A few months ago, when oil prices (at least here in the US) were through the roof, and there were a few reasons given why, one of them was that oil speculators were driving it up. So, in a college class about business procedures, I asked, and most people said something along the lines that the speculators bought oil cheep, held on to it, and then sold it for a profit. That didn’t make much sense to me, so I Googled it, and some sites that I looked at said that they by and sell stock in oil companies.
OK, that makes more sense…but…how would that drive up prices?
So, anyway, even though prices are down for the moment, and oil speculators haven’t been talked about in the news for a while now, just what did they do, and how did it, or how was it supposed to, drive up oil prices?
Oil speculators buy futures contracts. If oil is $50 a barrel today, they may buy X gallons of oil at $50, to be delivered next month. Their hope would be that gas is $75 a barrel next month so they can make a profit. They usually don’t intend to use the product but you could also say large companies, such as airlines are also speculators, as they want to buy a lot of fuel when it’s cheap. Heck, gas stations are speculators as they also try to buy when it’s cheap, for obvious reasons. The economics are beyond me, but it seems all the anger toward them is misguided.
Airlines are some of the biggest investors in oil futures for precisely that reason – they want to be able to predict their costs ahead of time so they can run their business. Even if prices go the opposite way from what they thought and they lose money on the futures, there’s still value in being able to know exactly how much fuel for February will cost in December.
That said, the majority of futures transactions are not done by people who intend to actually take delivery of the product, but those that expect to make a profit by predicting price fluctuations.
If I paid $50 in June to have a barrel of oil delivered to me, for argument’s sake at my house, on January 1, then I can resell that contract to someone who actually wants the oil. If oil is selling for $70 a barrel (the “spot price”), I can sell it to them for that amount or slightly less, and I’ve made around $20 for holding that contract.
Ahhh, gotcha. Oil speculators are almost like a middle man between the oil shippers and buyers. It’s almost like buying oil directly is like buying from a wholesaler, and buying from a speculator is like buying from a retailer, although in this case, it might actually be cheaper to buy from the retailer than the wholesaler.
Retail manufacturers, wholesalers, retailers and buyers form a more or less linear supply chain. Once a shirt or jacket leaves the factory, each step is a “value added” that increases the price until you see it for whatever it costs your local Gap or Banana Republic.
Oil is a commodity. They sort it into different grades according to it’s chemistry, but for the purpose of this conversation, let’s just pretend oil is oil.
The price of oil fluctuates with various factors like the economy or seasonal deamand. Companies like airlines or energy companies that use a lot of fuel may wish to reduce some of their fuels costs by buying when prices are low. So for example, in the spring when (I assume) fuel costs are lower, they would buy a lot of fuel now. As fuel doesn’t really keep, they would agree to take delivery during the winter months when heating demands drive costs up. The people who do this are called “hedgers” and the agreements are called “futures contracts”.
Hedgers are different from speculators in that they are actually receiving the oil for business purposes. “Speculators” aren’t looking to actually receive the physical commodity. They look to make money through changes in the price of oil or inefficiencies in the market through the buying and selling of contracts.
It’s not quite that simple. You’re ignoring the cost of carry.
This past week there was a big spread in the expiry oil contract on the NYMEX vs. the next month. The Jan. 09 contract expired at $33.87/barrel. The Feb. 09 contract went out at $43.10. There’s risk free profit. But, there’s such a glut of supply right now at, that difference is the cost of storing oil for that amount of time.
If you’ve got space for 100,000 barrels of oil, go but an oil contract on the NYMEX. Free money!
It’s not just oil, either. Look at the commodities market. You can buy futures on oil, natural gas, heating oil, lean hogs, cattle, etc. Obviously you don’t need to live on a farm to take delivery of them; you sell them to someone who actually wants them, hopefully at a profit…
Here’s a video of CNBC reporter Rick Santelli trying to explain that the run up in oil, if due to speculation in the futures market, would have shown massive price shocks in the near contract as it approached expiration. I’m no expert, but I can’t see the flaw in his logic.
I don’t think the comparison is apt. Onions are used purely by choice. Sure, I love onions mixed in with my stir-fry, but if they are 10 bucks a pound then I will just go without. I can’t go without gasoline in my car.
Plus, percentages with regards to onions are small anyways. 75 cents a pound to 3 dollars a pound is a 400% increase, but I would bet that only the smartest shoppers would even know what the prevailing onion rate is…
I’ll just toss in my 2 cents in case it isn’t clear yet. Speculation is the attempt to make a profit from a difference in price. It doesn’t have to be a futures contract at all- that’s just one way of doing it. I can speculate on real estate too if I decide to go bargain hunting so that I can sell it for more money later on. The key ingredient to speculation is that the speculator wants to make a profit without using the good or service at all.
So why does that affect prices? Because it creates “false” demand. As we all know, the more demand there is for a good, the higher the price will be for it. Well if I’m going to speculate, I need to buy the good first. To the market, it looks like demand, but I’m not actually going to use the product. In oil’s case, I don’t plan to take delivery. In real estate, I don’t plan to live in/rent/improve the property.
When we see prices jump in oil or housing, for instance, a lot of people are drawn to speculate that the price will keep going up. No one tries to speculate on a sinking ship or a stock that isn’t very volatile, after all. That forces an already rising price to keep going up.
But what does the aftermath look like? Eventually, other speculators stop jumping in. That removes the “false” demand. Some unload their stock/property/commodity. Others hold on to it too long and suffer for it. The price of the good, with no more demand and a flood of supply (since no one used the good), plummets.
Essentially, speculation is a pyramid scheme that builds a house of cards. Eventually, it all comes crashing down and you witness the current housing and oil prices.
I wasn’t trying to draw attention to the utility of oil vs. onions. I wanted to make the point that the price of onions was driven up in the same way, in an even more volatile fashion, than was the price of oil. This happened in the absence of a futures market.
Also, the nominal value of a good makes no difference when talking about percentage moves. If you were an industrial producer/consumer of onions, a 400% increase most definitely would impact your business.
What of the people shorting oil on the way up? For example, this Kansas oil company, SemGroup LP, that went bankrupt speculating oil would go down.
Now that oil is down, at what point will we hear outrage about people shorting oil all the way from $140 to $30?
False. Speculators usually operate on both sides of the market. Housing is perhaps a counter example. It was difficult for the average person to step in and short the housing market.
To quote Leo Melamed, Chairman Emeritus of CME Group:
Well, yeah, but the OP asked about oil speculation driving up prices. I wrote a paragraph on shorting but deleted it in an attempt to keep it a 101 lesson. I didn’t want to say bid/ask and see heads asplodin’.
Active speculation just makes a commodity market more volatile. Right now it is hard to predict the oil bottom. There are a lot of speculators who are trying. Once they purchase it they wait for it to go up and they make money. However sometimes you can not wait. Sometimes you have a date where you have to unload it no matter. Sometimes you just have to cash out.
