"We seldom get into trouble when we speak softly. It is only when we raise our voices that the sparks fly and tiny molehills become great mountains of contention."
- - Gordon B. Hinckley
June 5, 2012
Pointing Fingers over Gas Prices
by Adam Smith

Like robins, crocuses, daffodils, and lovesick teenagers, rising gasoline prices have become a sure sign of spring. You hear many different explanations for the increase.

For example, you will hear free marketers say it is supply and demand, because China and India are growing at incredible rates and increasing demand for oil. They are correct.

You will hear people in the oil industry talk about taking refineries off-line and changing their formulas this time of year because the oil companies have to make so many more grades of gasoline to meet the summer air standards created by the states. They are correct.

There are others that blame geopolitical issues - the Iranians may block the Straits of Hormuz, for example. And, of course, they are correct.

Others talk about the greed of oil companies, and they are correct. It should be noted that you will not find many publicly traded companies that do not try to maximize profitability, so the oil companies are not really different from any other company.

Over the past few years there has been another reason given that has gained some traction. More and more people are blaming speculators for the increase in the price of oil. The theory is that the speculators are betting that the price of oil will go up in the future, and they bid up the price of oil in the futures market. In the past 20 years, speculator activity in the oil futures market has increased from 30% to 65%.

Suppose a speculator thinks that the price of oil is going to increase ten percent over the next six months, and the current price of oil is $100/barrel. The speculator will purchase futures contracts six months out, as long as the price stays below $110/barrel and with a level of risk he is willing to accept. If the price of oil in six months is $110/barrel or greater, then the speculator makes money. If the price is between $100 and $110/barrel, the speculator will come close to even, and if the price falls below $100, the speculator will lose money.

If there are many speculators forecasting the price to be at $110, then with an increase in the demand for oil futures contracts, the futures price will quickly increase to about $110. The market, oil producers and oil purchasers, knows the speculators estimates on price and know they will try and not sell their oil contracts for less than $110. There has been no change in supply or demand. The speculators have increased the price of oil. This is the theory.

They do not call what these speculators do "betting" without reason. Entering into futures contracts is a very risky business. This is especially true when you do not have a need for the underlying asset, which in this case is oil. Unless you sell your contract, someone is going to deliver to you a million barrels of oil, which would be hard to store in the basement of your house. So why do the speculators make their bets?

First, oil is absolutely required to make the economies of the world run, and there is no economical substitute for oil. So the speculators know that tomorrow no one will be switching to algae-run cars.

They also know that the big producers in the Middle East are going to try and maximize their profits, so it is very unlikely that the energy market will be flooded with excess oil.

They also know that the governments of countries in Europe and the U.S. are publicly committed to a reduction in global warming gases. Domestic oil production will grow at a very slow pace, if at all.

All of these factors mean that the market (supply and demand) for oil is always very tight. And when speculators see an increase in uncertainty, they immediately begin to place their bets that oil is going higher.

Right now there is a lot of uncertainty about Iran and the Middle East in general. Also, the current United States Department of Energy secretary has recently has stated that a reduction in gas prices is not the objective of the administration but a reduction in the U.S. use of oil. Given the uncertainty of future oil production and the absolute need of oil by the industrialized nations, the speculators are betting on higher oil prices.

The underlying fundamentals I have outlined make the risk-reward equation very attractive to the speculators. The speculators see a possible huge payday with limited downside. People act in a rational manner and act in ways they are incented to act. But do the speculators cause the price of oil to go higher than it would without their interference in the market?

Speculators are informed investors and are known to make markets more efficient. In the case of oil prices, this means that they move the prices to a new equilibrium faster than if they were not involved. But speculators cannot create a price that the market will not support. Remember, if no one buys at the price they are selling, then the oil is theirs to keep. So it can appear that they are setting the price when they are actually just moving the price faster than if the suppliers and buyers of oil were left to themselves.

Consider the following: What if the United States decided to open up ANWAR for oil extraction and also greatly expanded off-shore drilling. At the same time, what if they built the Keystone Pipeline from Canada to the refineries on the U.S. Gulf Coast and also released oil from the national oil reserves. Would the speculators still be betting on an increase in the price of oil?

Change the underlying fundamentals and watch the change in behavior of the speculators. Speculators can make money whether they anticipate the price of oil dramatically increasing or decreasing. Are they still the evil villains when they quickly move the price of oil lower?

Speculators do not make the market. Companies or countries that drill and extract oil, companies that refine oil, and the billions of people that consume oil products make the market. Blaming speculators for the price of oil when the United States, by far the world's largest economy, has never had a coherent energy policy is a convenient excuse by politicians and others so that the blaming fingers do not get pointed at them.


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About Adam Smith

Adam Smith is obviously not the actual name of the author of this column. The real author has worked for two Fortune 500 companies, one privately held company, and a public accounting firm. His undergraduate degree was in accounting, and he earned an MBA for his graduate degree. He also has completed coursework for a PhD. in finance. He continues to be employed by one of the Fortune 500 companies.

The author grew up in the Washington D.C. area but also lived for several years in Arizona. He currently resides with his family on the East Coast.

The author has held various callings in The Church of Jesus Christ of Latter-day Saints.

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