Special to PAI
WASHINGTON (PAI)–Over the past eighteen months, oil prices have more than doubled, inflicting huge costs on the global economy. Strong global demand, owing to emerging economies like China, has undoubtedly fueled some of the price increase. But the scale of the price spike exceeds normal demand and supply factors, pointing to the role of speculation, and underscoring the need for policy action to clean up the oil market.

Reflecting their faith in markets, most economists dismiss the idea speculation is responsible for the price rise. If speculation were really the cause, they argue, there should be an increase in oil inventories, because higher prices would reduce consumption, forcing speculators to accumulate oil. The fact that inventories have not risen supposedly exonerates oil speculators.

But the picture is far more complicated: Oil demand is not very sensitive to price. In the short run, it is technically difficult to adjust oil consumption. For instance, the fuel efficiency of every automobile and truck is fixed, and most vehicle travel is absolutely needed, such as say, to, from or on the job. And though higher airline ticket prices may reduce purchases, airlines cut oil consumption only by canceling flights.

This illustrates a fundamental point: In the short run, reduced economic activity is the principal way of lowering oil demand. Thus, absent a recession, demand has remained largely unchanged over the past year. Moreover, it is relatively easy to postpone lowering oil consumption. Consumers can reduce spending on other discretionary items and use the savings to pay higher gasoline prices. Credit can also temporarily fill consumer budget gaps.

Although the housing boom in the United States, which helped in this regard, ended in 2006, consumer debt continues to grow, and the Federal Reserve has been doing everything it can to encourage this debt growth. Consequently, for the time being the U.S. economy has been able to pay the oil tax imposed by oil speculators.
Unfortunately, proving that speculation is responsible for rising prices–as some congressional Democrats contend–is difficult, because speculation tends to occur in booms, so price rises easily masquerade as a reflection of economic fundamentals. But, contrary to economists’ claims, oil inventories reveal a footprint of speculation.

Inventories are actually at historically normal levels and 10% higher than five years ago. Furthermore, with oil prices up so much, inventories should have fallen, owing to strong incentives to reduce holdings. Meanwhile, The Wall Street Journal has reported financial firms are increasingly involved in leasing oil storage capacity.

The root problem is that financial markets can now mobilize tens of billions of dollars for speculative purposes. This enabled traders collectively to hit upon a strategy of buying oil and quickly re-selling it when end users accommodate higher prices.

The situation is aggravated by the GOP Bush government, which has persistently added oil supplies to the U.S. strategic reserve, driving up demand–and crude oil prices–and providing additional storage capacity.

Absent a change in trader beliefs, the current oil price spike will be broken only by a recession that exhausts consumers’ capacity to buffer higher prices, or when the slow process of substitution of other energy sources for oil kicks in. Thus, economic fundamentals will eventually trump speculation, but in the meantime society will pay a high price.

Whereas oil speculators gained, both the U.S. and global economies suffered and been pushed closer to recession. In the U.S., heavy dependence on imported oil worsened the trade deficit and further weakened the dollar.

This sobering picture calls for new licensing regulations limiting oil-market participation, limits on permissible trading positions, and high margin requirements where feasible. Sadly, given the conventional economic wisdom, implementing such measures will be an uphill struggle.

But some unilateral populist action is possible. A major form of gasoline storage is the tanks in cars. If people would stop filling up and instead make do with half a tank, they would immediately lower gasoline demand. Given lack of storage capacity, this could quickly lower prices and burn speculators