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Understanding "Speculators" and Oil Prices

Written by Larry Kudlow

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Friday, June 20, 2008
by Larry Kudlow
lkudlow.jpgThe stock market plunged 170 points this morning and oil jumped over $3, allegedly based on a New York Times story that Israel is carrying out military exercises as a rehearsal to bombing Iran. But actually, the Times story, written by the very able war correspondent Michael R. Gordon, is talking about Israeli training exercises from early June, not now. It’s a rehash story with some new details. And it does in fact confirm the market rumors of June 5 and 6 that Israel was planning an Iranian attack to stop the rogue state’s nuclear-weapons program.


Recall that oil jumped almost $15 on Thursday, June 5, and Friday, June 6, largely in response to Middle East war worries. In fact, on Friday, June 6, stocks plunged 400 points as oil jumped $11 to close at its peak price of $140 a barrel. It was this oil spike that helped trigger various Washington and presidential-campaign attacks on so-called oil “speculators.” But what the heck? Anybody with half a brain operating in the oil markets who thought there was going to be an Israeli-Iranian war would be buying spot and futures contracts — which is exactly what happened.

So far as I know, there is no new news coming out of Israel. Today’s Times story is a look backwards.

But I want to make a separate point. Oil-market traders react rationally to new information. Instead of blaming them, senators McCain and Lieberman might want to visit with some traders on some of the big Wall Street trading floors to better understand the relationship between global news and price discovery.

There’s something more here. Democrats reading from their talking points are completely opposed to Bush and McCain proposals to open up new oil drilling offshore and onshore. The Democratic argument — which I heard again last night on my show from Robert Reich — is that it will take ten years to lift new oil, which will never help today’s price problem. Obama says exactly the same thing, as do Harry Reid, Nancy Pelosi, and all the rest. But they’re forgetting the role of oil traders.

Oil futures markets have contracts that run out five years and beyond. If these traders — or “speculators” — believe new oil supplies are on the way in the future, they will sell those out-year contracts. And before long market arbitragers will backward-ize those price drops toward the spot market, bringing prices down there as well.

In other words, trader/speculators can be very handy instruments of energy (and economic) policies. If demand exceeds supply they are buyers. But a prospective future supply increase makes them sellers. In a free market prices move both ways. And if Sen. McCain would take the time to learn this he could respond accordingly to Obama’s silly criticism that we shouldn’t drill because it will “take too long.”

This is all part of the key point that McCain can turn record energy prices to his political advantage, as polls now show 65 percent, or two-thirds, of the public favors drilling. But to do this the whole GOP must understand the role of oil traders and their speculations.
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Lawrence Kudlow is the host of CNBC’s Kudlow & Company (M-F, 7pm/ET), a host of WABC's "The Larry Kudlow Radio Show" (Saturdays 10am-1pm/ET), a nationally syndicated columnist and a former Reagan economic advisor. Larry is also a regular guest on Hugh Hewitt's nationally syndicated radio show every Friday night. CNBC's Kudlow & Company also airs on Sirius (ch.129) and XM (ch.127) weeknights at 7pm ET. More about Larry

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