Tuesday, March 6, 2012

On Speculation

I think I've done a post like this in the past, but like the seasons, we can count on people complaining about 'speculators' when the prices of commodities increase. The most recent eruptions is in the area of gas prices, but recent there have been complaints about speculators coming from European governments with falling bond prices. This is sort of telling: prices are going up? It's speculators! Prices are going down? It's speculators! My word, what can't speculators do?

First, let's define our terms. There are basically two participants in 'wholesale' commodity markets: those who have a productive interest in the commodity, and those who do not. In oil markets producers include those firms that extract oil, the refiners, and the marketers (i.e. gas stations). Speculators are those participants that are unrelated to the production of oil in any way. Essentially, speculators are making a price play. They are betting, hence the name, that the future price of the commodity will be either higher or lower than it currently is.

To avoid confusion, in this post I'll focus on spot markets and not futures markets. Thus we have a market in which firms produce crude oil and sell it to refiners and the refiners in turn sell the refined oil (e.g. gasoline) to gas retailers. Of course, crude oil is made into many products, so the above is just an example. But people are interested in gas prices, so here's a graph of the average price/gallon in the U.S. for the past 6 years.

The claim is that speculators cause prices to go up too much. I'm not sure how one defines "too much." But anyway, let's think first about how prices are formed. We know from basic economics that the market price will be at the intersection of market demand and market supply. A positive shift in the supply curve, due to finding new wells for example (e.g. Bakken reserve) will lower the price of oil which eventually tends to lower the price of gasoline. Better refining technology can reduce the cost of making gasoline, so the acceptable market price to suppliers can be a bit lower due to technology improvements. Of course demand has effects too. An increase/decrease in demand will raise/lower the price of gasoline.

By inference, the complaint against speculators in this case must be that they are increasing demand (buying) or reducing supply (hoarding gas). It's not clear though why all speculators must be on the same side. Consider the producers; oil refiners want to sell, so they need buyers. Gas retailers want to buy wholesale gas, so they need sellers. Why wouldn't some speculators be on each side, each thinking that the future price will move in favor of the speculator (up for buyers, down for sellers)?

One of the curious effects of higher prices is that more people want to sell. So think about speculators focusing on the buy side, and let's say speculators are large enough to actually affect the market price (this is highly debatable). Then the short-run prices will increase. The effect of this price increase will be that suppliers will bring more gas to market thus putting downward pressure on the gas price. And if gas prices are high enough for long enough, there is incentive for suppliers to produce more from existing wells and seek more wells to bring supply up even more and take advantage of the prices. So what have speculators done in this case? They have cause an increase in oil supply. If you think that's wrong, then you have to explain why firms aren't interested in maximizing revenue.

What about speculators on the sell side? This is pretty rare in the spot market. It requires gas hoarders (previous buy side speculators) to start selling. This may have a downward effect on gas prices, but such a downward effect may lead to increased demand as people drive more due to lower gas prices, and this will then lead gas prices to climb back up.

Thus it's not at all clear the speculators have any kind of lasting effect on the market price of gas. But that just means speculators don't do any lasting harm. Are speculators helpful in any way? In fact they are.

As Murray Rothbard shows in Man, Economy, and State, speculators speed up the arrival at the market equilibrium price. So that in itself is positive - it reduces search costs of finding the equilibrium and smooths trade. Speculators also provide a ready buyer for oil producers, and a ready seller for refiners or retailers, since speculators don't want to actually hold the oil or gas as a physical asset. Thus they reduce search costs in this way. And, it tends to be a lot of the same people who are middling the asset, so it's entirely probably that refiners are relying on relationships with speculators to move the oil.

And the occasional people who jump in to do some betting now and then? I think it's extremely unlikely that there is a large enough group of such people to actually move the price of oil. After all, U.S. oil production is 5.5 million barrels per day. At an average price of $107/barrel (2012 WTI crude price average) that's $588.5 million per day being produced. Really think that's an easy market to affect?


  1. One of the curious things is that when I hear folks blame speculators for high prices, and I ask them to explain oil speculation, they can never quite tell me how it works. Hence, they are simply relaying what they hear on the evening news.

    So, more learning here. Speculators take a long position in futures contracts, betting that the price will increase before the contract expires. They then sell the contract at a profit (or loss if the future price moves down). Like you said, it would take lots of folks doing this (on the buying side) to materially affect prices, especially for the long term.

    This is a risky endeavor as prices of commodities can swing wildly.

    1. In the futures market, for every long position there is a short position. Derivative markets are a zero-sum game. So the price pressure from one side is matched with price pressure from the other side.