Monday, June 16, 2008

Economics of Futures Trading, Part I

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 rising because super-star executive talent is scare 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 pass laws that 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 pass "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

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 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, or 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, 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 to follow.

8 Comments:

At 6/17/2008 1:03 AM, Anonymous Anonymous said...

Exxon Mobil, 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?

Anyone that knows how to do this would be a fool to explain it in a public blog.

 
At 6/17/2008 3:42 AM, Blogger OBloodyHell said...

> Think about it - Exxon Mobil, 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?


MAGIC!!!

It's all .... MAGIC !!!

And those EEEEEEvil HalibushMcBurton wizards are
KEEPING IT ALL TO THEMSELVES!!!

Hey, that's really the way libtards think
(if "think" is the word, granted).


But actually, it's just,
plain old
everyday
magic
(the world is just too strange and wonderful a place for libtards to actually appreciate without... MAGIC !! ).


:oP

.

 
At 6/17/2008 8:23 AM, Blogger rufus said...

Magic aside, the fact is when you buy at the "spot" price, you OWN it. NOW, you have to STORE it.

So, other than Iran storing some heavy, sour crude that they can't sell (because, the world's short on refining capacity for this stuff) in old tankers, Where Else is All This Oil being Stored?

 
At 6/17/2008 9:25 AM, OpenID sethstorm said...

No problem with the issue on gouging legislation's existence. It just needs an inescapable jurisdiction - the federal level. Also needed is it to automatically kick in and not be dependent on someone to activate it.

 
At 6/24/2008 6:34 AM, Anonymous Anonymous said...

Refineries are not running at full capacity now so Iran can definitely sell its oil. I would rather think that Iran is storing oil to keep the price up and by that avoiding war with US.

 
At 6/28/2008 11:36 PM, Anonymous Anonymous said...

The argument is sophistry. It's like saying, "barracudas can bite you, therefore sharks are harmless."

In reality, the market will respond to pressures without speculators, but might respond even more to additional pressure with speculators present.

Why would someone make such an argument? To throw people off the scent?

 
At 9/07/2008 5:22 AM, Blogger Nasir said...

The speculators are bidding the price up by increasing artificial demand. The real demand even though has gone up over the years has not increased as much if the speculators were not involved.

Where before there was only one player in the futures market (i.e. NWA) now there are two. So when two players are fighting for this one future, the seller is going to increase its price. Where only one is going to take the physical delivery of this product but he has paid a higher price than if he was the only one in the market.

Yes, the market will correct itself down the road as the speculator is just going to sell that product to someone actually taking the delivery at a loss. But, in the short term the price has risen for the end consumer and the end consumer is not holding any futures where the current prices he is paying is going to offset with lower prices in the future as these prices will never decrease below the previous cost. The profit will sit within the company and will not be suddenly be passed on to the end consumer (as it is the case now with such a decrease in price of crude oil not decreasing prices at the gas pump at the same rate).

 
At 7/08/2010 11:10 PM, Blogger SR said...

Nasir,
Is it your view that users of a commodity should not be able to insure against future price fluctuations? They should not be able to buy insurance which is really all a futures contract is? If users can buy insurance, in a free economic system, why shouldn't futures speculators?
Who decides?

 

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