Populists Against Speculators.....

There has been much fretting and gnashing of teeth over the role of speculators in the gigantic rise in the price of oil over the past several years. Also, our political leaders, including candidates Obama and McCain, have been taking populist regulatory stances against these important price finding mechanisms. What role does speculation play in the change of a price of certain commodities? I argue that it plays no role what-so-ever in the long-term price of any good or service.

Many years ago, the Hunt brothers tried to corner the market in silver. They purchased the physical commodity, put it in a warehouse and then continued to purchase silver in the futures markets (where one agrees to pay a certain price for delivery in the future). The implied threat is that the Hunt brothers would have forced delivery of the silver when supplies were already tight.

As per Wikipedia....

Beginning in the early 1970s, Hunt and his brother William Herbert Hunt began accumulating large amounts of silver. By 1979, they had nearly cornered the global market. In the last nine months of 1979, the brothers earned an estimated $2 billion to $4 billion in silver speculation, with estimated silver holdings of 100 million oz.

During the Hunt brothers' accumulation of the precious metal, prices of silver futures contracts and silver bullion during 1979 and 1980 silver prices rose from $11 an ounce in September 1979 to $50 an ounce in January 1980. Silver prices ultimately collapsed to below $11 an ounce two months later.

In 1989 in a settlement with the United States Commodity Futures Trading Commission, Nelson Bunker Hunt was fined US$10 million and banned from trading in the commodity markets as a result of charges stemming from his attempt to corner the market in silver, leading to a commodity crash known as Silver Thursday. This was in addition to a multimillion-dollar settlement to pay back taxes, fines and interest to the Internal Revenue Service for the same period.

Hunt filed for bankruptcy under Chapter 11 of the Federal Bankruptcy Code in September 1988, largely due to lawsuits incurred as a result of his silver speculation.

Oops. Those dreaded speculators lost money? In this case billions. Real markets humbled people that thought that they could control a market. Liberals, please take note. As an aside, the collapse of Freddie Mac and Fannie Mae shows that even well intentioned government programs cannot suspend the humbling hand of real markets.

So, back to speculators. Lets assume that speculators want to drive up the price of a commodity like oil. First, in order to benefit, they have to own oil to make a profit if the price rises. No speculator makes money if the price rises and they do not own anything. So they need to buy. And to own, they have to store it and that costs lots of money.

And, in order for prices to rise, there have to be more buyers than sellers. So, on balance, speculators can cause prices to rise, short-term by increasing the buying demand relative to sellers. Remember, for every buyer of any commodity, whether physical or in the futures market, there has to be a seller. That is how prices are reported, by actual transactions.

So, by definition, for every speculative buyer, there has to be a seller. Every transaction has to have both a buyer and seller. Some of these people are speculators too that sell. So if a speculator sells and the price rises, they lose. So in this mad rush of buyers and sellers, a price is determined. When prices rise very very high as they did with oil this past Summer, it is foolish to think, that speculators also were not sellers at those high prices tempering the rise.

So, blaming speculators for only the rise, is shortsighted particularity in light of of a CFTC report sited in this WSJ Op-ed...

Lo and behold, the CFTC found that index traders and swap dealers actually reduced their stake in crude oil futures as prices spiked. The number of contracts held by these investors betting that prices would increase -- the net long position -- fell by 11%, and more were shorting oil than going long over the six-month period. In other words, index traders and swap dealers were driving the future price of oil down.

Commodity index funds also have a much smaller share of the oil market than everyone thought: just 13%. Even if the figure was 70% or more, as some assumed, it wouldn't have mattered. In a futures exchange, trades are matched, so one trader's gain is another's loss. The overall volume is irrelevant.

Hmmmmm. I suspect, that in reality, people were concerned about inflation. As a result of that, some assets for large investors such as pension funds were moved into asset classes that perform well in inflationary times. So these funds flowed into buying hard commodities as an asset allocation strategy. These investors, by definition, are not speculators. so, on the margin, money flowed into buying these commodities casuing prices to rise. More buyers than sellers.

But one must also consider what impact higher prices have besides the populist higher prices at teh gas pump. One of the immediate impacts is that demand falls. Also, previously unprofitable supply finds its way to market. Furthermore, alternative energy sources become competitive in price such as wind and solar power.

So, in my humble opinion, the price mechinism works. We have been warned that we do not have unlimited supplies of oil and that we need, not as governments but as individuals, to think about how to change our lives and reduce personal risk tied to energy. Thank God that markets have been allowed to operate.