mean that speculating is evil.

I heard some one talking today about how the intrinsic (or the “real”) value of oil is actually only $75 per barrel. (The oil market closed today around $136 per barrel.) Oil is worth what someone is willing to sell it for and what someone is willing to buy it for. The oil-producing countries want the price of oil to be as high as they can possibly sell it. The people, or companies, buying oil would take it for free if they could, but will buy it for the smallest amount that the seller will sell it for. Therefore, oil is accurately priced; today, sellers sold it for $136 and buyers bought it for $136. I have yet to figure out how politicians think that they can regulate this.

Why is the cost of eggs 31% higher than it was a year ago? Because chicken farmers are taking advantage of the current situation? Or is it becasue the farmers have to? The cost of inputs is higher today than they were last year. The farmer is going to sell his eggs at the price that at the very least covers his costs to raise, feed, care for, collect the eggs and get said eggs to the market. He is going to sell the eggs for as high a price as he possibly can. As long as consumers are willing to buy the eggs, the farmer is going raise prices to ensure he gets as much as he can.

Why don’t we blame Iran for the high oil prices? Why not Israel? On June 5, the price for a barrel of oil jumped $15 on the news that Israel was practicing for a potential attack on Iran. Why did oil jump in price that day? Because there was a fear that there might be another war in the Middle East. Was it speculation that led to the $15 per barrel jump in price? Absolutely. But if these “speculators” were trying to artificially raise the price for a barrel of oil, it did not work. It was the free market – not market manipulation – that was actually raising these prices. Sellers increased their asking price and buyers increased what they were willing to pay. That’s free market capitalism at work, not market manipulation.

It is impossible to artificially destroy demand. At least not in a capitalist society. There must be a better alternative. If hybrid vehicles, solar or wind energy was actually a better alternative, there would be a greater demand. We are all demanding some change; but are we willing to change our behavior to make the necessary changes? As Jim Malone (Sean Connery’s character in The Untouchables) shouts with his last breath to Eliot Ness “What are you prepared to do?”

Only in a communist society – or a heavily, heavily regulated society – can demand be artificially destroyed. So for those Americans and politicians that are saying that we must, collectively as a society, make other Americans give up combustible engines and our dependence on foreign oil, are never going to make it happen, at least while America is still a capitalist country.

Let me make this clear: speculating is not a sound, long-term investment strategy. However, there is nothing wrong – or harmful to the public – with investors speculating on where the prices of oil, corn, stocks, bonds or frozen orange juice are going to go tomorrow or five years from now. And as long as there are free markets, there will always be speculators.

It is important to have laws, rules and regulations. But to place artificial restrictions on the price of oil because of “speculators” is short-sighted and foolish.

I don’t know if drilling in and around the United States is the answer or not. I do know, however, that as long as we continue to “demand” oil as a society, we are going to have to have it supplied. There are only two things that are going to drive down the price of oil: 1.) a dramatic decrease in the demand for oil or 2.) a dramatic increase in the supply of oil. The best way to do this is the let the markets decide, from an economic standpoint, that is.

Like everything else we have experienced during the last 10 years, we are simply in the midst of a bubble that is about to burst (I don’t know if that is in the next few weeks or next few years, but it will happen – it always does). We experienced a stock market bubble and then burst; a housing market bubble and then burst; and now we are experiencing a commodities bubble (this includes oil, gas, gold, silver, copper, corn, soy beans, etc). We will soon see another bubble burst.

We just don’t know if the bubble will be burst because of a diminishing demand or an increase in supply.

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