Now that I am a big mover and shaker, I am always on the lookout for my transformation into a giant sellout. (Some of you have aided me in this vigilant effort.) Well, today I found myself rolling my eyes at the Wall Street Journal's editorial on speculation, and nodding my head in morbid excitement while reading the CFTC's report (pdf).
If you have a half hour and really want to get up to speed on the nuts and bolts of futures trading in the oil market, I highly recommend the CFTC report. Now then, let's make fun of the guys bluffing at the WSJ. (And by the way, it takes one to know one. What I mean by "bluffing" is taking a confident position on something where, it turns out, one doesn't quite have the subject's nuances pinned down. It is unavoidable, I think, unless you stick to mathematical proofs. But the only way to keep the incentives right is to rip people when they get caught bluffing.)
Anyway in the July 22, 2008 editorial page (A18), they write:
Even the title of the Senate's bill--the "Stop Excessive Energy Speculation Act"--is idiotic. True, the volume of trading has increased by about sixfold since 2000, but it can't be "excessive." The inviolable law of futures markets is that someone has to take the other side of any option. That is, the value of contracts agreed to by sellers anticipating that prices will fall must equal the value of contracts agreed to by buyers anticipating prices will rise. The overall size of the market is irrelevant.
OK, first bluff: They seem to be classifying a futures contract as an option, when in fact it's a derivative. (An option is a derivative, but a derivative is not necessarily an option.) You don't have any option in a futures contract; if you haven't sold it by the delivery date, you are obligated to buy/deliver the underlying (or settle up in cash). With an actual option, you have the option of doing nothing (hence the name).
OK, but more important: It's not crystal clear, but it seems that the editorialists are arguing that by definition, speculators can't ever drive a price up. Because after all, for every long position there is a corresponding short.
But if this were true, then the futures market would lose one of its virtues; it wouldn't allow experts to communicate their insider knowledge to other people in the market. For example, if people knew that Israel were going to launch an airstrike on Iran next Tuesday, we want them to be "traitors" and start massively buying oil futures. (At least, that's good from the point of view of the oil market. If it tipped of Iran and they beefed up their air defenses, the Israeli pilots could understandably be furious.)
The way I've been thinking about it lately, is to make it analogous to international trade. Imagine that the physical producers and users (what are called the commercial users or "hedgers") have established their own equilibrium futures prices for various months out over the next 5 years. Now enter a bunch of outside investors who also (among themselves) take long and short positions, based on their expectations. They aren't hedging, they are pure speculators.
If the futures price in each closed system is the same, then there are no gains from trade and nothing happens. However, if the speculators end up on an equilibrium futures price higher than the hedgers, then once the two groups can trade, naturally what will happen is you'll end up with a unified futures price in between the two original ones. At the higher futures price, the oil producers will be short more contracts than they were before, the commercial users (airlines, refiners, etc.) will be long fewer contracts than they were before, and so as a group they will be net short.
On the other hand, the speculators as a group will have to be net long, to counterbalance the "international trade" with the nation of hedgers.
Now because the oil producers have sold more promises to deliver oil in the future than originally, they will cut back on current output (probably). Or, depending on the specifics, people might stockpile oil in order to fulfill these additional delivery orders. Either way, the spot price of oil goes up because of the influx of net long speculators.
Now, is this a good thing? It depends. If the speculators are right, and oil prices go up, then yes. If the speculators were wrong, and oil prices go down, then their interference was a bad thing.
So it's the same as with other entrepreneurial actions: Profitable actions coincide with correcting mispricings, while losses coincide with screwups.
Within that context, if you reread the WSJ editorial, you'll see that they probably don't really know what they're talking about. It's true, you could bend over backwards and say they were just harping on that word "excessive," but I think they were saying speculators can't move prices.
If nothing else, I heard Rush Limbaugh explicitly say that a couple of weeks ago. He went through and explicitly said that a futures contract is a zero-sum game, and that since one party is long and the other short, speculators can't move prices. But at least he had the sense to say, "Now I'm sure some economists are going to email me and complain..." when he basically said futures contracts were gambling and had no real effect on the economy.