Sunday, July 13, 2008

Oil Price Hikes Not Due to Speculation?

Slate's Underground Economist columnist Tim Harford has an interesting article, contrarian as usual, called "The World Needs More Speculators: Stop demonizing the investors who are betting heavily on oil prices."

Harford makes a case that speculation is not to blame for the run-up after all. Makes sense to me, but what do I know? Maybe our wanker/banker will comment...


drooga said...

sadly, harford misses the real point - he uses the old truism about speculators being beneficial from their liquidity providing behavior, but misses a more interesting observation.

to explain that, note that 'speculation' on oil prices occurs in commodity exchanges via futures - that is, a contract to buy/sell a given amount of crude at a fixed price on a given date IN THE FUTURE.

the point is that these contracts are supposed to provide price insurance for buyers and sellers of oil - for example, if the three month future crude oil price is $140 and you, the oil producer, find it profitable to sell the oil you know you'll have in three months at that price, then you sell crude at $140 for delivery in three months. conversely, the buyer agrees to take delivery of crude at $140 in three months.

now here's the rub: only a tiny fraction of these future contracts actually result in physical delivery of oil from seller to buyer. what that means is that most futures are simply people - speculators - placing bets with each other on what the price of crude in the future is going to be.

and that is an important point: for every speculator who buys oil at $140 for delivery in three months is a speculator who sells oil at $140 for delivery in three months. the buyer bets crude is going to be greater than $140 in three months, the seller bets its going to be lower.

the bet isn't settled by actual physical delivery of oil, but settled by the actual price in three months. for example, if the buyer bought one barrel of crude for $140 for delivery in three months and the price of crude turns out to be $150 in three months, then the seller pays the buyer $10.

so whats really going on is that speculators are all placing bets with each other on exchanges and then settling up with cash payments. the insurance feature of futures is subverted to the animal spirit of taking a bet.

as an analogy, think of the betting that takes place when the lakers play the celtics. nobody would dream of saying that the odds offered actually influence the game. now the analogy isn't quite perfect - of course future crude prices influence the oil market. but the point is that they are not the game.

the real game comes from the longer term contracts struck between crude producers and crude consumers.

Jim Leff said...

So oil prices ARE due to speculators? :)

drooga said...

no, no, no!

i said it badly - but the point is that speculators at best marginally influence the price of oil.

speculators are merely taking side bets, which they settle in cash and not actual deliveries of oil barrels. and for virtually every speculative dollar betting the price of oil is going up is a speculative dollar betting that it goes down.

speculators are as irrelevant to the crude price as the side betters are to the actual outcome of a lakers celtics match.

Jim Leff said...

Ok, got it. I got and liked your Lakers/Celtics analogy in the first comment, but wasn't sure if you'd doubled back or not.

I always enjoy your explanations, though I seldom emerge convinced that I fully understood them!

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