Among Politicians’ Favorite Scapegoats

Hey - you agree with Krugman on something!!!!

Getting mad at speculators for high oil prices is one of his pet peeves.

After thinking about it I guess all investing is speculating. When you invest you are buying apart of what you think the future performance of that asset will be. It could fail, you could win so I guess in that case there is no distinction between investors and speculators. Speculators get a bad deal, where would we be without investors what if nobody took the chance on mircrosoft or thousands of other companies.
The question I have is what market function do futures play? Oil is an input to make other goods. I feel anyone buying futures who will not take delivery is distorting prices. If you invest in stocks of an oil company they can use that money to buy assets, pay down debt, invest in new capital, etc and basically be productive. When you buy a future is that happening? Shouldn't the demand come from those who will take delivery (use) the oil not from investors who have no intention of taking delivery? They are just betting that there will be conflict in the middle east, the stored reserves will go down before summer, basically short term supply and demand.
If the price is distorted and high, this makes the 1000's of things produced by oil more expensive and don't we want everything to be cheaper to consume more and create wealth in society. I just don't see where futures come into play here, more specifically oil futures, possilby hedging, but aren't they hedging because of the short run volitilaty caused by just this thing?

Futures participation by non-industry players provides additional liquidity and price information to the market.

What if there's a brilliant scientist out there who realizes that the world's oil reserves are actually a lot lower than everyone thinks? What's the best way of communicating this fact to the producers and consumers of oil? He could run around like Chicken Little, or he could start buying as much oil as he can, which would send the signal that the commodity is rare and should be conserved. Should this scientist be prohibited from sending such price signals if he's not operating on behalf of Exxon?

Regarding high price distortions, that's not a problem so long as market participants are allowed to short oil futures freely as well.

In the end, oil is only useful for its input properties, as you note. So someone eventually will take delivery of the oil, and that someone will only pay a price that makes it worthwhile to them. If the future price gets out of whack with the value of the oil to people who actually use it, then short-sellers will step in and help bring the price back to equilibrium.

That is the job of any market to send those price signals. If the futures market did not exist the market participants would do the same thing. This would signal us to drive solar cars.
Again I don´t see the market function of the futures. The market would function with out them and I believe with lower prices.

Let's do a little thought experiment: Create your own business. Make sure this business requires input from commodities, such as oil.

Now, you work very hard for a while, and then you get a big break: someone offers you a big contract, to deliver him 100 widgets. The price per widget is set at $1000.

You don't have a huge business, so you can't just ship 100 widgets premade. In fact, you need to make the widgets. Being a small company, you can only make 10 widgets/month. So it will take you 10 months to build all 100 widgets.

Building each widget requires 10 barrels of oil.

You could, when you get the contract, pre-pay at the current price for all 1,000 barrels of oil at $50/barrel. That requires you to have $50,000 up front. Then, you need to store the oil, etc.

Or you could buy the oil right when you need it. But do you know what the price of oil will be 10 months from now? You could be buying oil at $140/barrel, which means you'd be making widgets at a loss!

Or, you could buy a future contract for the oil: Get delivery of 10 barrels of oil per month, every month, for $60/barrel.

For a small premium, you get the oil you need at the time you need, without having to bear the entire risk burden yourself, and also without needing to pre-purchase and store the commodity.

You're right that if the future market didn't exist, the market participants would do the same thing: they would create a futures market.

That is fine if they create a futures market for them (the end user). Companies make orders for all types of things months out and years out. Although there might be some contract provisions for inflation and or price increases, so yes the future price does hedge against this.
In your example I see the market function, hedging risk, which I mentioned before, but still I don´t see the market function of letting everyone bid for that oil. I mean in the next 10 months we know there will be an event in the middle east or nigeria and the price will spike, this has nothing to do with users of oil and their demand for it. It make affect the supply, but shouldn´t that be determined by if the oil actually shows up on the business´s door step, not the potential for supply disruptions?

I take issue with the notion that we "know" the price will spike. I don't know that. If you do know that, I suggest you buy lots and lots of oil now and sell it at that spike. I'll bet you can find lots of rich people willing to give you 2 and 20 to do it for them.

In the end, oil is only useful for its input properties. Let's say that buying oil futures becomes the new fad. Everyone wants to do it. Suppose that this drives the future price of oil up to $1,000 due to nothing but the fad (i.e., supply and demand for the physical commodity remain the same). When the people who don't plan on taking delivery eventually sell their contracts, the only players left to buy the physical oil will be the ones who want to use it. And they won't pay $1,000 per barrel, since supply and demand of physical oil haven't changed. Instead the market will quickly correct to the clearing price (~$70 or so today). And short-sellers, recognizing the fad, will act to bring down the futures price before it gets out of hand.

Lets say I have purchased a lot of oil, relative to my wealth, although for reasons not only concerning a conflict of some sort. If the conflict happens will you concede that I was right and that investors/speculators are driving up oil?
I mean in your example you suggest a "fad," this would not take place if only end users were buying.
Also do you really believe if Obama et al. eliminate speculators in the oil futures market that the prices will remain unchanged?
You made good points as well as robert; however, with this issue I am still undecided and need to do more research.

It's good that you ask these hard questions. It keeps us all on our toes.

Who's an "end user"? Producers don't care what the oil is bought for. Whether it's because you're planning to make widgets, or because you like to burn it in your Hummer, or if you just like it because it's shiny, or you want to hold on to it because you think it'll become more scarce in the future.

If speculators are removed from the market, the price of oil will definitely be affected: prices will swing with a much larger amplitude, guaranteeing higher highs, and lower lows.

You could extract that simply out of econ theory, or you can also extract from past attempts at curtailing speculation. Google "onion speculation" for an eye opener.

Interesting.
I read several of the articles and would like to read some of the references made in those articles.
This is one example and I do not take it lightly. I would like to know how world prices were and are there onion tariffs or anything of the sort.
Also onion supply can be more drastic as stated in the article about weather causing a supply crunch. These drastic swings were mentioned for only a 2 year period when the law went into effect in 1958. (I need to look at the paper by Roger Gray)
Thank you for your patience and continued responses. I feel that there are a lot of posts by Don and I can't keep up and others lose interest which affects my learning curve.

The Roger Gray paper. My jury is still out, but searching.

http://chla.library.cornell.edu/cgi/t/text/page...

Well then who was borrowing all that money from the banks?

I speculate these people don’t really have much of a clue.

Which makes me a speculator, I guess……

Give us a clue then.

And the only thing worse than speculators are speculators who live in a "bonus culture."

Didn't you get the memo, Don? The oil speculators went on vacation starting in summer 2008, which explains oil's fall from $147 to $30.

The thing that really worries me is peak oil. It will _only_ be a problem if the government imposes arbitrary restrictions on market participation and liquidity. In a free market, peak oil doomsday will be preceded by a sharp increase in oil prices, which will naturally reduce demand and increase investment in alternatives. And before you know it we'll be past oil as a fuel source. But without a freely functioning market in oil, the lack of supply will take us all by surprise and we'll have shortages and rationing and suffering. Can't you just see it?

Government officials continually cripple capitalism, then criticize it for limping. Sheesh.

This is another question I have been wrestling with.
What do you attribute the rise in housing prices, other commodities and the stock market to lets say very high levels?
I think we have to agree that speculation was for sure part of it.
Why not for oil?
Or are you just saying that who cares, it is the market functioning?

Note: With blogging the tone of voice is not heard. I am asking these quetions in interest and not attacking your position. I am generally interested in educating myself.
Thank you everyone here at cafe hayek

Well, it turns on the definition of "speculation." What differentiates a "speculator" from an "investor?" Personally I've never seen a cogent distinction. It seems that politically disfavored groups are branded as "speculators," while favored groups are "investors." They're all trying to make money with what they buy.

As to your question, the rise in prices of all sorts of assets can most likely be traced to the extreme levels of leverage we saw in the past 10 years or so. When interest rates are kept really low, it encourages market participants to buy more hard assets, which drives up the prices of everything.

After thinking about is Economiser I have to concede and agree here.

"Well, it turns on the definition of "speculation." What differentiates a "speculator" from an "investor?" Personally I've never seen a cogent distinction. It seems that politically disfavored groups are branded as "speculators," while favored groups are "investors." They're all trying to make money with what they buy."

I am now turning the conversation, if you like, to my new comment.

"What differentiates a "speculator" from an "investor?""

Speculators are traders who follow prices in a direction which politicians don't want them to go.

Economiser
"it encourages market participants to buy more hard assets"
What would you call these "market participants?" I would call them investors and speculators are a type of investor.
True "speculator" may have a negative connotation in the area of politics.
I think a distinction can be made time frame. Investing is usually longer term while speculation is for short term. Why would there be such a large disparity between short term and long term futures. Answer investors vs speculators and the information they use to enter the market; economic indicators, supply/demand vs emotion and short term trends.

But I think those are all arbitrary distinctions. The supply and demand effects don't change based on the reasons why people buy certain assets. For example, I could buy IBM stock as an investor, relying on a deep analysis of all the fundamentals with intent to hold forever. Or I could buy IBM stock because I think a greater fool will come along to buy at a higher price. Or I could buy IBM stock because it has a pretty blue border and I want to paper my walls with it.

The market price reflects no difference between the various demands.

Who's to say that one use is more deserving than the other? And can you, from the outside, really distinguish between the various buyers? If you can, then you can make a killing in the financial markets by shorting assets purchased for bad reasons, and the price will come back to equilibrium. If you can't, then why should we empower the government to quash "speculators" if no one can even tell who they are or which assets are subject to "speculation?" That's a recipie for disaster.

Let's get back to the original arguement of oil. Are you saying that investors have no reason of why the price went up.
You said
"When interest rates are kept really low, it encourages market participants to buy more hard assets, which drives up the prices of everything."
So wouldn't that raise the price of oil. Weather they are "investors" or "speculators" they raise the price of oil.
Have Obama come out or have some leak a rumor that oil futures will no longer be allowed to be traded by anyone except those who will take final delivery. See what happens to the price and see where the "speculators" go.

What you mean to say is when the government increasingly debases the currency in order to fund their agenda.This action creates many intended, and unintended consequences. One of which is accelerated money supply growth which leads to falling interest rates and a cheaper dollar. Commodity holders will therefore demand more dollars for their goods. The trends become obvious, and more and more investors, speculators jump in. The result is an increase in the beta of these commodities, or wild fluctuations in price, followed by public acrimony by those who didn't get in.

I agree totally that a devalued dollar will lead to higher commodity prices since they are priced in dollars.
I am not sure if that is what economiser was talking about, I thought he was saying that with lower interest rates, money is cheaper to borrow causing more investment in things that were not profitable before.

No, cheaper dollars in the short term will not make long term investments profitable.When commodities are held dearer they will command a higher price. Investors will be willing to exchange their currencies for a given commodity if they perceive that their dollars will purchase less of that commodity in the future . When circumstances change, for instance if taxes and tariffs were to rise, and a liquidity crunch would ensue, investors in need of funds would liquidate their commodity holdings. Again the gov. creating an unintended, or intended consequence. Given a stable supply and demand picture commodity prices will be driven by monetary or fiscal decisions.