Speculators & Scapegoats

If you're like most people, then you could use a little brief on how the futures markets function and, ultimately, the extent to which a futures market can actually affect current spot prices. I found this article quite good for that purpose.

The article makes the connection that most articles and media reporters do not: inventory. Inventories are the key to affecting any market's spot price. Put simply, or put otherwise, the spot price does not is not affected by volume fluctuations, but rather actual changes in demand and supply. To affect the spot price for a commodity, be that oil or wheat, there must be a change in the amount supplied or the amount demanded. If you look at futures traders as shoppers in a store, then the number of shoppers really should have no affect on the prices listed on the shelves. Instead, only those actually at the checkout are having an affect - the ones taking delivery of their orders. So how do inventories come into play?

Use your own logic; if you wanted to corner a market on a particular good, then what would you do? You would try to buy-up as much of the supply as possible and then be able to set your own price; right? Right! Essentially, you would be driving-up demand and causing a shrinking supply in that good. This is exactly the counter-argument against blaming speculators for the rising oil prices because the vast majority of participants in the futures markets never take delivery, but rather roll-over their contracts days before they expire; they are not taking deliver and are not hoarding those barrels of oil in secret warehouses until they can sell it at a higher price that they set themselves. The number of barrels available has actually increased.

So, then, how do you explain the very apparent bubble in the oil price? Well, we should start by considering not the U.S. market, but the global market as a whole. As much as American's (and Canadians, for that matter) don't want to hear it, the rest of the world (the Middle East excepted) pay far higher prices than we do. One could argue, then, that the North American market prices are simply adjusting to the global prices. The question I'm sure you will ask then, of course, is why now and why so dramatically. The argument there will likely involve a lot of pointing at China and India as their economies continue to grow at near-double-digits. Unfortunately, there's a counter-argument to that as well given that the growth of those economies is not high enough to fully justify the growth in the price of oil. So, then, we've come full circle without really answering any question.

Is speculation affecting the market price of oil? Yes, probably. Are the growing economies in China and India causing an oil price spike? Yes, probably. Can either be blamed exclusively for the rising cost of oil? No. In today's global economy there is never one reason for anything; it is the interaction of many forces that results in what we see reported at the end of a trading day. The headlines will try to point to one cause or another, but the wise investor will look at all the headlines over a period of time and apply a weight to each factor to form a more comprehensive picture of what may actually be occurring and then plan accordingly. We all want a silver bullet solution, but we all also, for the most part, recognize that that's rarely the right solution.