On Speculation

Well it looks like the nitwittery about oil speculation has started again. Some people are blaming the current high price of oil (and therefore gasoline) on oil speculators. Speculators make a handy scapegoat, but does this argument hold water? Or oil?

The argument, as far as I can tell, goes something like this:

A) We observe relatively high prices for oil. This is always in nominal terms.
B) We say that such high prices cannot be explained by fundamental factors like shifting demand and supply curves.
C) Therefore, it must be those dastardly speculators!

This is poor logic at best. First, is crude oil relatively expensive right now? You be the judge.

Second - where is the analysis to back up the conclusion in B? I see very little. The action in the middle east is unsettling and that can disturb oil production leading to a leftward movement in the supply curve - less supply, same demand equals higher prices. Also realize that domestic (U.S.) oil production is curtailed by regulations. If supply remains pretty stable in general, then occasional shocks make a big and noticeable difference. Also, demand drives price changes in such a case, which results in seasonality in oil and gas prices.

Third - speculation is widely misunderstood. Apparently the fear about speculation is being generated by action in the futures markets. Now, on the 15th of March, WTI quote for light sweet crude was 97.23/bbl. Futures prices from the Chicago Mercantile Exchange are here. The prices are all /bbl, and the volume and open interest are in contracts. Each contract is for 1000 barrels. Volume is the number of contracts traded, and open interest is the number of open contracts at the end of the trading day.

As one can see, this is a very active market. What's critically important about the futures world is that for every buyer there is a seller. In other words, for every contract there is equal buying pressure and selling pressure. So the idea that speculation should necessarily lead to higher prices is already suspect.

If I am long a futures position (meaning I promise to buy crude oil in the future) then that means I think spot (the price for immediate delivery) crude prices in the future will be higher than the price I can lock in today. Oil users like to lock in prices today and eliminate the chance of having to pay those higher prices in the future. At the same time, they eliminate the change of paying a lower future price. That's risk management.

If I am short a futures position (I promise to sell crude in the future) then that means I think spot prices in the future will be lower than the price I can lock in today. Oil producers manage risk using such contracts to lock in a certain future sales price, at the cost of not getting happy surprises either.

The speculators are those who do not have an underlying interest in the commodity (oil). Thus they are not producers or users of crude oil. They do serve an important function though - they provide liquidity to the market. If it was just hedgers, getting prices in small increments and a lot of dates would be more difficult, resulting in unwanted exposure.

Keep in mind a few factors that are also in play right now: most central banks are creating money, which has inflationary effects (although not uniform); China's industrial base continues to grow, along with their consumer base - thus the demand for oil is continually shifting outwards; the supply of oil is also shifting out, but much more slowly than demand. These factors, fundamentals really, have a much greater capacity to explain oil and gas prices than speculation in futures markets.