Thanks very much. It's good to see you all.
I'm going to address the question of whether the price of oil is justified by underlying economic fundamentals. So do garden-variety demand and supply factors explain the high price of oil, or is something else going on that is distorting these fundamentals? Are there perhaps speculative pressures that are buffeting the price of oil away from fundamentals?
There are many angles one could take on this issue. I can't speak to all of them; my expertise doesn't extend to all of them. I am going to look at the role of financial deregulation in promoting speculation.
Recently there have been a lot of funds out there, including money that has fled other problems in the financial markets in the wake of the sub-prime meltdown. The money is coming from institutional investors, sovereign wealth funds, pension funds, and index funds. I sense that Michael Masters might address some of this. My angle on this is going to be the following question: if this money enters commodity markets, thanks in part to regulatory changes, do these institutional investors that enter commodity markets exacerbate speculative pressures?
Historically, speculation in commodity markets has been a big worry to regulators in commodity markets. In the United States, for example, in the wake of the Great Depression there was concern that price manipulation in commodity markets had run up the prices at one point and then contributed to this disastrous stagnation and downfall in commodity prices later. To prevent that kind of abuse from occurring in the future, laws were put in place in 1936, and subsequent regulations attempted to prohibit or at least deter speculation in commodity markets.
Typically, these kinds of regulations were intended to put speed bumps in place that basically limited the influence of speculation. Examples of these speed bumps included position limits--a limitation on the size of any one investor's holdings in an individual commodity, and limits on positions for market participants that were in the market for non-commercial purposes, entities that were not buying or selling commodities for underlying economic purposes. These sorts of regulations don't eliminate speculation. In fact, nobody thinks it's really possible to completely eliminate speculation, nor is it desirable. But speed bumps of this sort make it more difficult for speculators to overwhelm commodity markets.
Fast forward to the 1990s. As financial deregulation gathered momentum, many of those speed bumps were relaxed. One of the deregulatory milestones was the Commodity Futures Modernization Act of 2000 in the United States. It put oil in a so-called exempt category outside the regulatory regulations normally imposed by the Commodity Futures Trading Commission, the body set up to basically put these speed bumps in place in the first place. Thanks to this deregulation, two types of energy derivative markets were thereby exempt. One involved transactions between two counterparties that weren't executed within a trading facility, and the other involved trades done electronically.
The idea that you could set up an electronic trading facility that could function without those speed bumps became known as the Enron loophole, so called because presumably Enron lobbied to have it put in place to facilitate its Enron online electronic energy market. The Enron loophole meant that limits on the size of positions that speculators could hold did not apply, so it in effect evaded the regulatory speed bumps that were supposed to deter speculation. In my opinion, the Enron loophole and other such manoeuvres to get around regulatory speed bumps have had an impact on oil markets. It's hard to quantify that impact. I can only rely at this moment on the IMF May 2008 regional economic outlook, which said it's hard to explain current oil prices in terms of fundamentals alone:
Producers and many analysts say it is speculative activity that is pushing up oil prices now. Producers in particular argue that fundamentals would give an oil price of about $80 per barrel, with the rest being the result of speculative activity .
So why should you care if speculative activity is at least in part elevating the price of oil? There are a number of reasons, and I'm sure you've discussed many, but consider this one. When the price of oil climbs, investment in oil-related sectors is stimulated. Investment projects that would not be viable if oil was at $80 a barrel become viable when oil is $100 or more per barrel.
Now, if the price of oil is determined by underlying economic fundamentals, then any free market economist would claim that additional investment in oil is justified. But if the price of oil is being pushed up by speculative pressures beyond what the underlying fundamentals would dictate, then investment in Canada in the oil sector may be distorted by speculation in oil.
This is one of the grave problems about speculative bubbles. In the dot-com bubble, for example, lots of investment in Internet-related projects went forward, and when that bubble burst it was subsequently revealed that investment was really wrong-headed. Ditto for the latest sub-prime bubble.
If speculation is playing as large a role in the price of oil as the IMF report I just quoted would indicate, it is possible that in Canada we are experiencing a grave misallocation of investment. It is possible that we're over-investing in oil and under-investing in other sectors. If we are experiencing that kind of unjustified distortion of investment because the price of oil is not a reliable price signal, then this could have a negative legacy far into the future. It would indeed be tragic if we let our manufacturing sector and others be hammered and our oil sector overblown, only to realize that we have been guided by price signals that have been distorted.
Thanks very much.