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Speculators are Part of the Market

07/24/2008

In a July 21, 2008 column in the Jewish World Review with a shouting headline of STOP OIL SPECULATION NOW!, Dick Morris and Eileen McGann argued that the government should take action to restrict trading in futures markets. They are mistaken, however, in their assessment of oil speculation. Speculation is an important part of the supply and demand process.

Futures markets are markets in which people trade the right to specified quantities of a specified commodity to be delivered at some point in the future. For example, one might be able to buy or sell a contract whereby the seller agrees to deliver a barrel of crude petroleum on December 1, 2016 at a price of $150. Traders who believe the price will be below $150 per barrel should sell such a contract. Traders who believe the price will be above $150 per barrel should buy such a contract.

This has important implications for how resources are allocated across time and space. The price of oil today and the price of oil in the future will tend toward equality after we adjust for the time value of money (one dollar today is worth more than one dollar tomorrow, so anyone who wants a dollar tomorrow will have to pay interest). According to what economists call the law of one price, the discounted present value of oil today will equal the discounted present value of oil tomorrow, all other things remaining equal.

It is the fact that all other things do not remain equal that produces profitable opportunities for speculators. People with better information about market conditions can profit from their insight and perform the valuable public service of ensuring adequate oil supplies tomorrow.

Speculation does not interfere with supply and demand. Speculation is part the process by which supply and demand adjust. What Morris and McGann seek to restrict is exactly the kind of behavior that supply-and-demand analysis would predict.

What Morris and McGann deride as “unbridled gambling” is an essential part of the market process. This may be rhetorically effective but it is analytically erroneous. Morris and McGann seem to think of trading in futures markets as being equivalent to spinning a roulette wheel, and if you don’t know what you’re doing, speculating in futures markets can be just as dangerous. The fact of the matter, however, is that speculators are not gambling in the pure sense of the word. They are acting on the basis of their best understanding of current market conditions and their expectations about future market conditions. They may be incorrect, but they are not “gambling.”

Morris and McGann write “(i)f there is any doubt that it is speculation, not the supply and demand for oil, that is driving up the price, look at this week’s history of oil prices.” He then cites President Bush’s executive order to permit offshore drilling and OPEC’s statement that oil demand was falling and argues that these were responsible for a $15 price drop even though “(n)o new oil gushed through the system.”

This is exactly what supply and demand would predict. If offshore drilling is permitted, this will increase the future supply of oil and drive town the future price. People who were holding oil in anticipation of higher future prices will instead release some of that oil onto the market today, increasing the current supply of oil. Nothing untoward is going on: the supply of oil today is changing in response to traders’ revised expectations about the supply of oil in the future. This is literally economics 101: what I have just described is what I teach in my econ 101 lectures on futures markets.

Morris and McGann conclude that “(o)il is just too important strategically and economically to allow that kind of speculation,” but speculation is the market mechanism by which price volatility is reduced and future supplies are guaranteed. If oil really is that important, we should be loosening the restraints on futures market speculation rather than tightening them.

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Contact Art Carden

Art Carden is assistant professor of economics, Brock School of Business, Samford University, Birmingham, Alabama.

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