Saturday, August 23, 2008

Speculator - Friend or Foe?

I was pumping gas the other day (once I had made the decision that driving to work was more important than adding to my new bubble wrap collection...its essential to have priorities in this day and age of $4 gasoline) and noticed something that really set me off. There was one of those mini-billboard advertisements sitting on top of the pump, usually touting the value of purchasing both a stale doughnut AND a cup of day old coffee for only $2, saving you 12 cents versus purchasing them separately. This time, however, there were no violations of health department code but rather an appeal to STOP OIL SPECULATION NOW!!!!!!!! The ad went on to ask things like "Do you have to choose between putting gas in your car or feeding your baby?" and other assorted pullers of heart strings. If you find yourself in this predicament, the ad says, its all because of oil speculation. Then it gives a website which I can't remember the exact address, but it could have been called something like, and encourages people to demand that their government representatives ban all speculation.

Now everyone loves a scapegoat, because it makes us feel better about things we have no control over. But this issue of speculation has become one of the biggest targets of congress during an election year where they want to do anything but blame themselves for high gas prices. As a trader myself, I have long understood the benefits of an active, liquid market. But apparently those smart enough to get elected to congress have absolutely no clue as to how markets work to find the true price of a commodity. I hope that in this post I can clear up the role of speculators and how they actually benefit society and keep prices in check.

First of all, we need to define what speculation is. Speculation is any action where you buy or sell something in anticipation of a future event that will affect that something. When you buy a good or service in a market its for one of two reasons. You either have a immediate demand for it that must be met with supply, or you think waiting to purchase it later will be more expensive.

Lets use an example. At some point today you will need a roll of toilet paper (or in my 3 boys' cases, 2 rolls, but we are still teaching them conservation). By the way, if this example does not apply to you then I recommend seeing a doctor. Now, you could go an buy one roll at a time, just as you need it. This would fulfill the first purpose of a market. Your immediate need is met. But in a couple of days you will need more. Buying one roll at a time would get inefficient, using more gas in the car, dealing with more Walmart cashiers, etc. Not to mention the risk that the price of toilet paper will rise by the time you need another one. The other option would be to go to your favorite warehouse club and buy the pack of 240 rolls. Now, this would save you a lot of time and money, but you would also get some strange looks from others in the store. This is especially bad if you are also buying cans of chili in bulk, trust me on this one...not that this has ever happened to me or anything. Well, moving on...even though you are saving money on bathroom tissue, you have other problems, like how to get it in the trunk of your Prius or where to store it all when you get it home. Well these problems happen all the time in the commodity markets. General Mills needs wheat for cereal, McDonalds needs beef for Big Macs, and Nestle needs cocoa for my son's addiction to Quick. How do they protect themselves from price increases so that they can manage their costs and compete with others? And what about the farmers who have these products and want to plan their operations for the next year? They need to control fluctuation in price as well.

This is where the futures markets come in. They are market places where producers can sell their grain/meat/cocoa before it is actually ready and companies like General Mills and Nestle can lock in a price for the product that they will use in the future. The other participant in these markets is the speculator. This is where you buy or sell the product in anticipation of a price changes in order to, hopefully, make a profit. Everyone is a speculator to some extent. When you bought those 240 rolls of tp, you were locking in a price for the near future. Had there been a dramatic increase in the price of toilet paper over the next few weeks, you could have sold some to your neighbor for the going price and made a profit. You weren't evil for doing so, you were just reacting to the fundamentals of the market that caused toilet paper prices to rise. In the futures market, a speculator is not even buying the actual product, but rather a contract to buy or sell it in the future at the agreed on price.

Speculators provide liquidity between the producers and consumers in the market. They are constantly buying and selling so that at any time you want to place a trade, there is someone on the other side of it to fill your order. They decide if they want to buy or sell by analyzing various data in the market. They may look at farm reports or government data or even simply patterns of price action on a chart of the commodity's price. They are not always right either. Speculation is very risky and many people lose all of their money when they try it. If you don't understand a market then you can bet there is someone else that knows more than you and will take the other side of your trade. Its all this buying and selling that leads to an efficiently priced market where all of the fundamental data that is known is factored into the price. If this activity were not going on, a farmer would never know how much his crop will be worth and from there, be unable to plan how to best use his farmland. The same applies to any market. Speculators act as a price seeker, constantly searching for equilibrium in the market, as we talked about in the previous post. This insures you will always pay the fair market price for something.

So, with all of that, how does it apply to oil? First of all, speculators are not buying or selling the actual physical commodity. The cash price of oil is not dependent on what speculators think it will be three months from now, but rather the other way around. Speculators look at the supply and demand picture today and then try to extrapolate where they think prices will be in the future. They actually provide a valuable service to the marketplace by signalling to oil companies where the price may be headed. If futures prices are high, oil companies will step up production in anticipation of selling into the higher prices. This results in more supply on the market, which then leads to a decline in prices. As this supply data is dispersed to the market, speculators take that information and sell their contracts, pushing futures prices lower, and the cycle repeats. Ultimately, this leads to consumers getting the "fairest" price based on the overall supply and demand picture, not on the "profiteering" of oil speculators.

Whew, this has turned into a long post, and I have only scratched the surface. I try to explain the basics so that the major misconceptions can be cleared up, but if anyone reading this has other questions about it, please post them in the comments section and I will try to address them in future posts. Now, I need to attend to lunch, the chili is almost ready!


Danny said...

This was very informative. You did a good job explaining speculation. I always thought they were full of it, but didn't really know.

Kirk said...

Hi Danny, Thanks for visiting my blog. A friend of Dennis is a...well, you are welcome anyway!...:)

Anytime congress is bellyaching about something and pointing the finger at a group outside of said congress, the actual problem is usually the fault of the bellyacher (according to my spell checker, "bellyacher" is not a word, but as an independent thinker I am going to go with it anyway.)

Tam said... continue to make me feel stupid. I am sure glad I got the looks!

WayneJ said...

Good read. What do you predict will happen if congress succeeds in prohibiting the trading of oil futures by those outside of the industry?

Kirk said...

Prohibiting non-producers from participating in the market would cause serious liquidity issues. This just means volume would dry up, and the "legally approved" people who wanted to buy or sell oil may not have anyone to take the other side of their trade without paying a lot more or selling for a lot less than would be available in a market full of traders. If there are fewer orders to buy and sell, then the spread between the bid (price you can immediately sell at) and the ask (price you can immediately buy at) will widen. If refiners have to pay more for oil because of wider spreads, then guess who they pass that on to? The tighter the spread, the more efficient a market is and the better the value to each market participant and as a result, to non-market participants, i.e. oil users like you and me.

A great example of the affect of liquidity on price is to compare a price chart between a high volume stock like T or IBM versus a stock that only trades a few thousand shares per day like Books-A-Million (BAMM). The low volume chart jumps all over the place, the difference between prices from moment to moment can be pretty large.

The other not-so-secret secret is that if trading were banned in the US, people would just trade on foreign exchanges. The only losers there would be the local floor traders that would lose their jobs and the exchange members that would lose the commission revenue.

Another great example of government action with zero regard for the true consequences.