Does No One Remember the Pain of the '70s?

Both presidential nominees -- Sen. John McCain (R., Ariz.) and Sen. Barack Obama (D., Ill.) -- joined the call to crack down on oil speculation in recent days. But government intervention could lead to worse problems in the oil markets if executed incorrectly.

McCain said in a speech about energy last week in Houston:

We all know that some people on Wall Street are not above gaming the system. When you have enough speculators betting on the rising price of oil, that itself can cause oil prices to keep on rising. And while a few reckless speculators are counting their paper profits, most Americans are coming up on the short end -- using more and more of their hard-earned paychecks to buy gas for the truck, tractor, or family car.

He would reform the futures market to increase transparency similar to the way stocks trade on the New York Stock Exchange (NYX Quote) and Nasdaq (NDAQ Quote). McCain didn't specify whether he planned to take any action against speculators above and beyond those that the Justice Department has under way. The McCain campaign did not respond to email requests for information for this article.

On Sunday, the Obama campaign released a detailed plan for rooting out speculation:

For the past years, our energy policy in this country has been simply to let the special interests have their way -- opening up loopholes for the oil companies and speculators so that they could reap record profits while the rest of us pay $4 a gallon. My plan fully closes the Enron loophole and restores common-sense regulation as part of my broader plan to ease the burden for struggling families today while investing in a better future.

His four-point plan includes: 1) closing the "Enron loophole" 2) ensuring that U.S. energy futures trade on a regulated market 3) working with other countries to coordinate regulation, and 4) having the Federal Trade Commission and Justice Department investigate market abuses.

Does no one remember the 1970s?

The Enron loophole arose from a provision introduced in the Commodities Futures Modernization Act of 2000 by former Sen. Phil Gramm -- an adviser to McCain's campaign -- which basically banned a single traded future. This prevents the Commodities Futures Trading Commission (CFTC) from investigating trading in the oil markets because so many occur as part of unregulated swaps.

Peter Zeihan, vice president of analysis at Stratfor (a leading publisher of online geopolitical intelligence), warned against drawing any parallel to the Enron scandal. "Enron made markets on things that didn't exist," he said. "The oil market is not like Enron. Oil trades in the real world with lots of capital behind it."

Clearly, the government failed to take action against Enron's illegal activities. While government regulation of speculators sounds like a good idea, oil and commodity markets are distinctly different from the bond and stock markets. Politicians need to proceed carefully, or every American could face ugly consequences.

The 1970s offer an excellent lesson for today. The 1970s disaster began when President Richard Nixon and Congress instituted price controls in an effort to mitigate soaring prices. This backfired dramatically. Shortages quickly sprang up, and Americans lined up around the block to fill their gas tanks.

President Jimmy Carter phased out some of those controls. Unfortunately, he couldn't resist the lure of taxing oil companies for windfall profit. None of these actions improved the price of petroleum.

Before politicians jump the gun, they need to determine whether greedy speculators really are forcing up oil prices today.

They aren't, if you listen to energy experts like Tom Wallin, president of Energy Intelligence, a firm that specializes in energy analysis. He wrote via email:

"I think there is a fundamental misunderstanding about the role of speculators in the recent run up in oil prices. I believe that they are playing a role but it is not because they are greedy speculators but because of the structure of the market."

Charles Ebinger, director of the Energy Security Initiative at the Brookings Institution, said: "These are hedge funds and investment banks who utilize the futures market in order to hedge versus inflation," he continued: "People's opinion I respect see the inflation hedge causing a $10 to $15 per barrel premium in the market."

Wallin agreed there's a small premium in the market. "If we could wave a magic wand and eliminate the distortions caused by speculation, we might see oil prices decline -- perhaps by 10% or so -- but that would not solve the basic problem," he said.

Oil prices remain high for reasons of supply and demand. Ebinger has experience working in Asia and suggests that demand has been underreported there. "Demand is accelerating through the roof," he said. "India alone has high demand for diesel fuel to power diesel generators because of an inconsistent electricity grid. Statistics lag behind the reality by 18-20 months."

Zeihan predicts that politicians in Washington will mettle with the markets because of bi-partisan support for action. In fact, Rep. John Dingell (D., Mich.) issued a letter last week demanding information on contracts and trading behaviors from the CFTC for the House Energy and Commerce Committee. The letter stated: "It is fair to ask whether large inflows from commodity index investors are distorting energy prices and undermine the price discovery function, and whether the CFTC has the data to help answer this question."

Ebinger warned against those who "too easily use criticism of the CFTC as a scapegoat." He commented Congress has to be careful not to limit use of contracts only for airlines and trucking industries. He agreed with Obama's position, and possibly McCain's, on closing the Enron loophole: "It makes sense." But he continued saying: "We have to let the markets operate, even if they remain behind the curve. Eventually the price will come into line as it did in the 1980s"

Zeihan asked the question: "Will Congress get it right?" He expressed concerns that an improper modification could lead to another market blow up similar to the subprime catastrophe. Wallin also wonders if intervention won't have unintended consequences:

As for the CFTC, if they try to ban speculation I think it will reappear in other forms. It will either go offshore, to London or some other jurisdiction. This would be bad for the Wall Street firms that advise the CFTC and that have plenty of political influence elsewhere as well... if they banned speculation, we would go back to the something like the oil markets of the 1970s, which were more opaque and inefficient than what we have now.

Inefficiency and a reliance on small, physical spot market would not lower the price of oil, just as it didn't in the 1970s. For example, back then, the fall of the Shah in Iran caused hysteria in the markets. The Middle East remains unstable today with the U.S. and Israel threatening to bomb Iran if they further attempts to operate nuclear reactors.

According to Ebinger: "We need a concerted national energy policy, and it cannot change every four years. Change has to include every available energy solution as part of the mix."

This sounds like excellent advice for the candidates and Congress, not chasing after so-called "greedy speculators."