Economics of Oil Futures Trading, Part II

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

From this previous post on the economics of oil futures trading:

$100 Spot Price per barrel + $5 Carrying Cost Per Barrel = $105 Futures Price (1 year)

Now suppose that speculators anticipate rising future oil prices, due to increasing global demand in China and India, and tightening world oil supplies. As in my previous example, let's assume that the increased speculative futures trading raises the price of oil in the futures market to $110 per barrel for delivery in one year, which then also raises the spot price to $105.

Q: What's could be so beneficial about speculators trading in oil futures, especially if they are contributing to both increases in spot prices and increases in futures prices for oil?

As Bloomberg's Kevin Hassett
points out, "If speculators know that the price of something is going to go up a month (year) from now, they buy today. If they are correct, they make money, and the price change is smoothed by the higher demand today. By loading up on futures, speculators pulled some of the price increase forward to today. This change is beneficial for society, as it forces consumers to conserve sooner, and suppliers to search for new deposits."

For example, think about what would happen if futures speculators were able to increase the futures price of oil to $110, without affecting the spot price (stays at $100). Consumers would then NOT conserve oil, and suppliers would NOT search for new oil. If speculators were correct about the rising future price of oil in one year, and if consumers and producers did not change their behavior (because the spot price didn't change), then it's likely that the future price of oil would rise above $110, say to $115 per barrel. And that would be an increase in price volatility over time - oil prices would increase to $115 without speculation in one year, instead of $110 with speculation.

By "pulling some of the price increase forward to today," speculators then actually help stabilize oil markets over time, by moving prices in the correct direction and helping allocate resources more efficiently over time. That is, the pain of higher spot prices today due to speculation, would be more than offset by the benefits in the long run, because behavior would change sooner to the increased scarcity of oil.

To paraphrase Walter Williams: "Suppose speculators are correct about future supply and demand conditions and oil will be scarcer in the future, what is the socially wise thing to do now so that more will be available in the future? The answer is to use less oil now. How do you get people to voluntarily use less oil now? By letting the spot price today rise."

Q: Do speculators raise spot prices and futures prices when a commodity will be scarcer in the future? Yes, but if a commodity like oil is expected to be less scarce and more abundant in the future, speculators would lower both spots prices today and futures prices. It works both ways, but speculators don't receive attention when they are lowering spot prices, only when they are raising spot prices.

Q: If oil is expected to be more (less) scarce in the future, is it beneficial for spot prices today to rise (fall)? Yes, and speculators help to make that happen.

Q: Are oil prices more or less volatile/stable over time with speculators? More stable, by pulling some of the expected future price changes forward to today. "Speculation has to be stabilizing if speculators are making money," says Hassett. And the more speculators are correct in their assessment of future market conditions, and the more trading they engage in based on those assessments, the more stable prices will be over time.