19

It’s all speculation


 

Just about every day, I continue to get letters and emails from readers, about this column from a few weeks ago, in which I argued that speculators are not really to blame for the soaring price of energy. Whatever role they play in the market tends to be positive, eliminating pricing inefficiencies and generally smoothing the rise and fall of futures contracts. The price increase is due to high demand, stretched supply and a shortage of refinery capacity.

It was, um, not a crowd pleaser. The general consensus among my correspondents is that speculators are evil, they are trying to ruin the lives of innocent ordinary folk, and dorks like me should lose our journalism licenses.

Well, the U.S. government task force charged with getting to the bottom of the speculator scandal issued its report yesterday. Bottom line: speculators aren’t to blame. The oil price is the result of high demand, stretched supply and a shortage of refinery capacity. Never easily daunted by mere facts, the Senate voted unanimously(!) to press ahead with debates aimed at curbing price speculation in the futures markets.

We do not want to hear that we are the cause of the oil price rise. And politicians do not want to be the ones to press that unpopular reality. So off we go to bizzaro world, where the facts don’t matter. Only emotions do.


 

It’s all speculation

  1. The problem is that we see some people making substantial sums of money in these markets, and assume that this money is coming from the consumer.
    I’m not trained in economics (to put it mildly) but if someone’s making a couple percentage points in profit off of the transaction, that’s coming from somewhere, isn’t it?
    If the experts say this isn’t the case, I’ll beleive them, but I’d love to see a basic explaination why not. Simply asserting it isn’t the case isn’t going to do a lot to convince me.

  2. Jameson – I’m delighted you asked.
    Speculation means buying and selling futures contracts. a futures contract gives you the right to buy oil at a particular price in the future.
    So, right now I can buy a contract that gives me a right to a barrel of oil, six months from now at, say, $130 a barrel, but I can buy a barrel right now, on the spot market from $127. anybody buying or selling those futures contracts are betting that the price is going up, and six months from now, the ability to buy a barrel for $130 will seem like a bargain. People buy those futures contracts for two reasons: to hedge against sudden surges in price, or to try to make a bet on the future price, and make money in the process.

    You are absolutely correct that people assume those profits are coming at the expense of consumers. They are not. Those profits are coming at the expense of other speculators, and large oil buyers who made a different bet.

    Speculators reflect expectations about future prices, they do not drive prices. To put it in context – bettors in las Vegas predict the outcome of a football game. Depending on how many are betting one way or the other, they affect the odds, and that has an impact upon how much other bettors win or lose. But those bettors do not affect the outcome of the game.

    Sen. Joe Lieberman is saying, in effect, the Patriots lost the Super Bowl because a whole lot of greedy gamblers put a whole lot of money on the Giants. Not true, but it sounds good to the grieving Patriots fans.

  3. I think the bit about the refineries is telling:

    The oil companies have not signifcantly upgraded refining capacity in decades, whilst population growth continues. Therefore there is less refined oil per person, causing prices to go up.

    Now, where is the incentive for an oil company to spend several billion dollars building a new refinery – look at the recent decision to scrap the plans to build a refinery at Sarnia. As far as I know, the only new refinery going in is being put in by Irving (an independent) in a bid to increase market share.

    This is where it would be nice to have a state run oil company. Not that this would be sufficient grounds to have a state run company, just that it would be nice.

  4. I am with Jameson in my knowledge of economics but surely speculators have an effect on oil prices.

    What if speculators are worried about war with Iran in six months, which would disrupt supply, and decide to hoard oil now. Wouldn’t that have an effect on prices?

    I am generally a great believer in markets, and doubt the wisdom of letting Senators get involved in pricing issues, but I can’t accept speculators have no effect at all.

  5. I feel the big issue here boils down to simple economics. Oil supply is constant (at best!) and demand is rapidly increasing. Developing countries like China and India need more oil to sustain thier growth, and they are willing to pay for it. So the speculators are right to drive up the price and we simply have to get used to paying more at the pump.

  6. Another thing I wonder about is the behavioural economics aspects of this. I know there is no way to quantify it but I wonder how society reacts to all the talk of speculators/speculation that’s in the news right now.

  7. “What if speculators are worried about war with Iran in six months, which would disrupt supply, and decide to hoard oil now. Wouldn’t that have an effect on prices?”

    Yes, but I’m pretty sure there is not some giant vault under Wall Street where speculators are stashing all the oil (though I do like the image). They are just buying and selling the rights to buy oil in the future. If they think the supply is going to be constrained, they buy futures now at prices lower then they think they will be when they come due. If not, they don’t buy them for as much. If the price of oil is higher then what their negotiated price is in their futures contract when it comes due, they make money. If it’s not, they lose it.

  8. jwl:
    Economics assumes we all are rational beings
    and act in enlightened self-interest.
    Apparently that’s why government should be run
    like a business.
    Then again,40-odd years ago,in Business 101,one
    of the first things I learned was that 95% of
    businesses failed within their first five years.
    Most of my classmates at the time thought government should be run like a business. Most
    of them became teachers.
    Oh, and speculative bubbles don’t exist.
    Derivative instruments are not rational.

  9. Steve,

    You summarize the report in a link stating: “The oil price is the result of high demand, stretched supply and a shortage of refinery capacity.”

    I wonder if you’re not mixing up two separate issues: the world price for oil (set by world supply and demand), and the price N.A. consumers pay at the pump for gasolene (influenced by supply and demand of gasolene through refinery capacity).

    It would seem to me that if you had limited refinery capacity, demand for oil would be constrained, keeping the the world price for oil lower, no?

    Care to elaborate? I didn’t see your original column nor the linked article specifically mention refinery capacity as affecting upward the world price of oil.

  10. Yes Dot – I am indeed conflating two separate (but related) issues. You’re right- the rising oil price is not the result of short refinery capacity. High gasoline prices are the result of short refining capacity, and that is also why gas prices and oil prices don’t work in lock step. Thanks for pointing that out.

    But short refining capacity doesn’t reduce demand for oil because gasoline is only one source of oil demand, and because currently refineries are meeting demand for gasoline in North america. (It’s just not clear whether they will be able to meet all future demand).

    I hope that clears up the confusion.

  11. sbt oil is an easily storable commodity. If I think the price of oil is going to continue to rise, the logical thing is for me to buy lots now and sell it on in 6 months for profit or to protect myself from the prices increases that I think are coming. Isn’t that what the US’ petroleum reserve is partly for?

    Sisyphus
    I am not sure if those are your opinions or if you just writing about what you learned. I would argue that humans are far from being rational, in the sense that I understand it, but I do agree that government should be run more like businesses.

  12. jwl – hoarding oil creates all kinds of logistical problems that increase the risks and costs substantially. For example, where would one store a million barrels of oil? What would it cost to insure? the futures market is where all of that kind of hedging takes place. It’s neat and tidy and doesn’t include the risk of spills and explosions.

    The strategic petroleum reserve is essentially an emergency stockpile to protect against a severe reduction in supply, as opposed to a sudden rise in price. It is really separate from the whole debate on what is driving prices. In the wake of 9/11 the US briefly tapped the SPR to calm jitters in the market. What it learned is that it’s useless for that purpose. There simply isn’t enough oil stockpiled to have a lasting impact on the market. so, the US will likely never do that again. They just want to ensure they have enough physical oil on hand to fill up the tanks and air craft carriers in the event that hell really breaks loose.

  13. jwl: As sisyphus pointed out, 95% of businesses fail in their first five years. You sure about wanting the government to be run more like a business?

    Here’s a thing, how about we run businesses like businesses, concentrating on providing maximal value to shareholders, and then run government like government — concentrating on ensuring that people have a chance to live a decent life.

  14. Sorry, I got a bit off track here. I was thinking of speculators in a general sense and not only the men/women on Bay St. I agree that speculators do not have a place to store 1 million barrels of oil but I do think their speculating has an effect on gas prices because people react to what they hear on the nightly news.

    I was thinking of governments when I had hoarding in mind. It would not surprise me at all to find out that some governments have bought way more then they need to protect against future price increases or that oil rich countries are holding back on production because they think the price is going to continue rising.

    All this aside, I think it will be a disaster if the Senate does actually involve itself in the price of oil. Nothing good can come from those puffed up clowns getting involved in something they don’t understand.

  15. T Thwim 95% of businesses go bankrupt because they are paying sky high taxes and having to follow a bewildering amount of regulations that governments impose.

    I don’t have a problem with some government functions but we have gone way too far. Governments spend like drunken sailors on a night out and it irritates me. They should be lean and mean, not big and bloated like they are now.

  16. If most of the people in suspenders believe the price of oil will go up for some extraneous groupthink reason then the price of oil will go up.

    So for example, what would their reaction be if a large producer of oil and gas with a significant share of known reserves announced its intention to nationalize its oil industry?

    Would the speculators keep an open mind, wait and see how this interesting new proposal for managing supply and deriving collective benefit played out? Or would they go apeshit and drive the price up overnight?

    I don’t have a problem with religion, it’s when you present it as science that I disagree Mr. Maich.

  17. Thanks for that, by the way. I think that while one might assume the average person has some idea of textbook Econ 101, there isn’t this widespread knowledge of how the markets actually work- not at the same level as there is about legislative bodies, for instance. And so you get someone who can follow all the fine print over at Kady’s blog, but has to ask for training wheels over here (ie me).

  18. it may also interest you all to know that there is no factual backing for the myth that 95% of all businesses fail in the first five years.

  19. Good catch, srf. Looks like, at least in the US, it’s about 50/50 odds. Still more often than I’d like to see government fail, however.

Sign in to comment.