Oil markets need speculators if the price is to be right

Speculators help set the price of commodities and give producers the confidence to create more product.

Whenever market prices, especially energy prices, start making things rough for consumers, or whenever importing governments are dismayed by the size of their trade deficit due to crude imports, speculators are blamed. You see it in the newspapers, you hear it on the television and I have even overheard shoppers in New York blame speculation for high petrol prices. Last summer, when US petrol prices reached US$4 (Dh14.69) a gallon, the US Congress was pressing to conduct investigations into futures markets and to clamp down on "wild speculation" they said was causing so much misery for consumers.

Was this the reason for the greatest energy price bubble and collapse in a generation? In fact, big oil companies, which are in the business of taking crude out of the earth and making useful consumer products from it, are very much reliant on speculators to provide them with something they otherwise cannot obtain: product price insurance. Speculators provide producers and consumers price insurance on the future valuation of the market good.

This is a function essential to market operations and the market's ability to correctly discover as closely as possible the true underlying valuation and price of the good for future production and delivery. Speculation does not produce or consume things, but like government services, financial services and insurance companies, it facilitates the smooth functioning of markets for producers and consumers.

Making useful products from crude oil available for consumption entails very long lead times and planning horizons. It also requires that the infrastructure, which itself takes perhaps five years to fabricate, already be present for this purpose. This situation is tailor-made for boom-bust product price cycling. Commercial operators thus seek price insurance on their product prices. The speculator is the one willing to take the other side of that trade, to assume the price risk the commercial operator wishes to avoid.

This actually mitigates some of the price swings by allowing commercial producers and refiners some price certainty, which they then pass on to end-use consumers. Speculators will buy or sell petroleum products from the commercial operators in the oil business, enabling the commercials to get out of the price guessing business and concentrate on primary producing activity. The speculators will do this in the hope of profiting from a change in prices over time, enabling them to remarket the petroleum quantities and realise a profit for their risk-taking activity.

Is the professional commodity market speculator a gambler? No more than your car insurer or health insurer is a gambler. Successful traders correctly estimate the future price for petrol or oil in six months or three years and alert the markets. This informs all market participants so that the correct quantities of the good can be prepared and marketed in due time. And it is the rich and successful speculators who are helping hedgers and markets the most, because they are the ones who correctly anticipated what future prices would be.

This good information was used by producers in offering the correct quantities to the market, so there would be neither surplus nor shortage at acceptable market prices, those prices under which both buyers and sellers can exist. So, what did happen to make oil markets rise to $147.27 a barrel in July of last year and then fall to $44.41 a barrel in February of this year before recovering? That was caused by the non-professional commodity futures speculators; that is, the rest of us. But it was also those speculators coming over from the stock and bond arenas, with little or no experience in commodity futures markets, who roiled prices with their naive, highly leveraged and unexpected activities, that caused prices to become unstable.

Looking for ever-higher prices, speculators feverishly bought and pushed prices even higher. Then some market news, the financial crisis in the housing market in this case, made them suddenly reverse course, dumping expensive crude they had previously been so glad to buy on a market already glutted with sell orders. This kind of self-sustaining feedback behaviour causes prices to soar or slide without their being any actual shortage or change in the fundamentals of supply and demand. It was entirely based on their outlook for future prices.

Markets are indebted to good speculators for providing a market for price risk on the future values of essential goods. They are rewarded with profits from their correct positions and punished with losses for their incorrect positions. The good ones have more "correct" positions than "incorrect" ones, and so profit over the long run; thankfully so, because their presence allows producers and commercial operators to concentrate on making things we want, rather than gambling on future prices for their products.

Dalton Garis is associate professor of economics and market behaviour at The Petroleum Institute in Abu Dhabi