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Page added on April 25, 2012

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A World Without Oil Price Speculators

Business

The quality of media reporting on energy has improved significantly since I started this blog in 2004.  However, one subject on which I think the state of energy reporting still leaves much to be desired concerns the role of market speculation in setting oil prices.  It’s a complex issue, and it has become highly politicized this year. Doing it justice requires more than just the obligatory video of the New York Mercantile Exchange (NYMEX) or interview with a “floor trader”. I’ve encountered plenty of speculation on how much lower prices might be without the influence of speculators, but I’ve yet to see anyone go the next step to ask how prices might be set in the absence of any speculation at all.  This is an important question, because the primary benefit of the futures markets in which speculators participate is transparent price discovery.  I’d like to offer some perspective on that from my own experience trading oil and its products in the 1980s and early 1990s.

Imagine a world in which we’re not really sure what the price of oil is on a given day.  If that seems a bizarre notion, it’s because the media have made the prices of oil futures contracts in New York and London nearly as ubiquitous as those of the Dow Jones and other stock market indices. That wasn’t always the case.  I can remember many occasions on which the price of an energy commodity was hard to determine, or was simply what a particular buyer or seller said it was that day.

When I started trading petroleum products in the mid-1980s, the NYMEX contract for West Texas Intermediate crude oil was relatively new, and the heating oil contract had only been around a few years longer.  Their influence wasn’t nearly as pervasive as now, beyond the localized Gulf Coast light crude and New York Harbor heating oil markets they were devised to support. The spot market transactions that I executed on behalf of Texaco’s US west coast operations normally involved a fixed price arrived at through one-on-one negotiation, based on the buyer’s and seller’s perceptions of the market from other conversations, with input from limited and often suspect reporting on recent, similar transactions. When I shifted over to trading crude oil a few years later, most deals were still based on the system of “posted prices” that had existed for decades, in which producers and refiners issued periodic bulletins listing the current prices at which they solicited offers for each specific grade of oil in which they were interested. We bought or sold at small premia or discounts to the relevant posting–up to “P-plus” a dollar per barrel or so–with minor adjustments for actual quality received.  Transactions for OPEC crude were similarly based on the producing country’s official posted prices, which sometimes didn’t change for months.

In other words, it’s not so long ago that prices for many grades of oil or refined products were often either obscure or inflexible, and largely determined by an exclusive “club” of participants. Moreover, there were times when it simply wasn’t possible to buy or sell a commodity when needed, because there were no active sellers or buyers. The management of my business unit had a strong bias against doing business with independent trading companies, the speculators of the day, but when we needed to buy gasoline or a cargo of crude oil because we were about to run out, and they were the only ones selling because our competitors were either in the same position as we were or didn’t care to assist us in competing with them, then they were usually willing to set aside those scruples. The nascent futures markets were an exception to that system, and as they grew in influence–complete with speculation–more and more business was transacted on the basis of an agreed premium or discount to a particular NYMEX contract. It wasn’t a perfect system, but it had the advantage of greatly increased transparency and liquidity.

When I hear people who have never participated in the oil markets suggest that only those parties with “legitimate” needs to do so should be able to buy or sell futures and options, I wonder if they understand that this could lead back to a market with inherently less transparency and less competition–one that might in some respects be easier to manipulate, with prices set more arbitrarily than the result they accuse speculators of producing.

In my view the old way of trading oil still has a few things to recommend it, even though it was roughly as prone to sudden spikes as the current system is. However, it’s hard for me to imagine that the public and politicians would really prefer to revert to a situation in which oil prices were set between producers and refiners–by OPEC and oil companies, if you will–instead of the present one in which they are determined in a market with much broader participation.  I don’t even think oil companies would want to go back, because they’re in a much better position to defend their profitability when they can state with confidence that they don’t actually set prices.

I realize that I’ve set up a more extreme choice than most of those who are unhappy with the current situation would advocate; most of them appear to want to restrain speculation, rather than eliminating it entirely.  Yet I wonder whether that view is any more realistic, or helpful.  I believe that the distinction that ought to be drawn more sharply is not between speculation and the participation of “legitimate” players, but between trading for either hedging or profit and attempts to manipulate prices.  It’s one thing to bet on the price of oil going up or down, which after all requires someone else to take the opposite bet.  It’s quite another to try to rig the game in your favor.

Energy Outlook



3 Comments on "A World Without Oil Price Speculators"

  1. BillT on Thu, 26th Apr 2012 1:21 am 

    I wonder what the price of an I-pad would be if there were 20 competing brands selling basically the same product instead of one brand, one set price, with no negotiation? $99? Less?

    After all, capitalism is built on competition and competition also means competition in price. In my mind, competition means lower prices (and higher quality), not higher prices. Am I wrong?

  2. DC on Thu, 26th Apr 2012 4:20 am 

    Since we have casino-like finanical system in which anyone with money(no real brains req’d), can place paper ‘bets’ on almost any commodity out there, before it gets transformed into anything useful, thats exacty what we get. When I go out to buy something, be it apples or wood, I cant ‘speculate’ at the store as to what I think the price will be next week or next month, I pay what they seller is asking. IoW, a direct seller-to-buyer relationship precludes ‘speculation’. Why do we all allow betting of price of wheat or oil or copper in so-called ‘markets’, but If I want say, an apple(at an actual market) I certainly do not have the option of speculating on what the market price for apples will be next week or month can I?

  3. BillT on Thu, 26th Apr 2012 9:31 am 

    DC, no, but if you lived where there is no fixed price, like here in the Philippines, you can adjust your price at the non chain stores and even at some of those. It’s called dickering or bargaining and you can often get the price down 10% or more if you know what you are doing. It’s almost a national sport in countries that do not have chain stores with set prices and no authority to negotiate.

    Now, if you want it from next season’s harvest, then you need to dicker and lock in a price before you know if it will be a bounteous or a poor harvest with prices to match. You are betting what the price will be when it arrives, not what it is today. This has been the case for many decades and maybe centuries for large buyers. Nothing has changed except there is a middleman in the betting process now. And may have been then.

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