Following Paul Krugman’s lead The Economist this week lays out the case that speculators are not to blame for oil’s increase in price.

Pointing out that the increase in speculation tracks nicely with the tripling of oil prices the author of the article then attemps to prove that this is a mere coincidence -

This reasoning holds obvious appeal for those looking for a scapegoat. But there is little evidence to support it. For one thing, the surge in investment in oil futures is not that large relative to the global trade in oil. Barclays Capital, an investment bank, calculates that “index funds”, which have especially exercised the politicians because they always bet on rising prices, account for only 12% of the outstanding contracts on NYMEX and have a value equivalent to just 2% of the world’s yearly oil consumption.

More importantly, neither index funds nor other speculators ever buy any physical oil. Instead, they buy futures and options which they settle with a cash payment when they fall due. In essence, these are bets on which way the oil price will move. Since the real currency of such contracts is cash, rather than barrels of crude, there is no limit to the number of bets that can be made. And since no oil is ever held back from the market, these bets do not affect the price of oil any more than bets on a football match affect the result.

Now I have to admit I am almost convinced that speculation is not driving up cost, but something about this explanation bothers me and maybe someone who actually invests in commodities can explain to me why I am wrong.

As I understand it when you buy oil futures you are paying for so many barrels of oil to be delivered at a certain date. You can then sell this oil (hopefully at a profit) at that time or if you have the facilities to take delivery you can hold it and sell it at a time when the price is more in line with what you want.

If I understand it correctly until very recently most speculation was done on a short term basis because federal regulations only allowed certain “persons” like an airline (Southwest would be a perfect example) to buy large numbers of futures and hold them without taking delivery. In addition there was a much larger up front cash payment required and a much more limited number of barrels could be traded; that changed in 2000 when a lot of energy markets were deregulated.

With these changes in place it seems to me that a feedback loop has been set up. The changes have made it more profitable to buy and hold oil for a long term than to trade it in the short term, which if my understanding is correct is the opposite of the way markets usually work. Usually the spot market is more expensive, Now when the oil that had previously been held by the specualtor comes onto the market it drives up the price on the spot market, which in turn increases the price of long term futures and the cycle repeats.

I know this is simplistic, but is it incorrect?

If my speculation on speculation is correct then everytime new futures are purchased the price is going to go up, until at some point some breaking point is reached and then we will probably see a crash like no ones business - much like the housing market.

Anyway that is my uninformed rant of the day.

This entry was posted on Monday, July 7th, 2008 at 9:23 am by Chad and is filed under Brilliant, but uncategorizable. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.