Kenneth D. Gartrell

By: Kenneth D. Gartrell

The ongoing media discourse on the state of the economy and the price of oil is very weak and reflects a large shortage of economic knowledge among politicians, surrogates and commentators. It is puzzling that no one has appeared to debunk the myth that “speculation” is driving the market. It is 100% the other way. Uncertainty in the market is driving the need to hedge (which is defined only formally as speculation by regulatory definitions). When commentators encourage an increase in futures margins, they fail to recognize that increased margins would not only drive up the futures’ price but also the spot market price of oil today.

The economy (as observed by the forward looking expectations of the stock market) largely reflects a growing belief that this election will bring a consolidation of left-wing power and a period of oppressive taxes and regulations. The markets also suffer from the increasing trend of “going private” transactions. Firms with good prospects and capital market attractiveness are going private rapidly to avoid political costs and regulatory costs such as compliance with Sarbanes-Oxley. The favorable performance of these companies is being systematically removed from the market indicators.

A remarkable phenomenon is reflected in the fact that political commentators are all buzzing with rumors of a near-term Israeli strike on Iran. Most pundits agree there is a 50 plus percent chance of an Israeli attack on Iran — which they correctly assess would shut down the Strait of Hormuz. All the same analysts and commentators also assert that expectations are not a big part of the price of oil. It appears we no longer have objective journalism because no one seems to see the paradox in these overlapping points of view.
How it is possible to believe that risks of an attack on Iran in 90 days is not in the price of oil today? It is impossible, from a financial economist’s point of view, to believe that this speculation could be so widespread with no impact on oil prices today.

The very same commentators have reported that 40% of the world’s oil travels in the Strait of Hormuz. Everything else equal, it has to be true that today there is at least a 50% chance of a 40% reduction of supply. It does not require the Theory of Relativity to understand this all leads to an expectation today that the price of oil would fall at least 20% (40% times 50%) if this uncertainty was resolved favorably. Obviously, the marginal effect is not linear either. In fact, all the same commentators say that closing the Straits of Hormuz could cause a 100% increase in price. If that is so, then today the price effect of the events would be at least about 25% (50% times 50%) of today’s price.

It is hard to avoid real doubts that in respect to economic issues and the world price of oil that our politicians and news commentators have no clue how markets and prices work. On one side of their faces they tell us of these threatening events and on the other side they tell us that China, India and speculators are behind the recent move up in oil prices and declines in market outlook. Incredible!