A little less than two weeks ago, some big names in the institutional investment game testified in from of Congress about the seemingly meteoric rise in gasoline prices as of late. With the revelation that nearly half of the current price per gallon of gasoline could be due to speculation in the oil futures market, there has been quite a bit of discussion of the relative merits of futures markets in general and what, if any, action our government should take in the possible abatement of the “problem”.

This morning, while making the rounds of the blogs, I stumbled across this piece (by a friend’s husband) that points to another piece appearing in Fortune magazine. The Fortune piece points to the Onion market (the vegetable, not the satirical “news” organization) as a good example of what bad things happen in the absence of a futures market. In short, the author concludes that since onions have no futures market, coupled with the fact that the onion market is highly volatile, leads us to conclude that not only are futures markets good, but that the oil futures market is clearly not to blame for the current price at the pump (to this I ask only this: Where oh where is Mike Shor when you need him?).

While its true that the Onion Example illustrates a situation in which futures trading could quite possibly attenuate the wild fluctuations in open market prices (its also possible, among other things, that tighter control over production could achieve a similar result), it would seem that the logic linking this example to the impact of oil speculation on gas pricing might suffer from the slightest bit of over-reaching.

The key comes in the second half of the third paragraph of the Fortune piece:

But onion prices soared 400% between October 2006 and April 2007, when weather reduced crops, according to the U.S. Department of Agriculture, only to crash 96% by March 2008 on overproduction and then rebound 300% by this past April.

At least to me, this sounds like a clear cut example of market forces in response to supply and demand.

According to the New York Times (6/24):

Pension funds, Wall Street banks and other large investors that have no intention of taking delivery of fuel have increasingly pumped money into contracts for oil and other commodities as a hedge against inflation when the dollar falls.

…

Many Republicans, analysts and regulators, however, say soaring oil prices are a reflection of macroeconomic factors, including the falling dollar, unrest in the Middle East and increased demand from countries like China and India.

Rather than serving as a way to smooth out price volatility over time, the oil futures market is being used as a hedge against downturns in other markets (or, more broadly, the US economy). To whit, “[investors] that have no intention of taking delivery of fuel…” are entering the market. So rather than being the bastion of those entities that have genuine use for the commodity in question as well as the load balancing effects of the proposed futures market, its become the playground for people who were never intended to participate. Add to that the increasing demand from China and India (who have their own stockpiling efforts underway).

Additionally, there’s the testimony of Michael Masters (Masters Capital Management), Fadel Gheit (Oppenheimer & Co), Edward Krapels (Energy Security Analysis), and Roger Diwan (PFC Energy Consultants) before the House Energy and Commerce Committe. All four agreed that nearly half of the current price per gallon is due to speculation (from the MarketWatch column; as of this column, the price of oil was approximately $135/barrel):

“Record oil prices are inflated by speculation and not justified by market fundamentals,” according to Gheit. “Based on supply and demand fundamentals, crude-oil prices should not be above $60 per barrel.”

What’s more, in a USA Today piece, Senator Byron Dorgan (D-ND), author of the End Oil Speculation Act, write about the true intention of his bill. Near the end of the page he writes (emphasis added by me):

I’ve introduced legislation to wring the excess speculation out of the marketplace, and to restore the market’s original purpose of allowing producers and consumers of energy to hedge their risks.

So while it might be tempting to point to the onion market as illustrative, in the end it might not be the best example to give in defense of the futures market; yes, in this case the absence of a futures market can at least be correlated with price volatility (as it is hard to establish strict causality here), it might not go as far as to exonerate the oil futures market in the current gasoline price run-up.