Economics of Oil Futures Trading, Part II

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.

Comments

[Marcus Aure...:]

You don't get consumers to use less gas by raising prices, you get consumers to consume less by putting out PSAs to tell them to stop consuming! I think the Energy Squirrel character is especially compelling!

2008 Jun 17 12:18 PM

[Brian27:]

The power of opportunity cost. It should be obvious that opening up Anwar, the Colorado shale and the Continental shelf to drilling will bring down spot oil prices by increasing the expected future supply of oil.

One note: Under excessive speculation with a huge run up in future prices one would expect that current supply would be dragged into the future by an increase in inventories.

2008 Jun 17 12:30 PM

[Alex Filonov:]

This article misses market dynamics. It explains static market (with relatively stable volume) perfectly. But what happens if there is an influx of new traders/investors? What happens when hedge funds and sovereign investment funds start buying oil futures like crazy? Long term, it shouldn't matter, market will humble anybody, but short term such influx can raise future (and then spot, as you perfectly explained) prices to the bubble values. Now imagine, funds found out that bubble is popping and start leaving future market in droves?

2008 Jun 17 12:33 PM

[ACapitalist:]

I agree with Muddling. This issue is not speculators; they clearly help keep markets rational just as Mr. Perry argues. The issue is index fund commodity investors which have been very large net buyers of futures for a number of years. This is simply supply and demand at work, except that this is a paper market and not the delivery market. More and more investors coming to the futures market as buyers only. Sure they have to close their positions before they expire, but as soon as they do, they reestablish new ones with even more money. The futures market was never set up to handle this kind of influx of one sided activity.
Muddling is right, if they, the index fund investors start exiting the market in droves, we might see the reverse happen with prices. What will happen if congress forces the federal overseers to limit the index fund buyers? I do not see congress being smart enough to figure this out so nothing will probably happen and this bubble will reach a natural popping point at some higher price.

2008 Jun 17 05:44 PM

[NOWHEREMAN:]

Speculators can't buy and hold. They would have to take delivery. They trade contracts. Contract speculation doesn't increase or decrease the underlying commodity.

2008 Jun 18 09:00 AM

[fxtrader07:]

@paultaut: of course, they can. you can buy an oil-etf such as uso and hold indefinitely. uso will buy the futures in turn and roll them over. if another 20billion$ flow into uso it creates an additional demand for nymex crude futures and swap products of about 20 billion value.
so the price goes up, of course.
But Mr Perry won't see it from his PhD ivory tower that obviously is not connected to the real outside world

2008 Jun 18 10:05 AM

[msgtb:]

fxtrader07 That just about says it all!

2008 Jun 18 12:51 PM

[Erick Tippett:]

Mr. Perry

I understand your explanations concerning the economics of oil futures trading quite well. However, to expect the American public, which is woefully uneducated in economics, to grasp these concepts concerning market dynamics is rather unrealistic in my view however unfortunate.

You also mention the quote of Bloomberg's Hasset that if speculators raise the price of oil today it forces people to voluntarily
use less oil. You also personally comment that "speculators don't
recieve attention when they are lowering spot prices, but only when they are raising spot prices".

Assuming speculators are in the business of making profits, my question in view of these statements is, do speculators profit
when they are influencial in lowering spot prices as opposed to when they are raising them?

2008 Jun 19 03:02 AM

[bg trader:]

It is a very simplistic view of the world. As we know the oil market is manipulated and is not a free market. Will also know that subsidies exist in many countries which also distort the picture so his argument about market forces leveling things out is just silly. The last time I looked there were the equivalent of 1 billion barrels of oil / day being traded on a real usage of what 85 million. Oil is an essential resource and as such should not be subjected to speculation. A bit of forward planing and legislation can also achieve a desired result without the enormous price swings that futures trading attracts. I do not see futures trading as being an efficient tool. Of course it may force change but at what cost?

2008 Jun 25 11:13 PM

[third world...:]

Mr. Perry's arguments are created within the cozy confines of theory, and of the high probability of his being able to weather the effects of market speculation and resultant volatility much better than, say, a poor farmer in Ethiopia. Also, his theory assumes a free market populated with rational individuals, and I think it's fairly obvious that such a thing is an idealization - in the long term (though nowadays one doesn't really get a sense there is a long term - we all seem to be living quarter to quarter) it works, but the issues occur in the short term, and that's where the social impacts tend to magnify/snowball

Someone's pointed out that oil is not really a free market - most developing countries have subsidies (maybe it's wrong in the first place, but it's what it is) that can't be changed without some impact - especially to the poorest segments

The problem with speculation, and of derivatives in my opinion(how about derivatives of derivatives?), is that they're designed with an element of self-fulfilling prophecy - these self-fulfilling prophecies somehow seem to cause maximum pain to maximum people and gain to only the handful who unfortunately have the power to influence markets.

2008 Jul 13 04:52 AM

[Pipo:]

Visit The Oil Traders Blog at:

oiltradersblog.blogspo...

Oil forecasts from top players and fund managers and real time prices. Good site for the oil aficionados.

2008 Nov 09 12:50 PM