Posted by: bmeverett | April 20, 2012

Speculators don’t set oil prices


Washington, as we all know, is an intensely political town. Truth in our nation’s capital has a purely political meaning. Everywhere else in the world, two plus two equals four. In DC, the answer to that and every other question is determined by focus groups.

President Obama, under pressure from Republicans over rising gasoline prices, proposed new steps this week to limit oil market manipulation. His proposals have no connection to the actual mechanics of the oil market, but I’m sure his campaign advisors tell him that they will play well with potential voters.

Let’s start with basic economics. Prices are set by supply and demand. Speculators can have a impact on prices if, and only if, they buy and hold the product, hoping to sell later at a higher price. We have seen this type of action in the past. In 1979, William Herbert and Nelson Bunker Hunt attempted to corner the silver market by buying and holding half the available silver supply. The Hunts succeeded in pushing prices up from $5 per ounce in 1979 to over $50 within a year or so. When the federal government stepped in to tighten the margin rules, the Hunts and their backers couldn’t come up with enough cash to cover their obligations and filed for bankruptcy after losing about $1 billion. The price of silver collapsed.

President Obama thinks that the oil market is being subjected to a similar “corner.” In his remarks, the President said, “We can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage and driving prices higher, only to flip the oil for a quick profit”. The oil market, however, doesn’t work this way. Buying silver is expensive, but storing it isn’t. The world’s daily production of silver would fill a box about 6 feet on a side. Oil, on the other hand is very expensive to store. The world’s daily production of crude oil would require a cube about 800 feet on a side – about three times the volume of the New Orleans Superdome. Finding and financing enough space to take a significant amount of oil off the market is very difficult. As a result, markets have come up with a very different mechanism for trading commodity risk – the futures market.

Futures markets do not require speculators to buy the commodity. Instead, they just make a bet on whether the price will rise or fall. In order to be meaningful, these bets must be backed by a right to receive or an obligation to deliver the product, but that almost never happens. The transactions are entirely on paper.

Every bettor has to have a counterparty. For example, Kansas played Kentucky in the NCAA men’s basketball final. You could not bet on Kentucky unless someone else was willing to bet on Kansas. Kentucky was favored to win, so at even odds, few people would have been willing to bet against them. The system therefore requires a mechanism to equalize the probabilities of winning the bet. Basketball uses point spreads. Bookies will increase the point spread until the number of dollars betting on Kentucky to win is equal to the number of dollars betting on Kentucky to lose. Just before the championship game, Kentucky was favored to win by 6½ points. In other words, a bet on Kentucky would lose unless Kentucky won by 7 points or more. In fact, Kentucky won by 8 points. (Please note that the number of bettors doesn’t have to be equal, just the number of dollars bet.)

The total winnings from betting on the Kentucky-Kansas game was approximately ZERO. In fact, slightly less than zero, since the bookies take a cut. Bettors as a group had no common interest in who won the game. No matter the result, an equal number of dollars would change hands from losers to winners.

The oil futures market works the same way. On Thursday, April 19, the price of US Light Sweet Crude for May delivery is $102.27 per barrel. If you buy a futures contract at this price, you are betting that the actual price of oil in May will be higher than $102.27/B. If the actual price turns out to be $103.00, you make $0.73/B. If the price turns out to be $100, you lose $2.27/B. No oil changes hands.

If most people believe that the price of oil is likely to increase dramatically in the next few weeks, the price of the futures contract will increase until the betting is even on both sides. Like basketball bettors, oil speculators have no group interest in the outcome. Whatever happens, some speculators will make money and some will lose. The net proceeds from the entire system will be zero, less the transaction costs of buying the futures contracts (the bookies’ cut).

The President doesn’t seem to understand this. In his remarks, he said, “We can’t afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick.” Oil speculators are buying paper, not oil. We’re talking about betting here, not the Hunt Brothers. Speculators as a group always lose money, just like Las Vegas roulette gamblers as a group always lose money. Gamblers gamble not because it’s a winning business but because they think they can beat the odds.
It’s understandable that the President and his Republican opponents want to appear to be “doing something” about high gasoline prices. The only thing politicians care about is getting reelected. Consumers, however, care about what happens in the real world. The best thing our politicians can do to help is to get out of the way and let the market work.

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