I have long argued that the one hope for Americans who wish to see bipartisanism in politics prevail, and for the left and the right to reach more common ground, is to banish the teaching of economics! Yup, I mean it. Nothing brings political harmony like economic illiteracy, shared equally by members of all political parties.
My favorite recent illustration is the “unholy alliance” that the right and left have formed about “oil speculators.” Darling of Fox News and the right, Bill O’Reilly, has been irate at the “wicked oil speculators” over the past two months. Famously on the left, President Obama recently spoke in the Rose Garden saying, “we can’t afford a situation where some speculators reap millions while millions of American families get the short end of the stick.” Of course, the empirical evidence for this does not exist even if some folks “profit” from speculating.
The main tool allegedly used by speculators in oil is the futures market in oil. Senator Bernie Sanders is right now crafting legislation to allow the government to stop speculation in oil. In a micro class it might be fun to do welfare analysis in the oil market to determine whether the claims of damage are justifiable, but we aim for a simpler task here, which is simply to ask how the futures market works and why it is exists.
The purpose of a futures market is to allow both buyers and sellers of an underlying asset to hedge their risks from the price of that asset changing in an adverse way. In the case of buyers of oil, they are worried that oil prices will rise in the future. In the case of sellers of oil, they are worried that oil prices will fall in the future. As there are millions of consumers of oil (not just drivers, but plastics manufacturers, drug makers, sanitary products, etc.) there too are thousands of producers – each with an interest here. So there are both natural buyers and sellers of oil, and therefore natural buyers and sellers of an instrument to protect themselves.
A seller of a future would be the producer of the underlying commodity. So, for example, Exxon-Mobil would be a seller of a futures contract. Typical buyers would be buyers of the underlying commodity, so gasoline refiners might be a good example, or airlines.
Right now, the current spot price of a commonly traded type of oil is roughly $99 per barrel. The futures price on a 4-year contract (Spring 2016 delivery) is about $89 per barrel. The spot price indicates that a barrel of oil today sells for $99. That is what Exxon could sell it for, and that is what a refinery could buy it for. The futures price indicates the price of a barrel of oil today, for oil that is to be delivered in 4 years. So, if Wintercow is a refiner and buys the oil future from Exxon, he will send Exxon $89 today. In exchange, Exxon is required to deliver a barrel of oil in Spring 2016. (A typical futures contract in oil is for 1,000 barrels.)
Suppose the price of oil in Spring 2016 turns out to be $109. What would happen when the contract expires in that spring, and what the net gain/loss is to each party to the transaction?
Exxon would have to deliver a barrel of oil to Wintercow in Spring 2016. What typically happens is that Exxon buys back the futures contract at the price that prevails at this time (so that Exxon does not actually have to go deliver the oil). So, Exxon would have been paid $89,000 for the oil in May 2012. It would buy that contract for 1,000 barrels back for $109,000 thereby losing $20,000 on the futures transaction. However, it would then sell its oil at the spot price of $109 for $109,000. Net of these trades, Exxon would end up with $89,000. Of course, it knew this at the time of the initial transaction – that was the point!
Wintercow would have paid $89,000 for the oil today, and then received $109,000 in May 2016 from the futures transaction, for a gain of $20,000. However, he would still need the oil for refining in May 2016, and must buy his 1,000 barrels for $109,000. Thus, he ends up with a guaranteed $89,000. Of course, he knew this at the time of the initial transaction – that was the point!
Suppose the price of oil in Spring 2016 turns out to be $79. What would happen when the contract expires in that spring, and what the net gain/loss is to each party to the transaction? Exxon would have to deliver a barrel of oil to Wintercow in Spring 2016. What typically happens is that Exxon buys back the futures contract at the price that prevails at this time (so that Exxon does not actually have to go deliver the oil). So, Exxon would have been paid $89,000 for the oil in May 2012. It would buy that contract for 1,000 barrels back for $79,000 thereby gaining $10,000 on the futures transaction. However, it would then sell its oil at the spot price of $79 for $79,000. Net of these trades, Exxon would end up with $89,000. Of course, it knew this at the time of the initial transaction – that was the point!
Wintercow would have paid $89,000 for the oil today, and then received $79,000 in May 2016 from the futures transaction, for a loss of $10,000. However, he would still need the oil for refining in May 2016, and could buy his 1,000 barrels for $79,000. Thus, he ends up with a guaranteed expenditure of $89,000. Of course, he knew this at the time of the initial transaction – that was the point!
In what sense are parties to these transactions “harmed?”
Clearly what we see is that the futures transactions guarantees a price for oil to both buyers and sellers. In other words, it is a contract that effectively guarantees a sharing of the gains from trade that would have occurred if all purchases occurred on the spot market. The harm to the parties in the transaction comes from the fact that should luck have worked in their favor, their gains would have been larger. But it is just as correct that each party “unfairly” gains in the event of a movement of prices away from what they would have liked.
Think about this. The existence of a futures market allows a commitment by parties with competing interests to agree to share the gains from trade. Wouldn’t the existence of such a market be grounds for celebration, particularly among the class of people who views the point of civil society as a giant insurance mechanism? Since neither the seller nor buyer in a futures transaction is certain that the price of a commodity is going to move in a particular direction, they end up sharing the profits they would have had if luck had gone their way. Isn’t this the exact thing that redistribution aims to achieve? To make people whole for events that are beyond their control and to ask the “rich and lucky” to share in their good fortune with everyone else. You’d think that individuals voluntarily engaging in these sorts of transactions would be cause for extra celebration, not excessive scorn.
Based on the above, who would have to be harmed from activities in the futures markets for O’Reilly’s and Obama’s observations to have any validity? Is such an outcome likely?
It must be the case that parties outside the transactions must be harmed, because no parties to it are harmed (and of course, we may have to make the extra assumption that parties outside the initial transaction have no way of partaking in such transactions, which is a poor assumption to make in the year 2012).
I don’t quite understand the conventional wisdom. So, the thinking goes that if speculators are somehow able to intervene in these markets and make purchases of oil futures, that must be driving the price of oil UP due to their guessing that future oil prices would be higher. Of course, if they guess correctly, then by keeping a barrel of oil off the market today when oil is less scarce and transferring it to the future when it is more scarce, the speculators are actually improving social well-being. If they guess wrong, then they would be hurting future well-being of third parties, but of course would be doing so in an era of lower prices, and competition seems like it would enforce discipline on those who regularly guess wrong.
Notice that right now the futures price of oil is lower than the spot price, meaning that “speculators” (by the logic of Sanders, Obama and O’Reilly) are causing much good right now. That is equally silly. Here’s a question to leave you with. If you are one of those folks who wishes to see “oil kept in the ground” what do you think of the mere existence of a futures market? Should you care of outsiders could participate in it?