Economics of 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.
18 Comments:
Q: What's could be so beneficial about speculators trading in oil futures, ... ?
Nothing. They play with forces that they see as mere numbers. The problem is when they don't understand that those numbers have huge social costs. These are not traded on Wall Street.
This article only provides more reason to clamp down and fast. When they complain about not being able to impersonate a higher power, go only to drop oil to $50-80.
sethstorm,
What exactly would you "clamp down and fast?"
Maybe crude oil prices?
How can you unnaturally regulate oil prices to $50 to $80 without supply shortages?
It's seems pretty obvious that when the media or politicians use the term "speculator" it is a synonym for "bogeyman".
If you actually probe on what it is they think "speculators" are doing they either have no idea or make a simplisitic argument like:
"They buy futures, which makes futures prices go up".
Dang, that is easy money.
But who sells them the futures?
How do they realize their gains without driving the price back down?
What would we expect to see in the physical market if speculators in the paper market had driven price above what supply-demand fundamentals would support? And are we seeing that evidence?
walt. g said:
"How can you unnaturally regulate oil prices to $50 to $80 without supply shortages?"
sethstorm's mind:
"Umm...hmm...ughhh....reasons too complex...brain overloading.....fuck it! I am CLAMPING DOWN!
Screw logic
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Screw reason
.
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TIME TO CLAMP DOWN!"
It seems like people always want to blame someone instead of addressing problems. In fact, sometimes the problems are only short-term and actually in our best long-term interests (possibly like high oil prices?).
It’s much easier to blame teachers’ unions for poor education, foreigners for job losses, greedy corporations for high prices, or oil companies for high oil prices than it is to understand the perceived problems as natural dynamic forces at work. Where events can be changed for the better, dealing with the root causes of problems—such as child poverty in education—will provide much better results than looking for scapegoats.
Educating ourselves and dealing with a changing world will go further toward a fulfilling and happy life than worrying about unsolvable problems.
To repeat a prevailing theme that this blog owner often states—we really do have it pretty good today. I wouldn’t trade now for anything we ever had in the past.
Ask them tougher questions than all of the previous sessions. Base the regulation on the results of that questioning. Ignore any token decreases (such as the one during the talks) and welcome decreases that are in good faith(towards the goal).
Second, remove the "in-the-way" environmental regulations.
Third, the $50-80 target is meant to keep people from just setting it at $79.
Fourth, be waiting for them at the exits when they wish to go off-jurisdiction. If they already have left for the exits, make sure they can do nothing here.
thanks for the great post professor.
another benefit of speculators is that they transfer risk from producers to themselves. in agriculture, farmers can get a fixed price for their crop now (say at planting time) by selling futures contracts. same for companies that use a commodity. they can lock in a price by buying a futures contract.
but i have a question. what if speculators are massively wrong? say they think that prices are going to be higher in the future (but the actual demand > supply really won't be there). so their buying of futures raises the spot price. at what point does this correct? what are the dynamics of this?
People often use the term "speculator" and "manipulator" interchangeable nowadays, and I've seen some of the comments confuse the meaning as well.
The hypothesis of many is that inflation expectations and instability in the middle east has caused a large number of speculators to believe oil prices will go up, and thus buy futures at ever-increasing prices.
This is more harmful than the inflation of your typical asset bubble, because people actually need to buy oil and use it, and the price has been driven up by speculators/investors/people not actually using the commodity (usually people only complain about asset bubbles when they burst).
There could be an oil bubble without any conscious market manipulation on the part of anyone. Blaming speculators as immoral is stupid, because they aren't colluding. And no individual is doing anything immoral, because no individual party is controlling market.
If it's true that institutional investors holding large amounts of oil are driving up the price, imposing holding caps at a level which wouldn't affect most hedgers would be the solution. If those caps are instituted, and the price drops, then we'll know it was a bubble. If the price doesn't drop, then we'll know it's supply and demand.
When speculators bet wrong they lose money. That's a self correcting feedback loop there. Part of a free market.
Sethstorm, your "answers" require a totalitarian and econonomically unenlightened government. Sort of like Mugabe and Zimbabwe.
If it's true that institutional investors holding large amounts of oil are driving up the price
There is no evidence that individuals are buying large amounts of oil. Inventories are flat to shrinking.
Speculators these days generally buy paper contracts. This requires someone to be selling the other side of the paper contract. There is no net length in paper markets. Nor any net profits.
Paper market prices are linked to physical market prices, but if there is a "bubble" that is not supported by suppy-demand in the physical market what should happen?
Well, what does page 5 of any basic economic textbook tell us happens when price is at a level above the economic equilibrium?
More willing sellers than buyers. Expanding inventories, etc.
Any evidence this is happening?
sethstorm,
Who is asking “them?” The U.S. Congress asking the large oil companies? Neither one sets the price of crude oil. Even if they did, how would you assure an amply supply of oil at an artificially low price? Would you fell better having 0 gallons of $2 gasoline?
If it is such a good idea why don't we speculate and future trade everything. Most people and companies buy what they require at the current price and the market corrects itself in current time.
Who is asking “them?”
Yes, I am referring to Congress, and most likely the next one. It would include the speculators as well as the usual suspects. Ask them what can be done on their end other than "nothing".
All of this can be done without looking like "some other country".
Didn't you demonstrate a large disparity between sport prices and future prices for oil?
Why does such a large disparity outside of the carrying cost exist?
Any ideas or explanations?
Seth:
You have no clue what you are talking about. You don't cite one single thing as evidence or counterargument to justify your absurd, unfounded, and senseless claim.
By all signs, you clearly don't even grasp anything indicated in the article, particularly when you claim "This article only provides...": the statement that follows makes no sense of any kind. Either you can't express your idea with the slightest semblance of competence, or you can't formulate your idea with any semblance of competence. Either way, your expression of opinion has no value.
> It’s much easier to blame teachers’ unions for poor education, foreigners for job losses, greedy corporations for high prices, or oil companies for high oil prices than it is to understand the perceived problems as natural dynamic forces at work.
Well, you screwed up the whole thing by including teachers' unions in that, walt.
THEY aren't boogeymen. The rest of them are, yes, but Teachers' Unions are second only in political clout to the AMA, and the difference is, people don't dislike teachers as a group, unlike doctors. So, along with the "Hey, it's FOR THE CHIIiiillllldreeeeeeen" mantra, they manage to pawn off all manner of BS onto parents and the taxpayers. The taxpayers and parents of children are notably in the majority in wanting to reform a broken system. But every effort to do so is shredded by the Teachers Unions. If the UAW had the kind of power that the NEA regularly exercises, we's all be driving Trabants (i.e., an example of a screwed up system which wasn't doing it's job in the leastwise effectively -- you know, like the public schools.).
> Educating ourselves and dealing with a changing world will go further toward a fulfilling and happy life than worrying about unsolvable problems.
One has to hope that the school system doesn't classify as an "unsolvable problem", considering that we're spending something like 8k and more a year to teach these kids. I think *I* could take 20 of them at random, along with 160k, and manage to teach them a hell of a lot better than the current system. They used to have such a system, it was called "the little red schoolhouse" -- and it didn't cost anywhere near 160k (in constant dollars) per class of 20 to make it operate. Even with greatly increased teacher salaries, you could get a class working for a lot less.
So it's not like we don't have models of systems that do work. (there are plenty of other examples of workable systems, but that one, pretty much *everyone* knows how it works and that it did)
> There could be an oil bubble without any conscious market manipulation on the part of anyone.
Correct.
Always remember
Hanlon's Razor:
Never attribute to malice that which can be adequately explained by stupidity.
Assuming they are wrong about the price, then it's stupidity, not greed, driving it.
> Sort of like Mugabe and Zimbabwe.
...And hey, wouldn't we ALL like to see 5,000,000% inflation ??
> There is no evidence that individuals are buying large amounts of oil. Inventories are flat to shrinking
Not to disagree with the general trend of this discussion, but wasn't there something recently, perhaps here at CD, about a shortage of available tankers because some part of OPEC (Saudis?) were using them as storage facilities for oil, having filled up all their land-based tanks?
Not swearing to that, but I thought I read that somewhere -- so take it with a grain of salt unless someone confirms it with a link.
If that is true, there may be forces driving up the price by holding supply off the market, but I don't believe that classic "speculators" are doing it. That would be more like OPEC doing it.
> Would you feel better having 0 gallons of $2 gasoline?
Walt, there are certainly some eco-crack-smokers out there who would certainly like this. Forget the price, just focus on the zero.
(Not suggesting seth is in any way associated with that misanthropic bunch)
> If it is such a good idea why don't we speculate and future trade everything.
This happens far more than you actually grasp, it's just done a lot less overtly. Why do you think it's almost impossible to find a heater at Wal-Mart right now? Why do you think that Wal-Mart doesn't stock fans in January (even in Florida and the Southwest!). The people who arrange those contracts are "futures" trading, in essence. They are saying the need for fans in January is so low that they aren't going to try to fill it.
> Yes, I am referring to Congress, and most likely the next one. It would include the speculators as well as the usual suspects. Ask them what can be done on their end other than "nothing".
Well, seth, in actuality, there are three things which they can do, other than "nothing".
1) They can screw things up
2) They can fuck things up
3) They can turn the whole thing into a massive clusterfuck.
Get the point? The system works seth. You can't tweak it, you can't crank the magic handle and make it run differently. There's no one out there (well, short of God) who has the ability to turn the magic handle. And he doesn't seem to be overly inclined to do so just so that we can have cheap gas, despite the fact that there is concern (right or wrong) that supply is inadequate to meet demand.
You don't grasp in the slightest way the function of prices in the economy
Your mission, seth, should you decide to accept it, starts here:
Economics for the Citizen
by Walter E. Williams
and, although it has nothing to do with this specific discussion, this is also of substantial value:
The Nation That Lost Its Jobs, But Got Them Back
by Gene Callahan
Most of what classifies as "Economics" can be -- literally -- astoundingly counter-intuitive. It's one of the reasons that it's still far from a true science:
The Swartzberg Test
The validity of a science is its ability to predict.
Economics, like Climate, is a science in its infancy. The topics are both of such a degree of complexity and subtlety that we are just now really gaining the ability to do more than just make vague statements about how they operate.
This blog comment will self destruct in 60 years. Step back from the monitor before this event occurs.
.
I agree with all the free marketers. There is far too much socialism going on in this country, and it is precisely because of the government intervention and regulation that we get abnormalities in the market place.
For years since the oil pipeline from Alaska, environmentalists have ruled the day, and with their willing accomplices, the politicians, have practially shut down the oil industry in this country forcing us to import it from other countries. These are the same people who want to create jobs, and yet they kill opportunities for jobs in the petroleum industry. Ever wonder why? Because they are not GOVERNMENT jobs.
Most recently, Democrats are proposing to nationalize the oil industry like Hugo Chavez did in Venezuela. So we want the same bureaucrats running our oil as we have running the post office or the passport office? You've got to be kidding. That is not what this country was founded on. If you want that kind of country, move somewhere else.
The Editor
www.FedUpNetwork.com
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