July 2, 2008

Oil Futures – Is there a Bogyman?

Futures also have to do with supply and demand. A futures contract is simply a sale agreed to at a specific price at a specific point in the future. However, futures contracts are still based on supply and demand. The futures price must be the current price plus the time value of money, otherwise there is an opportunity for arbitrage (which means a person can do some buying and selling and make a riskless return). Thus, if a gap opens between the relationship between the spot price and the futures price, investors will quickly close the gap through arbitrage transactions.

So, people are saying that the demand by speculators for futures contracts on oil is in essence pulling up the spot price of oil. Imagine that you are a speculator (an investor but sometime speculator sounds more sinister), and you believe that the price of oil will be higher three months from now. Thus, you go into the market and buy a futures contract. If a lot of investors are doing this, then the price of futures will rise and pull up the current spot price.

Speculators are not the only people who will be in the market. Companies who use oil (and oil based products) such as an airline will also likely be buying futures. They may decide that they can get by with the current price, but if it goes higher they will really hurt. So they purchase futures contracts to protect against price increases in the future.

On the other side of the contracts are sellers/producers of oil. They will sell a futures contract because they are afraid that the spot price will drop in the future. They are willing to give up the possibility of higher prices in exchange for locking in a price now.

Consider what happens to the speculators if price drops before the contract becomes due. They are obligated to buy the oil. They must either buy the oil and sell it at a loss (if they are speculators they have no actual use for the oil), or they have to cash settle the contract and pay the seller the difference in price and the seller resells the oil to someone else. In other words speculators are constrained by the risk of loss they face if they guess wrong.

Thus, the only real significant danger in all this is if somehow someone is manipulating the futures market. This is a possibility. If you remember the California electricity crisis of 2000, Enron and others were involved in manipulating the market. But, this means that they have to be able to artificially restrict supply and create the perception of greater risk in the market. Much of the world's oil market already is manipulated by the fact that it is controlled by OPEC, which is a cartel of the largest oil producers. They work together to decide which country will produce what amount. In that sense oil markets have been manipulated since the 1970s, but we have become used to such manipulation. I tend to resist conspiracy theories, and I tend to believe that high oil prices are the result of well understood events in the market. However, I would not be shocked if a year from now we find that some oil producing countries did engage in some manipulative practices. Such episodes do not tend to be long-lived and usually hurt those who engage in the manipulation. But, the high prices are encouraging people to reduce their oil use significantly. At that trend continues it will be harder and harder to support some plan to manipulate the market and if it is happening it will come to an end. Ask Enron.