The price is wrong

May 12, 2011

Never mind what the textbooks say, the price of anything is whatever you can buy or sell it for on the open market, and crude oil is no exception. But problems arise when the market is rigged, and right now the commodity markets are well and truly rigged. How? Well, for example, supposing as a refiner I want to purchase a million tons of crude oil. I go not to the producer but to the commodity market, where they will be happy to deliver me a million tons at a specified location on an agreed future date at a price based on the latest trade.

Jack O’Brien

Jack O’Brien

But the commodity market is far more than just a place to buy and sell stuff; it permits speculators to buy and sell futures with the intention of profiting from a rise in price, without having to take physical delivery of the product. Say I pay $100 a barrel, then sell a few minutes later to an accomplice who is offering $101, who in turn sells to another agent in a wide network of seemingly unrelated agents who is offering $102, thus driving up the price virtually without limit, completely independent of the available supply.

Needless to say, there is a solid phalanx of regulations specifically designed to prevent this sort of irresponsible behavior, but what a regulator can do, a better legal mind can circumvent, and some of the finest minds in the country are employed in the commodity markets. The last time this happened was in 2008, when the crude oil price rose from $50 a barrel to $147 over 14 months while a chorus of self-appointed experts assured us that the reason was increased demand by China and India. Then, a former trader testified before Congress as to what was really happening, and the price of crude promptly collapsed by year-end to $30 as terrified speculators cashed out. The resulting decline, of course, made nonsense of the experts’ testimony, and the fact that other commodities in heavy oversupply, such as cotton, showed a similar rise and fall confirmed the falsity of their story. At any rate, it was generally concluded that the regulators were asleep at the wheel, and appropriate steps were taken to prevent repetition.

But the speculators had to recover their losses, so the price of crude rose steadily from $30 in December 2008 to the current $114 a barrel, with no end in sight, so evidently the regulators are still asleep and the experts are yet again shamelessly singing their siren song.

I have a simple solution, albeit expensive and probably manageable only by the Fed. If Ben Bernanke will take a tranche of a mere $500 million from the QE2 fund, where it isn’t doing much good, and use it to short the crude oil market, the resulting downturn will once again terrify the speculators and the price will fall to around $50, where the ratio of supply to demand once again makes sense.

You might also like to take a look at the silver market, which is now being similarly rigged.

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