Oil Prices Are Up: Is It the Work of Evil Oil Companies and Greedy Speculators?
Prices are simply signals telling us to produce more or less. The only answer to high prices is flexibility for those who produce.
Some fallacious notions are at work here. If you trade regularly and know the ins and outs of the futures market, skip the next few paragraphs. This is for those who are confused about speculators and hedgers, buying and selling and long and short. It is a greatly simplified overview but hopefully with enough information to eliminate some common falsehoods around which certain pundits and politicians love to create hysteria. After reading this however, you will not, I repeat, not, be able to make a quick fortune in the futures market. My purpose is to give a basic understanding of the miracle of voluntary trade of which the exchanges and their hedgers and speculators are an important part.
What exactly is this evil entity, the “Speculator”? We are all speculators so watch out who you are tagging as evil. By that I mean that when we buy in advance of a possible price increase, or stock up on food for fear there will be a snow storm, we are speculating. The professional speculator is actually a very important person. This Speculator enables the market to work more efficiently for all of us. The Speculator is assuming a risk that the Hedger consciously does not want to assume and we, if we understand the circumstances, would not want to either. Further, the Speculator is a key entity in the all important function of Price Discovery. Prices are the signals that tell us to produce more or less. Speculators provide the liquidity that enables more accuracy in the signals.
First though, to fully grasp the necessity for speculators, it is important to understand the immense value of the Futures markets and the importance of its function to the Hedger. The Futures Market is a very old idea going back to ancient times. Historical accounts exist of innovative farmers gathering in the market square and negotiating pre-buying and pre-selling agreements. In America, the exchanges also evolved from the market square. The Clearing House has always stood as the counter party to every trade. (Thus the controversy surrounding the handling of customer's monies in Corzine's company; a topic deserving intense scrutiny, but for another time).
So what then is a Hedger?
The Hedger is quite simply someone who either produces or will need the commodity at some time in the future. This can be a farmer who raises wheat or cotton or a factory that makes bread or clothing. It can be an oil drilling company or a trucking company worried about the price of gasoline; whether too low to cover expenses or too high for trucking to be profitable at current rates. A Hedger might also be a business who will be harmed if interest rates or a particular currency moves adversely to his particular situation.
These Hedgers use the futures market to buy or sell their product at a price that may change before they are ready to actually buy or sell. The contract helps them offset a movement of prices which could be detrimental. If a Hedger's concerns are that a commodity price is going higher, and he will need that product in the future, he will buy or go long. If instead he is worried about the price dropping further before he is actually ready to sell, he sells or goes short. When it is time to actually buy or sell his product he usually closes out his futures position. The difference between what price he paid on the futures market and what price he closed his position is his profit or loss, which hopefully offsets what the actual market price is. At the worst he has minimized his loss by having the insurance of a set price at which he bought or sold. Many Hedgers further protect themselves with their use of Options contracts. Once people understand the Hedger's need for the insurance the future's market gives, they are more accepting of the Hedger.
Not so the Speculator and by the almost hysterical rhetoric we hear, they reserve their full ire for that wicked speculator. Both politicians and others make statements such as, “Speculators have no actual business affected by fluctuating prices so why are they even allowed to participate in the futures market? The government should do something! It should regulate prices, ban speculators, put in more regulation. Just do something!” The profound ignorance these remarks exemplify is frightening. If only they understood!
The Speculator, the Risk Assumer, is critical. If the market only had hedgers participating, it would be a “thin” market and much more volatile and irregular. A few markets, over time, have lost their speculators. With the loss of liquidity and without the constant adjustment of price action to reflect the cash market which the Speculator's trades give, the particular contracts withered and died. Thus the Hedgers who produce or use that product lose as they have no method to offset their risk.
Speculators can buy as well as sell, just as Hedgers can. People, though, rarely notice when prices are falling. They usually scream (and the politicians join in) when prices rise, but here is the truth. Speculators cannot force the prices up or down. Speculators do not last if they fight the trend. If the world-wide fundamentals are not in synch with their position few Speculators can afford to hold losing positions, as they must constantly add margin money to their account. There are too many people: producers and consumers, buyers and sellers, suppliers and consumers all over the world, for speculators to affect the price for long if they are on the wrong side of a trend.
This is immensely oversimplified, but my purpose is to defend the function of the Futures Market as an exchange that provides insurance for businesses which produce or consume products or have an exposure to foreign currency, interest rates, or other financial instruments fluctuations. The much maligned Speculators provide the cushion of liquidity that is essential for the Hedgers.
At this time, the amount of bureaucracy and misinformation, particularly in the petroleum industry, is immense. We now have constantly improving horizontal extraction processes which did not even exist a few years ago. Greater production eventually means lower prices. Unnecessary regulations suffocate and abundant red tape limits exploration, drilling and production. Some of the fallacies that need to be undone are the old, largely discredited ideas of “peak oil” and the related thinking of it being a “fossil fuel” and an unrenewable resource rather than an abiotic product. These and other false assumptions have determined the basis for detrimental administrative rules. These ill conceived ideas are limiting people of the benefits and availability of petroleum products.
As equally damaging are the economic fallacies:
- Speculators are evil and must be eliminated from trading.
- Profits are excessive.
- Oil companies get too many tax breaks.
- Prices are too high.
People who want to uphold facts and who think logically need to counter these erroneous and damaging ideas by countering that:
- Speculators are necessary for market liquidity.
- As long as earned honestly, profits cannot be excessive. (Though profits in the petroleum industry have improved, it still has lower profits than many industry sectors).
- Petroleum companies get no special tax breaks.
- Prices are simply signals telling us to produce more or less. The only answer to high prices is flexibility for those who produce.
Speaking carefully and honestly about a great and necessary industry, knowledgeable people need to speak up and advocate instead that Congress cease abdicating to the entrenched bureaucracy:
- Remove the impediments to production and prices will fall.
- Remove artificial supports on all products and the market will operate in the realm of reality.
- Eliminate the Federal Reserve monopoly on money and prices will accurately reflect current values.
Most important, however is a moral position:
Seek peace and trade rather than indulge in bellicose threats, murder by drones and interference in other nation's affairs. Perhaps more important results will be achieved than just a lower gas price.
Image Credit: CC BY-NC-ND 2.0/Shell