Speculation

Question:    I was reading this article about how if congress enacted a bill to eliminate price manipulation in the oil market. By stopping speculation it would reduce the cost of oil. I have some sort of idea of what speculation is, but I was hoping maybe you could explain it a bit better? And if it were 'stopped' what would be negative from a capitalist standpoint, if that makes any sense?

Answer:    Speculation is buying something at a cheap price and holding on to it expecting the price to rise in order to sell it at a higher price. You "speculate" or gamble that the price will rise. This is not pure capitalism; it is a corrupted form of capitalism because it is non-productive. No new production occurs from this process. The only thing that happens is that a middleman receives income because the market price is adjusting too slowly, and prices rise because the asset that the speculator purchased is taken off the market forcing the price up. Adam Smith himself referred to this income as "rent", which was income due to ownership, rather than "profit" which is income due to adding value or producing a product.

The major problem with speculation, besides it being non-productive, is that allows the possibility of price manipulation. If prices are manipulated we are no longer operating in competitive market. The market has been corrupted to favor those who control the prices. If speculation were purely bad for the market then we could easily make it illegal and improve the economy.

There are at least 2 problems with trying to outlaw it completely. 1) In some circumstances it actually helps prices to adjust more rapidly and accurately than they would without it. 2) The incentives to make a quick buck with little costs are very strong and would likely produce a black market for the goods anyway.

Having identified problems with outlawing speculation we can raise the question of regulation. It is entirely reasonable to identify specific markets, such as oil or pension funds, that are either strategic in some sense or are intended to be protected from rapid price changes and target those areas for regulation. Thus, we could allow the speculation but attempt to keep a damper on it and track any anti-competitive manipulation or irresponsibly risky trading that puts the assets or market at too high of a risk.
One very simple and elegant proposal made originally by Nobel Prize winner James Tobin, is to put a very small tax, say .1 percent (one, one tenth of a percent) on particular types of financial transactions. This would cost the speculator one one-thousandths of the traded amount, a paltry amount given the volume funds they are speculating on, but would slowdown the rate of speculation minimizing its negative impact. By the way, such a tax would raise enough money to retire the government deficit and remove all other taxes!
So the simple answer to last question is that outlawing it may not harm the market any more than it is currently being harmed by allowing it. Yet, it may be impractical to outlaw it entirely. However, the proper level of regulation may actually improve efficiency and competitiveness of the market.