It happens about this time every year: Kids across the land dust off their baseballs and Frisbees and flock to the park for some good old-fashioned fun. Strangely enough, the weather starts getting oppressively hot about the same time. The events have got to be related, no? Maybe if those darn kids would just stay home, we wouldn’t have to suffer the heat!
Of course, kids playing outside do not cause summer weather. Rather, it’s the summer weather that brings the kids out to play. The direction of cause and effect is so obvious here that even a U.S. senator can grasp it.
For one U.S. senator, however, the link between commodity prices and futures markets is not so obvious. In a CNN editorial, socialist Vermont Senator Bernie Sanders accuses vile “Wall Street speculators” of causing a steep recent increase in crude oil and gasoline prices, arguing that were it not for their antics, American consumers would be paying significantly less for this vital resource.
Sanders doesn’t say outright what he thinks the market price of oil or gas should be, but he cites some numbers suggesting that prices are 20–40 percent above the true market equilibrium level. The difference, according to Sanders, is due strictly to the actions of speculative players in oil futures markets.
Sanders never explains exactly how speculators cause high prices, nor does he offer substantive evidence for his case. He reasons as follows: There are lots of oil-market speculators; the oil price increased sharply; ergo, speculators cause high prices! But like the foolish notion that kids playing outside cause summer weather, Sanders has it backwards. In reality it’s the fluctuation in oil prices that brings speculators to the market. An economic analysis of futures markets reveals that not only are speculators incapable of sustainable price manipulation, their actions generally encourage healthy market functioning by mitigating price movements, reducing risk, and preventing shortages of important goods.
To understand the flaws of the “blame the speculators” argument, let’s first review how commodity futures markets work. Commodity prices are volatile, especially for goods like corn and oil, where supply can vary with the weather or the geopolitical situation. Producers and consumers would like some degree of price certainty so they can make reliable plans. Futures markets allow sellers and buyers to hedge against the risk of price swings by locking in the future price of the good. For example, an oilman whose projected costs of production are $100 per barrel could lock in a profit by selling a contract to deliver a thousand barrels in December for $109 per barrel. Likewise, an oil refinery could buy the same futures contract to ensure that its cost of crude doesn’t rise. We can think of futures markets as providing price insurance for such hedgers.
Speculators, on the other hand, attempt to profit from a price movement. Suppose an analyst believes that escalating Mideast tensions will cause oil prices to spike to $150 by December. She could earn a potential profit of $41 per barrel by buying the $109 contract—known as “going long”—and cashing it in for $150 in December. Another analyst expects a large new pipeline to come into operation, thus increasing future supply and pushing prices back down to $90. He could earn a $19 profit by selling the contract—“going short”—and closing it out at the lower price. In each case one speculator’s profit was another’s loss; in the long run profits only accrue to speculators with better judgment about the future.
Such speculators are the focus of Sanders’s wrath. His implicit argument is that they bid up the price of oil by buying lots of futures contracts, hoping to close out their speculative positions at inflated prices and take massive profits. But Sanders forgets that for every futures buyer there must be an equal and opposite seller, whether a hedging producer or a bearish speculator. Typically, because each side’s bets on the future oil price offset the other’s, there’s no discernible effect on oil production, oil stocks, or the spot oil price.
Occasionally, extremely bullish sentiment or attempts at market manipulation could exert upward price pressure through the futures market. In this setting speculators must bid futures prices up sharply to find willing sellers. But if it’s just speculation driving the price, and not supply and demand, the futures price will rise above the spot price—a situation known as “contango.” For example, say spot oil is $107 per barrel, but speculative bidding has ratcheted the December futures price up to $120. With futures prices elevated above spot prices, there is a clear profit opportunity in buying a few tanker loads of oil at $107, selling the December contract at $120, and pocketing $13 per-barrel profit (less storage costs) when the contract expires. Therefore, the more successful bullish speculators are at pushing the price up to unrealistic heights, the greater profit opportunity they present to offsetting bearish speculators to go short. And the more oil arbitrageurs stockpile now—reducing current supply to boost future supply—the lower the futures price will be. In any speculative market play, arbitrage ensures that the bears offset the bulls, leaving “market fundamentals” of supply and demand as the true culprit for any lasting price changes. As the classical economists indicated, markets are “self-correcting.”
The data back this up. Recall that hyper-bullish futures buying raises the futures price above spot (contango), which encourages stockpiling by short-side speculators. Yet with a significant 13 percent uptick in oil prices during February 2012, domestic inventories rose by a comparatively small 1.5 percent. More important, the fact that near-term futures were only slightly above the spot price, while longer-term futures were trading below spot, suggests a complete lack of an abnormal contango situation. In other words, there was no evidence of speculative fever in any direction.
To summarize: The futures price of oil expresses the market’s opinion of future oil fundamentals of supply and demand, and not much else. Indeed, history has proven time and again that speculators who recklessly gamble by trying to manipulate futures markets tend to fail fast and lose big. Consider the Hunt brothers, heirs of a Texas oil fortune, who (allegedly) tried to “corner” the market in silver in 1980 by aggressively bidding up the futures price to increase the value of their holdings. While they were able to dramatically boost the price with massive, highly leveraged long positions, their actions invited “the big shorts,” whose counteraction quickly crashed the market, costing the Hunts billions.
The only way to win at speculative trading is to have superior knowledge about future market conditions. Speculators are gamblers in a way, and they can lose big. But they perform a valuable function by taking the risk of price volatility off of hedgers’ shoulders. Because arbitrage ensures that erroneous or manipulative bidding (or shorting) can’t long endure, speculators typically move prices in the direction of long-run equilibrium, thus reducing overall volatility. This relative stability benefits consumers by saving them from roller-coaster prices.