You’ve heard the buzz word “oil speculator” shouted from the high heavens of Capital Hill, you’ve seen Americans at the gas pumps blaming these anonymous likely Caucasian men in suits for the high oil prices we are “suffering” with these days, but have you stopped to actually learn what an oil speculator is?
First let’s look briefly at how oil and all commodities are traded. The New York Mercantile Exchange (NYMEX) is one place commodities are bought in sold. Of course there aren’t 50,000 trucks and some oil tankers sitting outside, they’re only trading contracts called “futures”. For example I can buy a contract for 100,000 barrels to be delivered in December (the future) on the exchange. If my business requires the use of crude oil its great to plan ahead for delivery. As a business to business tool it is great to have a centralized location where a product of unified quality (like gold, oil, natural gas) can be purchased. Those individuals buying contracts are not necessarily speculators.
Speculation occurs when a buyer purchases a contract in an attempt to profit from the market fluctuations. This alone is not bad per se as commodities tend to be good investment vehicles to hedge against inflation and stock market performance. Speculators have actually played a role in stabilizing prices in commodities that can vary in supply year to year like corn (droughts and all that). But oil supply is very steady since the process is mechanical and rarely interrupted. A good example of an exception was Hurricane Katrina and the oil rigs in the Gulf of Mexico, but this is rare.
That was the supply side, what about demand? The key talking point here is leverage. Leverage allows any investor to supplement their investment by borrowing to invest more. If I wanted to buy a contract for a barrel of oil at $100 I could pay $100. Or, I could buy it for $50 of my own money and borrow the other $50. What is the advantage? We have to look at the increase in the price of oil to see. Let’s say the price of oil jumps to $150, I could sell my contract for a $50 profit. Dandy! That’s a 50% return if I invested $100. But if I just put in $50 of my money (borrowing the other $50) the return on MY investment is 100%. Double the return. The most important part of this is that I could get a 100% return even though the price of the oil only when up 50%. Reread this paragraph as many times as you need to.
What if I told you I didn’t need to even put down $50 for that $100 barrel of oil? What if it was more like $5? Putting down $5 per barrel allows me to buy 20 barrels from my $100. This would be a 5% margin buy (I put down 5%). If oil goes from $100 to $150 like before my contracts are now worth 20 X $150 = $3000. Since I borrowed $95 per barrel I must pay back $95 X 20 barrels = $1900. Subtract what I owe from what I made $3000 – $1900 = $1100* in my pocket at the end of the day. Since I only invested $100 to begin with I made a return of, yes, 1100%. Compare that to the S&P average of about 8% per year and you see why speculation is popular.
The concern is whether the presence of the speculators and their intense leverage use is driving up the price. In the short term it does. With all the money being dumped out of real estate and stocks and pumped into commodities there is an intense new demand. Since these people don’t want the oil delivered to their Manhattan offices they must at some point sell the contracts. Eventually there will be more of them selling than buying, and the price will drop. From time to time it happens quickly creating the bubble “pop”.
I have no doubt they have driven up the price, but I also cannot be certain when the bubble will pop. The government is interested in facilitating this pop instead waiting for the free market to act. This is because during the run up most regular folks pay the ultimate price in more expensive tangible goods (like gas). Congress could require higher margins (its something like a 50% minimum for stocks) thus investors would borrow less and put up more of their own money, curbing demand. This might control speculation but Wall Street is smart enough to find a way around it (and rich enough to lobby against it). No I don’t have a better idea but my tax dollars don’t pay me to think of better ideas. I pay Congress to do it, but we’ve all seen how brilliant that collective brain is.
Buying on margin is not evil. If that were the case you couldn’t have a mortgage. Buying a house with a loan is buying on margin, and the economy benefits because most of us can’t save up the money to buy a house with cash outright. But when people start abusing a system designed to stimulate progressive growth for their own quick personal gain, bubbles occur. We saw this in real estate with sub-prime loans and now in oil.
The bad speculators would say “If one person doesn’t exploit the market for personal gain then another person will; might as well be me”. Pimps would say “Don’t hate the player; hate the game”.
Just like “hedge fund”, “sub-prime mortgage”, and “crack-cocaine” the term “oil speculator” has now been associated with all things bad. As a matter of fact, all these investment vehicles serve a purpose that actually benefits the economy. It’s just some greedy folks started abusing the system and gave birth to the negative associations we all have with them today. Alright, maybe we can do without the crack, but the rest are good when used properly.
*Note we did ignore transaction costs and the interest on my loans. In the grand scheme and volume of these trades these costs are insignificant. Scaled down to this level it would be pennies.
 By The Weakonomist |
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