How to bring down oil prices, part 2

We have been hearing that oil inventory levels indicate the supply of crude oil is essentially in balance with demand and that the current high price is due to speculation.

To understand the effect of speculation requires knowledge about the basic tool of the trade, the futures contract.

A futures contract is a standardized agreement to sell or buy a specified quantity of a specified asset for a specified price on a specified delivery date. This contract creates an obligation to buy or sell on the delivery date. The seller of the contract is the party providing the asset; the buyer of the contract is the one taking delivery.

There are two broad categories of traders in futures: hedgers and speculators. A hedger has an interest in the underlying asset while a speculator is looking to make a “paper profit” by correctly predicting the future value of the asset.

A hedger is typically either a producer or a consumer of the asset. For example, a farmer believing the price is going down may sell a wheat future contract to lock in a higher price for his crop. On the other hand, a bread manufacturer may purchase wheat futures to lock in the current price of the raw material if it is believed to be going up. Or the farmer may simply want to eliminate risk in the price of his product by giving up a potentially higher price in return for a guarantee of the current selling price. And the manufacturer to ensure he can get the raw material he needed at any price. It was this fundamental purpose the futures market was originally created; not as a casino.

Before the creation of the futures market, a farmer might bring crops to town after harvest and find that supply vastly exceeded demand. His product might be worthless and left to rot in the street. Conversely, someone who needed the crop may find the supply to be nonexistent, such as in the offseason or in bad years. The initial futures market was for grain and served to stabilize prices and ensure supply, both by matching sellers and buyers and by increasing the size of the marketplace beyond the local town.

A speculator is merely betting that the value of the asset will go up or down with no intention to make or take delivery in the asset. Once a contract is made, it cannot be cancelled; but one or both of the originating parties may opt out of delivery by taking an opposing position in another contract so that the two cancel out with respect to the quantity of the asset. There is usually a value difference between the two contracts and that is how money is made or lost in the futures market.

Where did the speculators come from and why are they there? To a speculator, the futures market is just another of many places to invest his money to try to make a profit. In the past year, returns in the stock market have been disappointing. Interest rates are down. Real estate is losing value in many cities. The dollar has become very weak. There is much money looking for a place to multiply and commodities have great intrinsic value because the global economy has been expanding. This shifting of capital has affected not only oil, but gold, copper, wheat and rice. The effect may not be desirable or “fair,” but it is not illegal.

So why don’t we just prohibit speculation to bring down the price of crude oil? Speculators do serve a useful purpose in the market by providing liquidity. If only those with an interest in the asset were allowed to trade, it would be a very small marketplace indeed. Price discovery is the process in which each trade in a market tends to drive the price toward the true value of the asset, provided there is no shortage of buyers or sellers. The problem with a small marketplace is that it may be very difficult to match a buyer with a seller. A seller may have to settle for an unreasonably low price to make a deal at all or a buyer may have to pay an exorbitant price. In either case, the transaction price bears little resemblance to the true value of the asset. Not a good thing. Any regulation to discourage speculation has a side effect of making the marketplace less efficient for those using it “legitimately.” Investigations into whether there has been any oil price manipulation have turned up nothing so far.

The problem is not the speculator but the belief that oil will be worth more tomorrow than today, and more than in other forms of investment. Bear in mind that the speculator is not in oil today because he wants to be in oil; he is there because he thinks there is currently money to be made in oil. Several things can be done to encourage the speculator to take his money elsewhere.

One is to raise interest rates. If the rate of return is higher, many speculators will gladly shift money into safe government and corporate bonds rather than risk it on the futures market. Some will argue that a higher cost of borrowing will slow the economy, but the high cost of oil has a similar effect.

Another is to improve the value of the dollar. While the dollar is only one of many currencies in the world, it is the denomination of the futures market. As the dollar got weaker, commodities got cheaper for the rest of the world relative to their currencies, putting pressure on each commodity to go up in value.

The most effective solution is to substantially change the long-term balance between supply and demand.

As oil has become a virtual necessity in the economy, a drastic reduction in demand is not easy. High prices have made some consumers reduce how much they drive. And a slowing economy will reduce demand for fuel by businesses. But without a major cultural shift such as a 4-day workweek or widespread telecommuting, the demand for gasoline will not change much. Only a prolonged period of high prices will cause widespread replacement of vehicles with more energy-efficient ones. Some companies are learning to become more energy efficient, but there are limits on the easy savings.

The growth of emerging economies, namely in Asia, are blamed by some for adding demand for oil. There is some truth to this as some of these countries subsidize the cost of fuel and by keeping the price for the consumer artificially low, encourage consumption instead of conservation. These subsidies are a major burden for the treasuries of these countries, so this situation is due for a change. China is a huge offender, but do not expect any change in their energy policy at least until the end of the Olympic games in August.

Oil has seen many dramatic price changes in its history. Members of OPEC are notorious for cheating on their production quotas in the past and this flooding of the marketplace has driven some of the major price declines. But with the price so artificially high, many currently realize that they can maximize their revenue by not driving the price down.

New sources of oil do not have this incentive to keep prices high. Any amount they make is an improvement over the zero they make now. Only by adding to the sources can the supply be truly increased. Those already in the marketplace will not produce at full capacity because they can make more by producing less.

So how about it, US of A? You have as much in proven oil reserves as nearly any oil producing country. And you stand alone as the one not increasing your production. The ball is in your court…


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2 Responses to “How to bring down oil prices, part 2”

  1. jwcooper3 Says:

    Snuck this right in on me, eh?

  2. Bill Says:

    jwcooper3 – yes, I did. The experiment was to see how much traffic I could generate without any active promotion on my part. Just links in my comments, tags within WordPress and allowing search engines to index the posts.

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