Oily Speculations

by Don Boudreaux on July 9, 2009

in Financial Markets, Hubris and humility, Myths and Fallacies, Prices, Regulation

Here’s a letter that I sent yesterday to WTOP radio (103.5 and 107.7 on your FM dial in and near DC):

News Editor, WTOP Radio
Washington, DC

Dear Sir or Madam:

This morning your anchors interviewed University of Maryland law professor Michael Greenberger on President Obama’s plan to reduce speculation in oil markets.  Mr. Greenberger’s answers revealed his own confusion.

Most obviously, Mr. Greenberger repeatedly objected to persons investing in oil futures “passively” – as he said, “with no interest in actively controlling these assets, just hoping to make a buck when their prices rise.”  Ummm…. Does Mr. Greenberger own stocks only in companies that he actively manages?  If not, why is it okay for him passively (and speculatively!) to buy, say, a few dozen shares of Microsoft “hoping to make a buck when their prices rise” but not okay for other persons to speculate in oil for the very same reason?

Second, Mr. Greenberger presumes that all speculators speculate long and that doing so is a sure thing.  Neither presumption is valid.  It’s just as easy to speculate short as it is to speculate long.  And if speculation were as risklessly profitable as Mr. Greenberger presumes it to be, then high gasoline prices would pose no problem because everyone and their grandmothers would be raking in riches by speculating in oil markets.

Sincerely,
Donald J. Boudreaux

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{ 46 comments }

MnM July 9, 2009 at 8:13 am

If not, why is it okay for him passively (and speculatively!) to buy, say, a few dozen shares of Microsoft "hoping to make a buck when their prices rise" but not okay for other persons to speculate in oil for the very same reason?

Great question. I wonder what his response would be.

JohnK July 9, 2009 at 9:04 am

If the market consists of individual transactions, how does the commodities market make any sense?
If I had an oil well in my backyard, why is the price determined not by what I and the refinery determine is a fair price, but by the commodities market?
It seems to go against all free market principles.

vidyohs July 9, 2009 at 9:34 am

JohnK,

If you were just funning and I am walking into your trap, so be it.

The price you negotiate with the refinery for the oil produced from the well in your backyard is an individual transaction and has no commodities market dictates contained in that deal. The commodities market prices could be used by the two of you as a guideline, advice as to worth of your oil at the current time, if you will; but, nothing prevents you from selling above or below that price, and of course nothing prevents the refinery from beating you down in price as much as they can.

So, going into the negotiations you might be advised to check the market prices just so you know what your starting place in the negotiations is going to be.

vidyohs July 9, 2009 at 9:39 am

JohnK,

I am sorry, I forgot to mention that the thoughts I just expressed did not include the obvious.

Your ability to negotiate your own price for your own deal, just as all other buyers and sellers, is why the prices in the commodities market flucuate. Otherwise they would just remain stagnant.

JohnK July 9, 2009 at 9:45 am

vid,
But who is doing the negotiating? Is it the producer, or some third party speculator that buys the oil on paper from the producer and then sells it to the refinery?
If it is the latter, then could the speculators be driving up the price as third parties do with regards to health care?

vidyohs July 9, 2009 at 10:10 am

I am no oil expert so these are just my street understandings from being a businessman now for a long time.

From your perspective, I don't see what it matters who buys your oil, as long as you negotiate the price you can be happy with. It might be a third party, it might be the refinery, but the speculators are simply the people that buy the stored oil, oil in transport, or I would suppose oil still in the ground; and, then resell that oil at the best price they can get at the time they believe will bring them the maximum return on their investment.

When a speculator sells, it may be to another speculator who thinks the price is going to benefit him, or it could be to an actual refinery. Either way, we see movement in the price reflected in the commodities market.

Like Don pointed out, there are speculators to line up on either side of any negotiation, some will make money on a price increase and some will make money when the price drops.

Also as Don has pointed out, speculators can be subject to the same vagrancies of fate as you and I. Oil may be scarce, so a speculator buys with the expectation that the scarcity will drive the price even higher; yet be caught out badly when a new oil field is brought on-line, or some country unexpectedly releases oil from a national reserve to drive the price down. When such a thing happens, the speculator either takes a loss, or he holds on with his money tied up until the price comes back up. Not an enviable position to be in.

I'll let someone else address your comparison to 3rd parties and healthcare. I have to go shoot a couple of doctors…..with my camera, of course.

I hope that I will be corrected by someone with real actual hands-on knowledge if I made statements in error, but I believe I was accurate in at least the broad sense.

Sam Grove July 9, 2009 at 10:25 am

If I had an oil well in my backyard, why is the price determined not by what I and the refinery determine is a fair price, but by the commodities market?

Your question only makes sense if the refinery were the ultimate consumer of the oil from your backyard or if your backyard was the only available source of oil.

If you negotiate a certain price with the refinery and they found another source that was cheaper, they wouldn't buy any oil from you at all.

So, you either go with the market, or you wait until the market price matches your negotiated price.

John July 9, 2009 at 10:33 am

Thanks guys, it's gone from clear as mud to clear as fogged glass.
At least a little light is getting through.

Methinks July 9, 2009 at 10:43 am

John,

The price of oil is a reflection of perceptions of future supply and demand, not negotiations with refineries.

Refineries buy oil at the going rate, which is set by the market. "Speculators" make decisions about the prices they are willing to buy and sell oil based on their perception of future supply and demand.

Futures, along with options, are important hedging instruments for end users and producers alike as both use those contracts to hedge their price exposure. The more deep and broad the market (the more participants), the more reliable and less volatile the price and the lower the risk that large positions will move the market. Punishing speculators will only reduce the number of participants, sucking liquidity and its associated benefits out of the market. All we will end up with is a more volatile and less efficient energy market.

As a side note, it's interesting that the government is trying to make it as hard as possible to short stocks and as hard as possible to buy oil. So, government is engaging in price manipulation that would be illegal if you were doing it. It's baffling that in the face of this massive manipulation by government anyone can blame markets for anything since markets are now more rigged than I've ever seen them in the two decades I've been participating.

dg lesvic July 9, 2009 at 11:19 am

All of our actions are speculative, directed toward an uncertain future. When we go to the market to buy food for our evening dinner, we are speculating that we will live long enough to eat it.

Supposedly then there are two kinds of speculators, good and evil, the good, the ones who buy for their own consumption and end use and, the evil, those who prey upon them, buying for resale at a profit.

But they can profit only if the price goes up, meaning that they are serving the ultimate end users by withholding the item from current consumption for the sake of consumption at a later date when there will be a greater demand for it. And it is that service to the ultimate end users for which they are paid and deserve to be paid.

Could the speculator do more than just anticipate the market, could he alter its course? No, for no part of the market is bigger than the market as a whole. And if anyone is foolish enough to think that he is bigger than the market as a whole, there is no need for the "government" to remove him from the market, for the market itself will do so by the losses that it inflicts upon him.

Dallas July 9, 2009 at 11:27 am

Perhaps speculation is making oil prices less stable, however that instability may be good for our future. With much of the oil money flowing into the hands of unfriendly nations and institutions, which in turn increases are defense budget by 100's of billions per year and our political class lacking the balls necessary to put a $100/bbl tax on all oil, radical price variation will drive consumption reductions. These consumption reductions will provide long term benefits.

Variability is not as good as a known tax on oil, but it is better than nothing at driving the consumption down. If you know that oil prices can change by factors of 3 or more without warning, your decision making on your next car will be different than if our president says that he won't let the price go up by that speculative amount.

Γερώνυμος Αμάτι Nώνυμος July 9, 2009 at 11:41 am

"
manipulation that would be illegal if you were doing it. It's baffling that in the face of this massive manipulation by government anyone can blame markets for anything since markets are now more rigged than I've ever seen them in the two decades I've been participating.

Posted by: Methinks | Jul 9, 2009 10:43:00 AM
"

Only the Fed Chair should be allowed to legally hammer the closing tick, the Chairman or those who pull his string. Fight fair plebs.

Grazia

John Dewey July 9, 2009 at 11:58 am

dallas: "Perhaps speculation is making oil prices less stable"

Spot prices may be less stable than they would absent an active futures market. But the existence of that active futures market enables firms – and individuals – to remove the variability in commodity prices. Firms which consume commodities in production of goods and services can – through heding – reduce greatly their exposure to commodity price fluctuations. Doing so allows those commodity-consuming firms to sign long term price contracts with their customers.

If Obama reduces the liquidity of commodity futures contracts, he will succeed in driving up prices of goods and services which consume those commodities.

James July 9, 2009 at 12:18 pm

"Supposedly then there are two kinds of speculators, good and evil, the good, the ones who buy for their own consumption and end use and, the evil, those who prey upon them, buying for resale at a profit."

Why is this evil?

"But they can profit only if the price goes up"

Really? Well, I suppose this is true on many stocks since Obama has banned their short sale, but this is certainly not true in general.

Sam Grove July 9, 2009 at 12:41 pm

Speculators act a temporal smoothing filters.

They add demand to the market when prices are lower and add supply to the market when prices are higher.

There will always be those who complain about the profitable activities of others, to matter the benefit to everyone.

Superheater July 9, 2009 at 1:19 pm

There's only one profession more odious than a barrister-a law professor.

I'm not sure how a JD and a tenured professorship entitles one to determine the validity of private activities more than any other occupation, and clearly this is an example of how our public finance of the academy has created a parasitic leisure class that seems to not understand that it lives off value it contributes precious little to its creation or maintainenance.

Methinks July 9, 2009 at 1:27 pm

Spot prices may be less stable than they would absent an active futures market.

How so? An active futures market adds liquidity and a benefit of liquidity is lower volatility.

S Andrews July 9, 2009 at 1:51 pm
dg lesvic July 9, 2009 at 1:55 pm

James, you're right, of course, that speculators can profit from falling as well as rising prices, and I was at fault for overlooking that.

Let's put it this way: those speculating on rising prices can profit only when the prices do rise, and those speculating on falling prices only the prices do fall.

And both serve the consumers, the speculators on rising prices, by conserving scarce resources for the satisfaction of greater future demand for them, and the speculators on falling prices by dampening the production for which there will not be a corresponding demand

Thus, the speculators are the real regulators of the market, and those self-styled "regulators" curbing them the real deregulators.

dg lesvic July 9, 2009 at 2:07 pm

Isn't it amazing that after 200 years of economics people like Krugman and Summers are held up as great minds by the most august journals and a Don Boudreaux can barely get a letter published once in a while.

We all laughed at George Costanza bemoaning this topsy turvy world in which heroes are cast as villains and villains as heroes.

I think he was on to something, and I may be the George Costanza of economics.

dg lesvic July 9, 2009 at 2:11 pm

Anyways, I'm sure as hell not the Blinder than a bat of economics.

muirgeo July 9, 2009 at 2:46 pm

Greenberger explained his position well.

Futures trading has a very definitie role to play. But allowing huge companies like Goldman Sachs to manipulate the market by holding large quantities of supply off the market to simply exploit the process and set up a casino to extract money from the productive economy does nothing.

You would think true defenders of markets would see this sort of manipulation for what it is.

John July 9, 2009 at 2:49 pm

Isn't it amazing that after 200 years of economics people like Krugman and Summers are held up as great minds by the most august journals and a Don Boudreaux can barely get a letter published once in a while.

It's no surprise at all.
Politicans can use Krugman as an intellectual argument to justify their actions increase their power.
That gives Krugman influence, power, and the spotlight that comes with it.

If Don were to change his tune and start defending and justifying the actions of our political leaders, I'm sure he'd get a piece of the spotlight as well.

Thankfully he does not appear ready to sell his soul.

dg lesvic July 9, 2009 at 3:27 pm

Muirgeo,

As usual, you're not paying attention.

John Dewey July 9, 2009 at 3:30 pm

methinks: "How so? An active futures market adds liquidity and a benefit of liquidity is lower volatility."

I agree. But there is an argument that has not, to my knowledge, been resolved:

To what extent does herding increase the volatility of commodity prices.

When participants make decisions based on following the herd – and not based on fundamentals – they could move prices away from fundamentals and increase volatility.

I'm not familiar enough with the research on herding in commodity markets to know whether this aregument is valid. That's why I wrote:

Spot prices may be less stable …

dg lesvic July 9, 2009 at 3:58 pm

John Dewey,

You asked,

"To what extent does herding increase the volatility of commodity prices."

Obviously, the more mistakes, and correction of them, the more volatility there will be.

But, what does that mean, that we should outlaw mistakes, or the correction of them?

John Dewey July 9, 2009 at 4:11 pm

dg lesvic: "But, what does that mean, that we should outlaw mistakes, or the correction of them?"

Of course not! As I pointed out just before noon today:

"If Obama reduces the liquidity of commodity futures contracts, he will succeed in driving up prices of goods and services which consume those commodities."

Someone else commented about the volatility. My point was that regardless of volatility, a highly liquid futures market benefits producers and consumers.

Methinks July 9, 2009 at 4:23 pm

When participants make decisions based on following the herdand not based on fundamentals – they could move prices away from fundamentals and increase volatility.

John, herding happens. Thinning out the "herd" doesn't solve the herding problem. Thinning out the herd simply creates another problem – illiquidity, which allows prices to deviate from fair and for prices to move more and more sharply as market makers are able to charge a wider spread for making a market because they have artificially less competition in providing a bid and offer. Thinning out the herd also increases the odds that prices can be manipulated.

…and not based on fundamentals – they could move prices away from fundamentals and increase volatility.

Infinitely more likely to happen when there are fewer bids and offers. Increased price volatility is a hallmark of thinly traded securities (actually, anything thinly traded).

Methinks July 9, 2009 at 4:26 pm

Obviously, the more mistakes, and correction of them, the more volatility there will be.

dg Lesvic,

That's true. But if you have more participants, the mistakes are smaller and the volatility is lower as a result. But, as you point out, all price discovery involves some volatility as opinions and changing market conditions are factored in.

John Dewey July 9, 2009 at 4:33 pm

inks: "Thinning out the "herd" doesn't solve the herding problem."

I have no desire to see Obama or anyone else restrict futures trading.

methinks: "But if you have more participants, the mistakes are smaller and the volatility is lower as a result."

Makes sense to me. But I'd feel better if I could find research that confirms that greater participation in oil futures has reduced volatility.

dg lesvic July 9, 2009 at 4:58 pm

John Dewey,

You wrote,

"I'd feel better if I could find research that confirms that greater participation in oil futures has reduced volatility."

What difference would it make? Would it lead you to reduce or increase the number of participants? And how would you do that?

John Dewey July 9, 2009 at 5:17 pm

dg lesvic: "What difference would it make? Would it lead you to reduce or increase the number of participants? And how would you do that?"

I can't figure out what point you keep trying to make. Are you just looking for a fight? I'm not.

I have no desire to see any changes whatsoever in energy futures markets. But Obama does. And he needs to be stopped.

All I'm looking for is arguments to send – directly and indirectly – to my elected officials. If research shows that energy futures trading has reduced energy price volatility, I'd like to know about that. That would be a significant counter to the widespread belief that speculators are causing wild swings in oil prices.

K Ackermann July 9, 2009 at 5:36 pm

I heard the CEO of Jet Blue say the same thing once: the only people who should be speculating in commodities are people who own or consume the commodity.

I thought it was a pretty odd thing to say, as I tried to stick a bar of bar of gold up my bum.

dg lesvic July 9, 2009 at 6:40 pm

John Dewey,

Volatility is just a pejorative for change. And that is a fact of life that you cannot get away from, until you're dead.

Methinks July 9, 2009 at 7:10 pm

Makes sense to me. But I'd feel better if I could find research that confirms that greater participation in oil futures has reduced volatility.

John Dewey,

I do realize you aren't advocating for limiting the number of participants in the oil futures market. I'm focusing on the connection between the number of participants and price volatility.

There is plenty of research that liquidity reduces volatility in every other security. Why should we assume oil futures would be different? Your research doesn't have to be specific to oil – just google price volatility and liquidity and I'm sure you will pull up countless articles.

The only thing I would say about your elected officials is that they don't care what you say. The PACs give them more money and command more attention than you do. There are the insider PACs – those whose constitutions are commodities trading concerns that act as liquidity providers who will benefit from a reduction in the number of participants as it will reduce competition and allow them to widen their spreads and make more money. Then there are the non-insiders like hedge funds who also have PACs who will make the argument I'm making. In the end, it's all about which PAC will be able to buy enough politicians and whichever way the political wind is blowing. IMHO, your best bet is to make the liquidity = less volatility argument because it applies to all markets and everyone will be trotting out research to support it. I believe that elected officials often think that their constituents don't understand these things and alerting them to the fact that you do may make your point not just for oil but also for all other markets. Regulation, which everyone is clamouring for, reduces the number of participants and alerting the m to your understanding of the implications of such an outcome across markets may even make an even bigger impression. Just thinking "out loud".

richard July 10, 2009 at 5:19 am

Don,

> Second, Mr. Greenberger presumes that all speculators speculate long [...]

For every man that buys a security on the exchange, there must be another man that sells it.

Which one is the speculator?

Colin Keesee July 10, 2009 at 7:27 am

JohnK, you do ask an interesting question. I beleive the most striaghforward answer is that the prices that comes from coomodities markets are the result of what is fairly close to a perfect market. The good is homogeneous, the information about prices is almost costless to obatin for buyers and sellers, there are multiple sellers and millions of buyers and very low transaction costs (because the rights to the goods are sold and not a bundle of the commodities and their transportation to given location, which would make for veriable and potentially huge transaction costs. That, and the costs of making a routine sale on commodities market is very cheap and does usually require special contracts or escrow periods)

In most markets some or none of those conditions are met and the prices are decided by sellers pickin ga price and finding through some trial and error what is profit maximizing and in otehr cases the prices emerge frequently through negotiations. In commodities markets, the nature of them makes the prevailing price a very important number, you take the prices more or less a given that will govern all transactions. The reason is that if the slelers asks for a price above what the market is offering, the buyers can find lower price bein gofefred on the market. Conversely, if the buyers want a lower price than the market price, the seller has a multitude of better alternative out on the open market.

There is no coercion at all, just very good information and a market whose features lead to what is more or less standard price emerging. That price is a very accurate reflection of current and expected future supply and demand of the commodity interacting in a perfect market and an instance where something in real life looks almost exactly like something from an intro to economics lecture.

John Dewey July 10, 2009 at 9:20 am

methinks: "The only thing I would say about your elected officials is that they don't care what you say."

I suppose I could be insulted by your statement. You really know very little about me, and what connections I may have with U.S. Congressmen.

What you probably meant to say is that elected officials don't pay any attention to what the typical individual voter has to say. On this issue that is probably correct. But that's still no reason to belittle a person's efforts.

Methinks July 10, 2009 at 10:26 am

John Dewey, nothing I said was meant to belittle you or your effort. In fact, in the sentence you excerpted I said "the only thing I would say about your elected official…". I said nothing about you personally and I did make the assumption that you were a typical individual voter. You have to admit that in the absence of your biography, it's not an unreasonable assumption. I don't know what connections you have with U.S. congressmen and it is unreasonable for you to assume that I would. If you have them, I am delighted to know that it is who has their ear.

Good luck in your effort. I still don't think you need research on oil specifically to make your point. However you took it, I was trying to be helpful.

John Dewey July 10, 2009 at 11:39 am

methinks: "However you took it, I was trying to be helpful."

OK.

I do have connections. I also believe – naive as this may seem – that elected officials stay alert to voter sentiment as well as to contributor sentiment. When polls show that the electorate overwhelmingly does not want taxation of health benefits, for example, elected officials pay attention.

One way to influence polls is through letters to the editor. One person will not by himself change the opinion of millions. But I can still hope for contributions from dozens of other letter writers across the nation on an important issue.

I admit we will not see a grass roots effort to save futures markets from intervention. Voters do not understand the issue and how it affects them. Our mass media has already made a mess of trying to explain it.

muirgeo July 10, 2009 at 3:50 pm

For every man that buys a security on the exchange, there must be another man that sells it.

Which one is the speculator?

Posted by: richard

The speculator, I guess, is the guy who puts these things into their retirement portfolio… That's the 99% of us working to hard producing things of real value to have time to figure out how to keep such things from infesting our portfolios.

Its these asymmetries of information in the now computer age of the finance industry which are leading us down the same road of financialization of our markets and the creation of a rentier class that has lead to the collapse of empire after empire from the Dutch, to the Spanish and followed by the Brits.

People here defending all sorts of casino products as legitimate instruments in our economy disregard real market dynamics and productivity. They disregard the obvious fact that as we shift profits to those who create fancy paper to those who actually create value that the resultant economics are what you now see before you. History is replete with this lesson.

In 1970's and prior the amount of corporate profits going to the finance industry was around 10% now it is over 35%. And these Wall Streeters who feel they are doing something important and of value claim the rest of us just aren't smart enough to understand the value they add. The fact is most of them are of even less value then the most lowly and inept of politicians. They quite literaly are destroying our economy and our society with it.

So this fear the government and praise the grifter attitude we see on libertarian sites like this is beyond all rational comprehension. Nothing but blind faith and dogmatic allegiance to an ideology in spite of mountains of contrary evidence.

Methinks July 10, 2009 at 4:34 pm

John Dewey, I'm obviously just much more cynical than you.

I know politicians, but they don't care what I say. If you have influence, then I'm glad you're willing to take the time and energy to use it and more power to you.

Have a good weekend.

Mesa Econoguy July 10, 2009 at 6:42 pm

Hi guys.

Just to echo Methinks’ succinct, insightful expert opinion (there will be a quiz later), what continually gets lost in this discussion is the functional purpose speculation and especially derivatives, play now in literally everyone’s portfolio.

Methinks (and I) said this before in slightly different contexts: derivatives, at a fundamental level are insurance, nothing more. Try banning insurance, see what happens.

Speculation in commodities provides liquidity which smoothes price fluctuation (see last fall’s short sale ban in financial equities), and speculation in derivatives provides a deep & robust market in protective mechanisms. Yes, they can be abused. So can (is) everything government does, except there’s no check on what they do, and most do not even understand what it is they're regulating.

As for the “fear the government attitude,” this is in fact contrary to all evidence, market-based and otherwise. This is an ignorant (and incorrect) belief. Government is an uninformed, manipulable, lethargic player in most matters financial.

People like this cannot fathom more than what they see in front of their face; our example most likely cannot even see this, which is what makes our current situation incredibly frightening.

Sam Grove July 11, 2009 at 12:42 pm

George imagines that "the vote" gives "regular" people significant power over the political process.

What it does is give regular people an illusion of control, thus making them complacent in hopes that the "right" people are in power.

Hence, despite popular opposition, bailouts.

Anonymous August 15, 2009 at 6:55 am

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Anonymous August 27, 2009 at 8:05 pm

This criticism seems to take Professor’s Greenberger’s comments out of context and is thus sorely misguided. First, the professor’s assertions about passive investing was merely intended to distinguish between those who are hedging their positions in commodity markets and have an interest in the underlying assets (such as farmers do in wheat). Second, until recently, betting that oil prices would increase was a pretty sure bet (especially if you were engaging in wash sales) just as betting in real estate was a sure bet (again, until recently). The reason why “everyone and their grandmothers” don’t do this is because: 1) commodities trading is fairly esoteric and typically thought to be the exclusive domain of the “professionals;” and 2) the profitability could be assured only where speculators traded in sufficient volume to drive the market, something grandma cannot do.

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