The Grass is Always Greener

This is a funny story about how the ban against futures trading in the market for onions, introduced in the late 50's, may finally be repealed to help stabilize the volatility in prices... yes, I said stabilize. All this, while the news is rife with talk about how futures traders (a.k.a. so-called speculators) are blamed for the persistently climbing oil prices. So where's the truth? Do traders help stabilize or do they increase volatility in the markets?

The price of onions, apparently, has soared as much as 400% between October 2006 and April 2007; that puts the rise in oil prices to shame. This happened, of course, with no futures market at all so analysts have no choice but to put the blame on the good ol' forces of supply and demand. All that volatility came on the back of swings in the weather; as the supply of onions dried-up, the prices soared. It's just that simple. So why, then, can it not be the same for the oil market?

As with a lot of things in life, it's more than likely that the truth lies somewhere in the middle. You must recall that a futures market was introduced primarily for the purpose of stabilizing the commodities markets by providing producers, farmers for example, with a way to hedge against changing weather conditions and ensure themselves of a more predictable revenue stream against which they could plan their businesses. Again, as with many things in life, there's a downside. Just as the futures markets can stabilize prices, they can also exacerbate fluctuations.

There are two fundamental forces: demand and supply. Weather affects only one side: supply. Similarly the arguments about how much oil is in the ground are all arguments about supply. The futures market makes it easier for people to speculate on the future price of good and this, simply, drives greater demand for that product. Without a futures market, the only people who are buying a commodity are those who can take delivery - just as you would at a grocery store. The futures market allows you to place an order for, let's say oil, with the option of canceling your order before it comes time to pick-up your order. That's what people have labeled speculation. It's nothing more than higher demand with a fancy name. So, then, what does this all mean?

The introduction of a futures market in the market for onions or, similarly, the legislation against speculation in the oil futures market will not really resolve anything in the long-term. In each case, market participants are responding to the current market conditions without much consideration for how the market outlook six-months or six-years from now. A futures market does stabilize the prices in a market during times of turbulent weather and may actually increase volatility in times of stable market climates. The futures market is a synthetic market introduced by laws and regulations; whenever you introduce such legislation you have to take the good with the bad. For any benefit that comes from a law, there's bound to be some negative externality that balances the scales. The grass is not actually that much greener on the other side of the fence. Sorry.