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speculators and commodity prices

Page history last edited by Brian D Butler 8 years, 1 month ago

 

 

 

In Defense of Oil Speculators

At ForeignAffairs.com, Blake Clayton argues that speculators help energy prices respond to shifts in supply and demand, benefiting producers and consumers alike. Read the Snapshot »


Milton Friedman Proved Wrong by Aluminum Market

Peter Orszag counters that financial speculators can destabilize commodities prices for brief periods of time.Read More »

 

 

 

 

are speculators to blame for increased commodity prices?

not likely....

 

It drives me crazy to hear again and again that “speculators are driving up the price of oil”. This is just not true, and clearly shows the ignorance of news broadcasters, politicians, and it exposes a deep misunderstanding of finance, and the way in which financial markets operate.

 

Lets clear the air…first of all…speculators don’t buy any physical oil, but instead are trading paper (futures and options contracts). This means that speculators can not influence the market where physical oil is traded because they are not actually buying any of that oil. In reality, only the refineries are actually purchasing any physical oil. Every contract for oil that speculators buy must be sold back to the market before the contract expires. At the future date, when the future contract is set to expire (as they do all the time), they have to settle their positions. If the price of oil didn’t go in the direction they bet that it would…they could loose a fortune.

 

One of the popular targets of this rage against speculators is the “index funds” that bet on price increases in oil. The popular line on TV goes that these speculators are to blame for the price increases. But, index funds, in order to keep their position in oil, must not only buy, but also sell futures contracts for oil. Why? Because the short-term nature of the contracts means that index fund managers must constantly sell their old contracts and replace them with new contracts to maintain the same position. This means that index funds end up being big time sellers of futures contracts. With this unique dynamic going on, and considering that they are not buying any physical oil itself, but instead are just trading paper bets on the future price movements, it’s difficult to see how they could be to blame for the actual price increase in oil itself.

 

Betting on the price of oil prices is very similar to betting on a sporting event. It doesn’t matter how much money is changing hands in the stadium because the bets don’t change the outcome of the actual game. Oil speculators are like fans betting on the outcome of the game. If you bet a hundred dollars or a million dollars, it only makes money for you if the outcome turns out as you expected. If the price moves in an opposite direction, you lose.

 

Further evidence that speculators don’t move markets can be found by looking at other commodity markets in which speculators trade. One blaring example is the metal “nickel” in which there is a thriving speculation market, but the price has fallen by over 50% in the past year. On the other hand, there are other commodities such as iron ore, or rice which are not traded on exchanges, but for which there has been a similar rise in price as we have seen with oil. So, as these examples illustrate; clearly its not the presence of speculators that is driving up the prices of these other commodities. There must be other factors going on globally that is working to drive up commodity prices. Perhaps it the booming emerging markets? Can anyone say “supply and demand”?

 

Size matters: The total value of all of these speculative contracts (typically index funds) is minute in comparison to the total value of yearly oil consumption. According to Barclays Capital, the oil index funds total value is only 2% of the value of oil consumed each year. With this small value, it’s hard to see how such a small trade (relative to the size of the oil markets) could actually be moving the markets.

 

There are many reasons that the price of oil is going up. But thinking that speculators are to blame is misguided. While they may play an important role in establishing price signals, it’s clear that speculators have neither the volume (compared to the oil market), nor the power to set the price of the oil markets.

 

In fact, oil speculators might be largely responsible for LOWERING the price of oil. By establishing a free market for futures contracts (and options), these speculators help oil companies to smooth out the expected price for future production. As happens in any commodity markets (such as pig farming, corn growing, etc), it is very important for commodity producers to have stable and predictable future prices so that they can borrow more cheaply, invest more wisely, plan accordingly, and produce more efficiently. If there were not orderly futures market established by speculators, there would likely be underinvestment, and a corresponding price increase in oil (over time, in the long run)

 

More Views:

As one economist puts it:  "Today’s explosion of commodity prices is the result of a very real global financial storm associated with large excess liquidity in several non-G7 countries and nourished by the low interest rates set by G7 central banks. This price explosion could be a leading indicator of future inflation driven by fundamentals."

 

See discussion on CNBC:

 

 

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