Thursday, June 5, 2008

Speculator scapegoats

It has become fashionable to blame "speculators" for the rise in oil and food prices as well as the sub-prime mess. The Almighty Economist cogently explains why that is mistaken, at least if you care about facts:

Investment can flood into the oil market without driving up prices because speculators are not buying any actual crude. Instead, they buy contracts for future delivery. When those contracts mature, they either settle them with a cash payment or sell them on to genuine consumers. Either way, no oil is hoarded or somehow kept off the market. The contracts are really a bet about which way the price will go and the number of bets does not affect the amount of oil available. As Mr Harris puts it, there is no limit to the number of "paper barrels" that can be bought and sold.

That makes it harder for a bubble to develop in oil than in the shares of internet firms, say, or in housing, where the supply of the asset is finite. Ultimately, says David Kirsch of PFC Energy, a consultancy, there is only one type of customer for crude: refineries. If speculators on the futures markets get carried away, pushing prices so high that refineries run at a loss, they will simply shut down, causing the price to fall again. Moreover, speculators do not always assume that prices will rise. As recently as last year, the speculative bears on NYMEX outweighed the bulls.

The speculators by definition do not consume these commodities. They don't hoard or stockpile them. They merely hold temporarily hold the rights to them. The end result is roughly the same amount of product delivered at the appointed time for a price acceptable to the eventual buyer.

Indeed, because the speculator cannot actually take delivery (lacking tankers or silos), they are in some sense at the mercy of consumers because they absolutely must sell their rights before the futures contract's delivery date. These people are taking risks, risks that could blow up in their faces. That possibility of total loss to the speculator keeps them reasonable.

Is it possible for that price to be higher than it would be without speculation? Yes, but it is also possible that the price is lower than it would otherwise have been. This kind of financial maneuvering can help reduce risk to both producers and consumers, and thus stabilize price and supply.

Of course, the logic is different when these outsiders get into the business directly. Different, but with the same result. If these people are paying too much, they're going to get hurt by it. If they're getting a good deal, other people can get that deal, too. Worst-case scenario is that there's volatility and then things return to normal. The best-case scenario is that our agricultural infrastructure gets a lot better. I can live with that.

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