Saturday, September 12, 2009

In Defense of Oil Futures Markets

By Michael Labeit

A gutsy individual named Ron has objected to my critique of Rep. Peter DeFazio's claim that speculative activity causes "oil bubbles," instances of rapidly rising oil prices. He clearly states that he endorses "Any successful effort to curtail speculation in oil futures, by whatever source" since, as he argues, "The price of gas, diesel and other petroleum derived products has wide impact on the economy of the the world." "Let the monied interests go to Las Vegas if the need to gamble gets too overwhelming...," he proclaims. Let us educate Mr. Ron.

Ron subscribes to a sentiment that many, many people share. One of the most commonly held assertions among both economic laymen and academics alike is that speculators make money through "pump and dump" schemes, manifesting their high demand for commodities or financial instruments by making large purchases, causing prices to increase significantly (the pump phase). Once prices have reached an ostensibly arbitrary point, these speculators send the market into a chaotic tailspin by abruptly selling the commodities or financial instruments they've previously acquired (the dump phase).

The net effect is a momentary but nevertheless socially-detrimental rise in prices to which everyone in the economy is subservient to, cheating all of its "honest" non-speculating participants, especially those innocent citizens and small businesses remorselessly dependent upon gasoline and other petroleum-derived goods. And since there are no real substitutes to gasoline and diesel fuel (unless you're one of those individuals that has the fortitude and patience to convert your engine to run on fast food by-product) the little guys and gals of the economy remain unable to shake this dependency that many in the media and academia have had the nerve to call an "addiction." Thus, they are being exploited.

Depressing, surely, but spectacularly incorrect.

First of all, speculators en masse cannot make money by manipulating the prices of commodities by aggressive buying and selling; they can only profit by exploiting spatial and temporal discrepancies in prices caused by exogenous phenomena - events external to the actions of the speculators - that affect the demand for and supply of goods. Speculators who attempt "pump and dump" gimmicks run the risk of being undercut by speculators who have made previous purchases and seek to exploit price differentials themselves by pre-selling other speculators.

Institutional speculators are extremely vigilant economic agents; they are supremely sensitive to changes within the market and since they're well-equipped with high-frequency trading technology they're very responsive to market movements and stand ready to react to price signals. This speculative competition makes "pump and dump" contrivances far too risky to prosecute. Thus, (temporal) speculators must yield profits by going through the trouble of forecasting future prices, juxtaposing those expected prices with current prices, and acting accordingly in order to ensure that profits are created and/or losses are avoided.

This is how oil speculators make money - by forecasting the future price of oil, comparing that future price with the current price or spot price, and acting in accordance with that comparison in order to reap a profit and/or evade a loss. True, by increasing demand for oil in the present, speculators raise the spot price of oil. But this completely ignores the crucial function of oil speculators within the marketplace.

Let's say that oil speculators, ever so eager to gain new market information, identify a series of potentially unsettling new facts. Rebels in Nigeria are stirring up hostile popular sentiment against the local corporate oil drillers, expressing their disgust by sabotaging vital transport pipelines with home-made satchel charges. Russian politicians are harassing yet another hydrocarbon enterprise that operates north of the Caucasus Mountains through frivolous and unnecessary lawsuits and audits. The Iranian military expresses an interest in purchasing additional Kilo-class diesel-electric attack submarines from the Kremlin, seeking to add additional units to their Persian Gulf fleet that may be used to patrol and eventually halt commerce in and out of the Strait of Hormuz. Venezuelan dictator Hugo Chavez mobilizes his groveling conscripts in preparation for a long-planned seizure of foreign-operated oil rigs as part of his grander agenda to achieve a "socialism for the 21st century." OPEC decides to cut output in a political maneuver to pressure the West into politico-economic acquiescence.

All these events seriously threaten to produce a lower future aggregate supply of crude oil. Meanwhile, artificially cheap bank credit, electronically manufactured by central banks around the world, is still flooding global capital markets, giving young, ambitious entrepreneurs financial hard-ons. In addition to this, reliable economists forecast a future end to a lingering, Fed-produced recession (somehow, among this international fiasco) and, concomitantly, an eventual rise in aggregate demand.

These seemingly fateful occurrences ultimately point to one effect: significantly higher oil prices. These economic phenomena, while dreadfully inopportune for gasoline-for-use buyers qua gasoline-for-use buyers, by contrast make for a rather fortuitous opportunity for oil speculators. In order to explain how speculators may profitably exploit this opportunity – and benefit society in the process - we must make a brief excursion into the wonderful world of futures contracts, for the futures market is a fundamental haven for speculators and speculative profit-making.

A futures contract is a standardized, voluntary agreement between two parties where one party, the contract-seller, agrees to deliver a specific quantity of commodities or financial instruments (assets) to the other party, the contract-buyer, on an agreed-upon date in the future at a presently agreed-upon price. The price of the assets purchased by the contract-buyer, the futures price, is set by the futures market and reflects the expectations market participants have of the future spot price of the assets in question, the future spot price being the price of the underlying asset on the exact date of delivery as stipulated within the contract. The futures price is derived from expectations of the future spot price; hence oil futures are derivative instruments.

Institutional speculators who believe that the price of oil will increase notably in the future assume the contract-buyer position before the advent of the price increase. They believe that the futures price does not accurately convey supply and demand factors, specifically that the underlying assets of the futures contract are underpriced. With all of the tumultuous events above occurring within the same general timeframe, the speculators will most likely be successful in both their assumptions and their decisions, given that they tend to be the first ones in possession of such knowledge and, therefore, they tend to be aware before the rest of their comrades within the larger market (don’t be mistaken - an amalgam of these incidents would send oil prices into the stratosphere).

When a contract-buyer and a contract-seller successfully participate in a futures contract, they are required to submit a preliminary deposit equivalent to a specific margin requirement into a margin account to be upheld by a broker who works through a clearinghouse (clearinghouses set margin requirements and broker exchanges ultimately between contract-buyers and contract-sellers in futures markets). The net daily adjustment in the value of a given futures position is added or subtracted from a participant’s margin account (credited or subtracted respectively) at the termination of every trading day in a procedure called “marking to market.”

Once the speculators purchase their respective rights and obligations as part and parcel of assuming a contract-buyer position, they wait for the international supply and demand forces to exert their influence upon the spot price. As time passes, the futures price and the spot price both rise but the futures price approaches ever closer to the spot price. The futures price and spot price equalize upon the delivery date because, as economist Dr. R. Glenn Hubbard notes, “At the date of delivery, no investor or trader is willing to pay more or less for the underlying asset than its current market value, which is the spot price.” As the futures price rises to rendezvous with the spot price, the margin accounts of the speculators increase as they are supplemented by daily monetary additions derived from positive changes in the value of their futures positions. They are making money!

As more speculators purchase more oil futures and as the oil spot price increases, the oil futures price increases as a result. However the discrepancy between the oil futures price and the oil spot price decreases as the former pursues the latter to equivalence, quickly reducing opportunities for speculative profit-making. Since oil speculators want the profit, not the oil, they sell their contract-buyer positions to other economic agents before the delivery date when they feel that any further assumption of the contract-buyer position is no longer in their best interest. Voila! Upon the sale, they finally reap their rewards, for their selling price is much higher than their buying price.

How have our oil speculators benefitted society? Well, their initial acquisition of oil futures prompts oil producers and stockpilers to stockpile and restrict the production of oil since the producers and stockpilers know that the speculators qua speculators buy oil futures only when they think that the oil spot price is headed for a real rally. If a major incline is in the destiny of the oil spot price, than the oil producers and stockpilers can make serious temporally-based profits of their own by postponing both oil production and the release of oil stockpiles until the oil spot price truly ascends. This way, oil futures markets permit speculators to disseminate vital price information to producers and stockpilers which in turn allows producers and stockpilers to adjust production and oil deliverance in accordance with supply and demand signals, decreasing production and deliverance when supply is high and/or demand is low and increasing production and deliverance when supply is low and/or demand is high. This way, futures markets help market participants conserve scarce resources. How environmental, yes?

Futures markets grant speculators the ability to rapidly adjust prices in accordance with human needs and desires. Accurate prices - those that reflect real-life supply and demand factors – must be established because only an accurate price for a good or asset can equalize the quantity of that good or asset demanded with the quantity of that good or asset supplied. If prices are too high, the quantity supplied exceeds the quantity demanded, creating surpluses that represent wasted resources. If prices are too low, the quantity demanded exceeds the quantity supplied, creating shortages that represent failures to satisfy the needs and wants of consumers. By adjusting prices in harmony with real world events, oil-derivative speculators set in motion a chain reaction that encourages economic agents to set prices and allocate resources in a way that proves to be socially beneficial.

Futures contracts do not create the price fluctuations that people commonly protest. Ironically, it’s the existence of price fluctuations that help create a demand for futures contracts, for the existence of substantial price fluctuations in goods creates a demand for speculation and hedging, two market maneuvers made possible by derivatives like futures.

We are all too accustomed to the half-witted ridicule that derivatives instruments, in particular oil-derivatives, receive from blitheringly ignorant pundits, academics, and politicians who have not as of yet pulled their heads out of their asses. Let us understand the nature of the battle our comrades in the speculative-derivative trenches wage against mal-adjustments and simultaneously develop the intestinal fortitude to publically praise their efforts in the face of a most unsophisticated intimidation from Washington.

Michael Labeit is an economics major, a disgruntled army reservist, an aspiring freelance writer, and an amateur logician. He currently resides in the People's Republic of New York City and can be reached at logician179@yahoo.com.


-Hubbard, R. Glenn. Money, the Financial System, and the Economy . Addison Wesley; 6 edition (July 23, 2007).

-"The Market Works Just in Time." Ludwig von Mises Institute. 7/7/2008. http://mises.org/story/3027

-"Stockpiles and Speculators." Ludwig von Mises Institute. 1/7/2008. http://mises.org/story/2819

-"The Social Function of Futures Markets." Ludwig von Mises Institute. 11/29/2006. http://mises.org/story/2399

-"The Social Function of Stock Speculators." Ludwig von Mises Institute. 11/22/2006. http://mises.org/story/2381


Copyright 2009 EPJ Group LLC

3 comments:

  1. The Mises articles are by Dr. Robert P. Murphy if anyone is interested. He also goes by "B.P. Mizzle."

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