Some of the ire over high gas prices has recently caused some, including Congress, to set their sights on speculators in the oil markets.  The fact is that such demagoguery only exposes the ignorance of those shouting the loudest.  Speculators of all kinds are key elements of any thriving market and history bears out that restricting their investments only exacerbates perceived “problems.”

A friend at work was complaining about speculators when I asked him what he thought about Southwest Airlines speculating in fuel prices.  The air carrier has done quite well despite the general downturn in commercial aviation because they took a risk and bought futures contracts for fuel on the assumption that prices were going to rise.  (It should be said that they were one of the few, if not only, airlines with the cash on hand to sign those contracts a few years ago that helped secure their strong position.)  They are currently getting a majority of their fuel for about 40% of the going price.  That is speculation.  It enables them to make money while charging reasonable fares.

My friend relented and admitted that all speculators are not bad, just those who purchase the commodity with no plans to use it.  Southwest was different because they use the fuel in their operations, he explained.  I asked what he thought about wholesalers.  Those individuals purchase raw materials and finished products directly from manufacturers with no intent to consume them in any operational process.  They purchase them with the hopes that they can sell them for more - hopefully much more - than they paid.  That is speculation.

Speculation is how markets work and we all engage in it to some extent.  Unfortunately most people can’t conceptualize how speculation serves to stabilize prices and supplies over the long run.  Speculators are in it to make money and when professional investors put their money at risk they don’t tend to do so at random or to punish society.  They make informed decisions based on available facts in the hopes of maximizing their returns.  They will dispassionately bet on the price going up if that is what the facts suggest or down if the facts suggest otherwise.  Remember - “… from their regard to their own self interest,” as Adam Smith said.  This can be seen in political markets such as Intrade.  Forget what the talking heads on television and radio say.  If you want to know who is going to win an election then follow who people are betting their hard earned money on.

Let’s look at oil, since it is the fuel behind this post, although you could substitute any commodity directly into this paragraph.  When smart people who study the oil market for a living think that future demand will outstrip available supplies then they will speculate accordingly.  Before you curse at them think about the positive consequences of their actions.  Oil companies will recognize that futures prices are higher and they will make decisions to expand exploration and production into areas that were not profitable at lower prices.  Because of this recognition of futures prices the increased production will work to offset the anticipated supply deficit.  In fact, the oil companies could expand production too rapidly in the hopes of making large profits and cause prices to fall.  Without the speculation the companies would have no way to know how to react to what will happen in the future and therefore may not be able to prepare for surges in supply or other perturbations that speculators may have identified.  That lack of information could cause prices to swing more rapidly and unexpectedly in either direction.

No one likes to pay high prices for gas.  I know that I don’t.  But there comes a point where rational analysis has to stand in the way of stark emotion and political posturing.  It is unseemely to some that speculators make money on oil while gas is $4 a gallon.  However, keep in mind that many of those speculators also lose money (they don’t call it speculation for nothin’) and that without their efforts the price could be even higher.

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This entry was posted by Brian on Friday, July 11th, 2008 at 11:10 pm and is filed under Energy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site. Please note the copyright policy.