Wednesday, July 16, 2008

Speculation v. Supply & Demand

It's starting to feel like every 15 minutes I hear a politician, pundit, or friend proclaim the conventional "wisdom" that today's oil prices are due to "speculation, not supply and demand".

Utter foolishness.

And these politicians, pundits, and friends all come from varying sides of the political aisle. ... It's not just foolishness, it's bi-partisan foolishness. Economically ignorant bi-partisan foolishness.

So why is it foolishness? Basic economics. That's why.

You have to start with the assumption that "the oil companies" want to maximize their profits. But that's a given for the "evil oil companies", right?

Well, to do that, you want to price your product at the optimal price point (aka "the equilibrium price"). That's the price at which the amount of a good they are willing to sell (to supply) is equal to the amount of a good consumers are willing to purchase (that they demand).

If the seller sells at a lower price, they miss out on revenue from customers that were willing to pay a higher price. If the seller sells at a higher price, they lose sales from customers unwilling to pay such a high price.

So, if the oil companies ignore supply and demand for their pricing, they miss out on profits. But we've already established they're evil, err, I mean, smart and interested in maximizing profits.

OK, so it is "supply and demand" that's being used to determine the price of oil/gas/etc (just about every good in a free market). What about "speculation"?

"Speculation" (which I've come to the conclusion that a good chunk of the Congress (and maybe even some number of my friends) aren't even sure what is) you can loosely think of as just a fancy name for betting on what the future price of something will be. You can do this in various ways. For instance, you could buy a barrel of oil now and hold on to it for a while and then sell it (you would hope at an increased price) later. What the pundits are probably talking about though is trading futures contracts.

Again, dramatically bringing that concept back to earth - suppose I think that next year oil is going to be $200 / barrel. Well I don't want to pay that much. You have the ability to be able to provide me oil in one year and think oil will only be $150 / barrel then. So, we sign a contract that you will provide me with one barrel of oil in one year's time for $175. Based on what we believe about what the future price will be, we both feel we are coming out ahead.

So, can this speculation affect the price of oil today? Of course it can.

Suppose I'm selling oil and I can see that I can get $100 for a barrel today, but the futures market indicates in a year I can get $175 for that same barrel of oil. I could choose to take that barrel off the market today and hold onto it. (Removing that barrel from the "spot market" (today) so I can sell it in the future.) That reduces the available supply, affecting supply and demand, impacting today's price.

I suspect that maybe when people say "it's speculation, not supply and demand" they actually mean "it's speculation manipulating supply and demand" or "it's speculation, but not any other factors of supply and demand."

Of course, if that's what they mean, they're still wrong.

Why? Because we don't see suppliers hoarding (storing for the future) any significant amount of their oil. Effectively all of it is getting sold today to be consumed today. Thus, no affect on supply, thus no effect on price.

Now, I'll grant that the above all simplifies things considerably. A full treatment should get into if/how speculation in the futures market could affect the demand in the spot market and other such things. But the basic principles dictate that unless you see oil producers dramatically drop how much oil they are producing (so they can leave it in the ground to be sold later) or start storing significant amounts of oil (again, so it can be sold later), the price of oil is not being dramatically increased by so called "speculation."

Advise those that tell you otherwise to enroll in an Econ 101 class.

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