Are you trolling, forgetful, or just plain stupid?
This is ec-101 level stuff. I talked you through this like a month ago. Should I have avoided words larger than two syllables?
OK, y’all are right, in the 1970s that was probably the root cause of shortages in the USA.
So clearly that’s the only cause we’ve seen in our lifetimes. The question I have is… is that the only possible cause of a shortage?
Forgetful. My mistake.
This is ec-101 level stuff. I talked you through this like a month ago. Should I have avoided words larger than two syllables?
So is understanding that the direct cause of the price of a future – and any investment, really – is pure speculation and investment choices and only partially driven by real-world supply and demand.
argh, sorry for the bitchiness. I’m really frazzled from work, probably shouldn’t be posting in P&R.
Anyway:
- shortages (e.g. not enough supply to meet demand) cannot happen in a free market. If demand exceeds supply, price rises until they reach an equilibrium. That may leave people disappointed that they can’t afford a good, but that’s a whole other story.
- Yes, futures markets are based on speculation in the sense that people are making an educated guess on where the price of a commodity will be in x weeks. It does not follow from there that the price of oil on any given date isn’t driven by supply and demand.
Well, if I weren’t being such an arrogant SOB to start with, I wouldn’t be pissing everyone (not just you) so much, so it’s not really your fault.
Anyway:
- shortages (e.g. not enough supply to meet demand) cannot happen in a free market. If demand exceeds supply, price rises until they reach an equilibrium. That may leave people disappointed that they can’t afford a good, but that’s a whole other story.
Certain commodities have what’s called “inelastic demand.” Rice in Asia, for example; it’s what people eat and know how to cook, and a high price isn’t going to stop people from wanting to eat it. Oil is such a beast here in the USA; we can drive less and more fuel-efficient cars, but trucks, planes and trains that are expected to drive, fly and run on time take months to alter their schedules. There’s a limit to how much we can do in a short period of time. We can cut back on plastics, but that also takes months, not weeks.
- Yes, futures markets are based on speculation in the sense that people are making an educated guess on where the price of a commodity will be in x weeks. It does not follow from there that the price of oil on any given date isn’t driven by supply and demand.
Supply and demand for what? If you base it on pure oil production and consumption, the numbers don’t fit. The supply and demand that directly affects the price is supply and demand of buyers and sellers for futures contracts, which is based as much as what people want to invest in this month as anything. As I mentioned earlier, right now ridiculous amounts of money are being thrown into commodities as a hedge against inflation and a weak dollar; crude is getting extra attention due to fears – not reality, but fears – of an impending supply drop. That money represents people who want to buy futures contracts for no reason other than investment purposes, and that competition among buyers for contracts is going to lead to the few contracts that do get sold going for inflated prices.
While the situation differs from the housing bubble in that in this market someone has to actually use the item on a certain date, that doesn’t mean that the item won’t change hands between a bunch of folks buying it from each other prior to someone who actually wants the good getting it due to nothing more than a surfeit of buyers. Even though they never plan on taking delivery, their mere presence pushes the price up if most of them want to buy or down if most of them want to sell.
Try looking at it this way - when you buy a future what you’re betting on is that someone, somewhere will be willing to buy that commodity at that price at that date. If you lose that bet, you get fucked. The buck stops there.
If the price of oil were really based entirely on futures traders and not the underlying supply/demand relationship we’d expect to see a whole bunch of traders having to take delivery of oil they can’t sell at a profit. That hasn’t happened yet - so when will it happen?
I sense there is some form of circular logic going on here, but I can’t pinpoint it…
We’re kinda talking at each other a little.
Correct; now the question is, supply and demand of what? Is it the actual production and consumption of oil, or is it based on something else?
I think the price that a delivery is finally taken at reflects the supply and demand relationship for that commodity.
I don’t understand enough about the futures markets to have an opinion on the degree to which speculators are responsible for the runup in oil prices. That said, I think the above summary is incomplete.
A buyer of a futures commodities contract enters into an obligation to take delivery of a specified amount of the commodity at a certain time. The price of these futures varies daily, based on estimates of future prices. For example, today’s settle price for a Dec 2008 gold future contract was 936.90/oz. For comparison, today’s current market price for gold was 928.73/oz. A person could buy a Dec contract for $93690 (contract size is 100 troy oz). In reality, many purchasers will make use of margin. The purchaser only has to have a minimum of $3250 per contract in his or her account.
Two groups of people buy futures contracts: hedgers and speculators. Hedgers are end-users of the commodity that want to reduce risk by locking in a price. A jeweler might need a lot of gold in December in order to make items for Christmas & Valentine’s Day. They could wait until December and buy gold then, but the uncertainty of the price of materials makes it a pain to estimate future profits. Alternatively, the jeweler can buy a futures contract and guarantee a material price of 936.90/oz. Even if the jeweler thinks market prices might be 925/oz in December, she might be willing to pay a bit more now to eliminate the risk that gold spikes to 1000.
Speculators buy futures contracts hoping that price expectations rise prior to the contract’s expiration. They accept price risk and don’t plan to take possession of the commodity. Let’s say market prices for gold in October turn out to be 973/oz. That Dec 08 contract might settle at 976.90/oz. The speculator sells the contract and makes a profit of $4000 (100 x [976.90 - 936.90]).
If prices decline, the speculator will lose money, but he’s not locked into taking delivery of 100 oz of gold. As the futures contract nears its expiration date, the settlement price will be virtually identical to the commodity’s actual price at that time, so the speculator simply sells the contract at market prices. For example, the last trading day for Dec 08 futures is Dec 29, 2008. On December 23, gold market prices are 896.65/oz. The Dec futures contract might be trading at 896.90/oz (very close to the market price), so the speculator sells the contract for a loss of $4000 (100 x [896.90 - 936.90]).
Sorry for the length, but I was confused by two issues in your post.
-
Buyers of commodity futures contracts aren’t betting that someone will be willing to buy the contract in the future at the price the buyer paid. Rather, people buy futures to either lock in a price for the commodity (hedgers), or in the hope that someone will buy it in the future for a higher price (speculators).
-
I can’t think of any situation where traders would have to take delivery of their commodities. They might not make a profit on their speculation, but they should always be able to sell their contract a few days before expiration at the market rate of the commodity (plus or minus a few cents).
Sidd yeah you’re right - realistically futures traders aren’t going to take delivery of oil - they’re going to sell their contract to someone who is willing to take delivery of oil and take a loss.
Sidd_Budd’s explanation is excellent.
What it comes down to is that the actual price movement is defined primarily by the supply and demand of the futures contract itself. And everyone who is buying – and those who are selling! – are gambling about what’ll really happen to the value of the commodity. But their perception is the reality in this case – the price is actually defined by this guesswork. Now it won’t stay out of kilter forever; reality exerts pressure. And that’s what I think is causing the price to lose 1/8th of its value in just 2 weeks, and what will cause it to continue to lose value until it gets closer to a rate that reflects the actual consumption and production of oil.
I think the problem with assuming futures don’t affect oil prices, is assuming the market is simple.
How do major oil producers decide what is a fair price to sell at?
The declining liquidity of the physical base of the reference crudes and the narrowness of the spot market have caused many oil-exporting and consuming countries to look for an alternative market to derive the price of the reference crude. The alternative was found in the futures market. For instance, instead of using dated Brent for its exports to Europe, several major oil-producing countries such as Saudi Arabia, Kuwait and Iran rely on the IPE Brent Weighted Average (BWAVE) as the basis of pricing crude exports to Europe.
Determining prices this way seems to have worked just fine, until the recent liberalisation of futures markets turned this pricing scheme into one enormous positive feedback loop.
My guess is that the Saudis and others won’t be wanting to change as long as the futures price stays high.
I suppose they can’t be realistically concerned over alternate energy.