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Source link: http://archive.mises.org/8327/speculators-are-part-of-the-market/

Speculators are Part of the Market

July 24, 2008 by

In a July 21, 2008 column in the Jewish World Review with a shouting headline of STOP OIL SPECULATION NOW!, Dick Morris and Eileen McGann argued that the government should take action to restrict trading in futures markets. They are mistaken, however, in their assessment of oil speculation. Speculation is an important part of the supply and demand process.

Futures markets are markets in which people trade the right to specified quantities of a specified commodity to be delivered at some point in the future. For example, one might be able to buy or sell a contract whereby the seller agrees to deliver a barrel of crude petroleum on December 1, 2016 at a price of $150. Traders who believe the price will be below $150 per barrel should sell such a contract. Traders who believe the price will be above $150 per barrel should buy such a contract.

This has important implications for how resources are allocated across time and space. The price of oil today and the price of oil in the future will tend toward equality after we adjust for the time value of money (one dollar today is worth more than one dollar tomorrow, so anyone who wants a dollar tomorrow will have to pay interest). According to what economists call the law of one price, the discounted present value of oil today will equal the discounted present value of oil tomorrow, all other things remaining equal.

It is the fact that all other things do not remain equal that produces profitable opportunities for speculators. People with better information about market conditions can profit from their insight and perform the valuable public service of ensuring adequate oil supplies tomorrow.

Speculation does not interfere with supply and demand. Speculation is part the process by which supply and demand adjust. What Morris and McGann seek to restrict is exactly the kind of behavior that supply-and-demand analysis would predict.

What Morris and McGann deride as “unbridled gambling” is an essential part of the market process. This may be rhetorically effective but it is analytically erroneous. Morris and McGann seem to think of trading in futures markets as being equivalent to spinning a roulette wheel, and if you don’t know what you’re doing, speculating in futures markets can be just as dangerous. The fact of the matter, however, is that speculators are not gambling in the pure sense of the word. They are acting on the basis of their best understanding of current market conditions and their expectations about future market conditions. They may be incorrect, but they are not “gambling.”

Morris and McGann write “(i)f there is any doubt that it is speculation, not the supply and demand for oil, that is driving up the price, look at this week’s history of oil prices.” He then cites President Bush’s executive order to permit offshore drilling and OPEC’s statement that oil demand was falling and argues that these were responsible for a $15 price drop even though “(n)o new oil gushed through the system.”

This is exactly what supply and demand would predict. If offshore drilling is permitted, this will increase the future supply of oil and drive town the future price. People who were holding oil in anticipation of higher future prices will instead release some of that oil onto the market today, increasing the current supply of oil. Nothing untoward is going on: the supply of oil today is changing in response to traders’ revised expectations about the supply of oil in the future. This is literally economics 101: what I have just described is what I teach in my econ 101 lectures on futures markets.

Morris and McGann conclude that “(o)il is just too important strategically and economically to allow that kind of speculation,” but speculation is the market mechanism by which price volatility is reduced and future supplies are guaranteed. If oil really is that important, we should be loosening the restraints on futures market speculation rather than tightening them.

{ 16 comments }

rtr July 24, 2008 at 6:42 pm

More simply, speculation is pure future demand and future supply. Prohibiting futures “speculation” would be disastrous for supplying oil, and cause immediate net poverty. If you eliminate the tight bid/ask spread speculations bring about, hedging and insurance costs will increase. The entire insurance industry exists upon pure speculation of what future disasters might be.

It is exactly equivalent as if these politician morons were to declare every insurance from home to life to automobile to be “bad”, and argue it should be prohibited. Oil speculation provides insurance for both suppliers and demanders of oil. It is speculation that pays for cars damaged in auto accidents, that pays the hospital bills for people injured.

The rise and decline of futures oil prices are market signals to produce more oil, or to produce less oil, so that people don’t waste their efforts duplicating unnecessary production or focusing on other less profitable areas. It signals what the demand will be so that producers and users don’t have to operate with uncertainty in the dark. The higher the price of oil the more people will compete to supply a greater supply or supply a greater supply of alternate substitute energy goods.

If there were no futures markets with lots of speculators people would be blindly guessing and truly gambling on how much oil they should produce and how much oil they should contract for to use. We should teach such politicians lessons by asking them, or revoking taxpayer subsidized policies, to drop any and all insurance policies they have, health insurance included. Won’t they then feel better that they are no longer speculating!

Walt D. July 24, 2008 at 6:56 pm

WASHINGTON (Reuters) – The Commodity Futures Trading Commission said on Tuesday that a government interagency task force has found that the huge jump in oil prices is due to “supply and demand factors” and that speculators are not to blame for high fuel costs.

In its interim report, the task force said “preliminary analysis to date does not support the proposition that speculative activity has systematically driven changes in oil prices.”

The world economy has expanded at its fastest pace in decades, especially in developing countries like China and India, which has led to substantial increases in oil demand, according to the task force.

“The imbalance between scarce supply and growing demand, and expectations that this imbalance will persist in the future, have led to upward pressure on oil prices and greater market reactions to any actual or perceived disruptions in available supply,” the group said in its report.

Blame Congress!
Banning speculation will do nothing. It will be as futile as Nixon’s price controls (which will be resurrected when this fails?)

David Switzer July 24, 2008 at 8:00 pm

As Walter Williams put it in his “Scapegoating Speculators” piece, futures markets and higher future prices encourage people to conserve now — without them, the shortage in the future would be even worse. Get rid of oil speculation and perhaps prices come down and we consume more, but prices in the future will be even higher than they would have been without the speculators. Since Congress discounts the future (when they might not be in office), don’t expect them to pay any attention to this.

newson July 24, 2008 at 9:07 pm

well said, rtr!

gambling is a man-made pursuit, for entertainment purposes. speculation addresses real and existing risk.

as others on mises.org have mentioned, the classic case for futures trading is that of the onion market. here’s one of the many articles about this:
http://blogs.ft.com/undercover/2008/07/the-onion-has-no-futures/

mitchel eisenstein July 24, 2008 at 9:12 pm

Lets say for arguments sake that speculation is good and essential for the market to work properly. Now lets see the results of that market freedom and see if it produces the desired effects.
1 Gas Prices, tripled
2 heating oil bills, tripled
3 airplane fares, tripled
4 profits for speculators who have absolutely nothing to do with needing oil except as a financial investment instrument, massively increased
5 oil company profits, massively increased. (as oil prices rise the oil company’s have less and less incentive for any investment in refining, production or alternative energy as it will only decrease oil prices)

from a purely economic theory perspective, restriction of the market is always wrong.
but look at the catastrophic effects on the economy.
when the mortgage industry went belly up the feds came to the bail out rescue. but when the people cant afford to pay their heating bills or afford to commute to work, that kind of regulation is looked down upon. i just want to throw up

rtr July 24, 2008 at 9:48 pm

mitchel eisenstein that’s a signal for *you* and your friends to go into the oil supply business. A “gold rush” was never some previously existing gold mining companies oligopoly announcing the discovery of a big new deposit. It was massive numbers of new start ups on a mission for profit. Imagine all the profit you could make if you just sold your marginal supply of oil for a couple dollars less than the oil companies and oil producing countries! All you gotta do is go get it.

That’s what prices signal, directed action. You can invest in new oil company start ups. There’s no problem with the market raising that type of capital for internet businesses. Oil is black gold! :P Or you can invest in wind like T. Boone Pickens. Or solar energy. “High” prices create new profit opportunities. Action is constantly redirected away from lesser profitable actions toward more profitable actions.

Jeremy Wiebe July 24, 2008 at 10:06 pm

Mitchel,

You wrote: “as oil prices rise the oil company’s have less and less incentive for any investment in refining, production or alternative energy as it will only decrease oil prices”

You’re a bit mistaken. As the price for a good rises (in any industry) the company has a great deal of incentive to produce more of its product. It should desire to produce a number of its product at a given price so as to maximize its profit. Now, consider that there may not be only one company, but several independent producers all competing to offer the same good with variations according to consumer taste and preference. Each producer will want to offer the best product at the best price (relatively, meaning that a high-quality product at a slightly higher price may fair better against a lower-quality product at somewhat lower price). Doing this he is able to sell a greater number of his product than his competitor, earning a greater profit (assuming that while selling at a lower price he has kept his costs down). However, suppose that all these producers agree to control their production so as to restrict the supply of available goods on the market, forming a cartel and thereby raising prices to such a point where a greater profit can be made. If this were the case we must still assume that there is nothing that would stop an upstart from going against the cartel and dragging the prices down in competition.

However, the reality today is that most of the world’s oil supply comes from countries with corrupt governments very much involved in the restriction of supply and the cartelization of the industry. In fact every government of every major oil-producing country has restricted the supply in one way or another. This and the general debasement of the dollar are, in my opinion, the two main reasons for oil prices that are higher than the prices we would see in an unhampered and unadulterated free market.

magnus July 24, 2008 at 10:10 pm

from a purely economic theory perspective, restriction of the market is always wrong. but look at the catastrophic effects on the economy.

The “catastrophic effects” you mention were not CAUSED by the activities of speculators. They were caused by prior interventions in the markets by government, in particular (a) the artificial restricting of supply and (b) the (rapid) devaluation of the currency via several forms of inflation.

The study of economics is the study of causation. You cannot legitimately argue that because speculators exist and prices are higher than you would prefer to pay that, therefore, speculators have caused high prices.

That’s the intellectual equivalent of burning women in the village as witches because your crops failed.

Jim Fedako July 24, 2008 at 10:13 pm

Oops … I just speculated.

Forgive me, but I had to. You see, gas prices are lower than I’ve seen in a while, and with a weekend approaching, I topped off my tank — hoping to beat the likely weekend price increase.

So, if you were waiting to purchase gas, my demand today might have caused tomorrow’s price to increase. Blame it on the speculator — me!

Brent July 24, 2008 at 11:36 pm

What do you expect? It’s Dick Morris after all. The guy gets paid to be slime (he sure doesn’t get paid to be right about anything… isn’t he still predicting with absolute certainty that Hillary is going to be the Democrat Party nominee??)

Walt D. July 24, 2008 at 11:49 pm

Mitchel wrote:
profits for speculators who have absolutely nothing to do with needing oil except as a financial investment instrument, massively increased
The future market is a zero sum game. This is particularly true of the London ICE market. It only has speculators. So for each contract there is a winning speculator and a losing speculator.
When all is said and done, the speculator is just someone placing a bet. Without speculators, markets would be illiquid. You would see more price swings. Speculators keep the bid offer narrow and provide liquidity.

LibertarianFundie July 25, 2008 at 4:25 pm

Reason has an interesting article about Stop Oil Speculation Now!
(http://www.reason.com/news/show/127738.html)
What is interesting is that those supporting this movement (If I can call it as such) are airline companies (e.g.: Southwest). The same companies that are engaging in such speculation. I suspect those companies just want to eat the whole cake for themselves.

Murph July 26, 2008 at 10:23 pm

If a credible long-term commitment was initiated to exploit of our own reserves, speculation would work to reduce prices just as quickly as they have gone up.

Murph July 26, 2008 at 10:23 pm

If a credible long-term commitment was initiated to exploit of our own reserves, speculation would work to reduce prices just as quickly as they have gone up.

Walt D. July 26, 2008 at 11:50 pm

Election-year gullibility?
Global warming speculators are causing the polar ice cap to melt! I’m sure if this hit the headlines, you’d find people who actually believed it.

Power Tagging for Link Building February 12, 2011 at 8:06 am

With the news of the recent stressexamination on Hospitals in Europe due out shortly it has to be a worrying time for the economy. Let’s hope we’re not headed for the next double dip again.

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