Economics of Oil Futures Trading, Part I

Includes: DBO, OIL, USO
by: Mark J. Perry

Politicians seem to generally dislike high prices (except maybe when they're selling their own houses or their own stocks) and are quick to conduct investigations or propose legislation any time they feel that prices are "too high."

If market-driven CEO compensation is high and rising because super-star executive talent is scarce relative to the demand, politicians generally condemn the high salaries. If market prices for plywood or generators rise after a hurricane because of increased scarcity, politicians condemn "price gougers" and sometimes put them in jail. When gas prices rose after 9-11 and after Hurricanes Rita and Katrina in response to significant disruptions in market conditions, politicians investigated oil companies and gas stations for "price gouging."

If rents in NYC or Berkeley are rising due to increasing demand for rental housing interacting with a limited supply, politicians have passed "rent control" legislation.

In the most recent period of high and rising oil prices, there's a new bogeyman on the block, coming under the watchful eye of politicians: SPECULATORS. In their perpetual mistrust of market forces, politicians cannot accept that high prices might actually be a result of either rising market demand, or falling market supply, or both. And there seems to be a general misunderstanding among both politicians and the general public about the basics of futures of markets in general, and the relationship between spot prices and futures prices in particular. Consider that:

Spot Price + Carrying Cost = Futures Price

For a one-year period for oil it would be:

Spot Price of Oil Today + Carrying Cost of Oil for One Year = Futures Price of Oil for Delivery in One Year,

where the carrying cost includes storing oil for one year, and the opportunity cost of $100 of capital invested today to buy oil at the spot price (foregone interest for one year). Assuming the carrying cost of oil is $5 per barrel per year, and a spot price of $100 per barrel, we would have a futures price of $105 per barrel:

$100 Spot Price per barrel + $5 Carrying Cost Per Barrel = $105 Futures Price.

Assuming that the $5 carrying cost remains fixed in the short run, we can see that there is a direct one-to-one relationship between the spot price and the futures price, and if the futures price rises, the spot price would rise by about the same amount. And that 1:1 relationship would exist even if speculators were banned from the market, and only hedgers remained to trade.

For example, assume that Northwest Airlines (NWA) and other carriers anticipated that rising global demand for oil and tightening oil supplies would put upward pressure on oil prices for delivery in June 2009. To hedge against the price risk of higher oil prices, NWA and other transportation companies that rely on oil as a major input might start buying oil futures contracts for delivery in one year, which would put upward pressure on the future price of oil, say to $110 per barrel. Now the relationship would be:

$100 Spot Price + $5 Carrying Cost < $110 Futures Price.

At the spot price of $100 per barrel, arbitrage profit opportunities would exist. You could buy oil today at the spot price of $100 and simultaneously sell contracts at the futures price of $110. After adjusting for the $5 carrying cost, you would have a $5 profit per barrel. But others would join you in your money-making plan, and the rising demand for spot oil would raise the price to $105 per barrel, such that:

$105 + $5 Carrying Cost = $110 Futures Price.

Notice that the spot price went up when the futures price went up, due to the trading of hedgers like NWA, and this would happen EVEN IF THERE WERE NO speculators in the market.

Conclusion #1: Spot prices generally rise (fall) when futures price rise (fall), due to market forces today and anticipated market forces in one year.

Conclusion #2: Conclusion #1 holds even when ONLY hedgers participate in a futures market.

There is a straightforward, mechanical relationship between spot prices and futures prices that doesn't necessarily have anything to do with speculators. In fact, speculators don't determine market forces, they respond to market forces of supply and demand.

Therefore, speculators can't be blamed for high oil prices, because high oil prices are ultimately caused by factors beyond the control of any speculator: rising global demand in places like India and China, and global supply in places like Saudi Arabia, Nigeria and Venezuela. No individual speculator, nor any group of speculators, has an iota of influence over the demand for gas or oil in Brazil, nor do they have one iota of influence over the amount of oil in Canada or ANWR, or any control over OPEC quotas.

Think about it - Exxon Mobil (NYSE:XOM), one of the largest oil producers and private oil companies in the world, has NO control over the world spot price of oil, so how could a small group of speculators?

Part II follows.