Thursday, February 18, 2010

In Praise of Speculation

In Praise of Speculation

Markets work best when there are well informed speculators. There is a current move by various guilty or ignorant parties to demonize speculation in the oil market. So I thought I'd list some of the benefits that we should get from substantive expert speculation.

If the future price of oil at time T will be X, then speculators should ensure that the price of oil now is at least X minus the cost of storing the oil till T minus the interest on that money till T. This brings forward the rise in the price. This is good because:

  • Alternatives become cost effective sooner, encouraging innovation and investment in time. Without that one is trying to bring new technology infrastructure on line without adequate lead time.
  • The higher price reduces consumption, effectively saving the finite resource for the most important uses.
  • The higher price allows investment in more marginal oil sources.

The owner's of the oil are in a privileged position as potential speculators, since they can store oil at minimum cost by not pumping it. So it is nicely ironic that the Saudis have said they'll do exactly that, just as they are leading a push against speculation. In fact speculation is minimal so far, as shown by the lack of any stored reserves.

So let's encourage speculation. We should also demand transparency so that the speculation can be well informed.

On a slightly related note: Peak oil for the world is very different for peak oil for a particular country, since world peak oil affects the price much more. We also observe that when there is a sudden 1% drop in supply then the price has to go up enough to cause sufficient instant demand destruction. However that price rise will be too much, much too much, for a long term drop of 1% in demand. So, for example, at the current price of oil the reduction in economic activity will be too much, so the price of oil will fall back for a while. The reduction in supply is like a land slip under water, and the resulting wave is literally like a tsunami. So with supply falling and incipient demand still increasing and waves of demand destruction rippling, its going to be hard to see the signal for the noise. Lots of transparency and lots of well informed speculation will smooth this stuff out.

[This was a comment on The Oil Drum in mid 2008. It was right about the rise being followed by a fall, then a rise. However that was the end of the oscillation with prices stuck around $80].