The tirades by politicians against oil speculators are mostly baseless and uninformed. Without these speculators, oil consuming countries will be at the mercy of the devil himself or price cartels like OPEC. By Vivek Sharma

''Finance minister P Chidambaram is spot on in blaming financial speculators for driving up international oil prices'', said the country's biggest financial daily this week in its editorial titled ''FM hits the nail on head''. Chidambaram, like most politicians in all parts of the world, has been blaming speculators for a while now and the editorial writers were referring to his most recent tirade at the Jeddah Energy Summit last weekend.

The editorial seeks to validate the finance minister's argument on two grounds. The first contention is that very low margin requirements make it very easy to trade in oil futures and, presumably, this attracts more speculators. The other flaw the paper finds with oil futures is that the daily volume of trade is almost 10  times the daily physical production of crude oil. The suggestion is that most of the trades are by and between financial speculators and not between real producers and consumers, which indeed is the case.

As we will see later, both these arguments fall flat when we look at them closely.

The real face of 'speculation'
Most critics who blame speculation often do not have a clear idea of how futures markets work, in oil or any other commodity. Commodity futures were devised to help producers and consumers hedge their price risks. So a producer can 'lock in' the price even before his output is ready for sale by selling futures. Similarly, a consumer can lock-in the cost by buying futures before he physically needs the commodity.

Futures contracts are typically set to expire on a specified date, usually at the end of a month which is then used to identify the contract – like July contract, August contract and so on. So, if a producer or consumer wants to cover a short-term price exposure he will buy or sell the near month contracts. If the exposure is a few months down the line, he will buy or sell contracts corresponding to the month when the physical exposure is expected to arise.

The most common misperception about futures trading is about the role of speculation. The futures market is not all that different from a physical commodity market, except that contracts are set for future dates. In every physical market, there are traders who act as intermediaries between consumers and producers. They play an important role by helping easier price discovery and reducing volatility. All other factors remaining the same, more traders lead to more competition, better trading efficiency and less volatility in the market. In other words, traders provide market depth and without them markets tend not to function smoothly.

The financial players, or the so called speculators, perform the same function in the futures market. Their role is very important in commodities like crude oil, where the real consumers who need to hedge their price risks far outnumber the producers. How will the market function if, for instance, the big oil producers are not in a mood to trade when Reliance Industries wants to buy oil futures and the quantities offered by smaller oil producers are not sufficient to meet Reliance's requirements? Reliance will be forced to bid up the price to attract more supplies. In practice buyers like Reliance may tie up a good portion of their requirements through long term contracts with oil suppliers, but the price exposure may still exist as long-term contract prices are often linked to benchmarks like the Brent or NYMEX.

Unlike physical markets, traders cannot 'hoard' a commodity in the futures market and create artificial shortages by limiting supplies because futures contracts expire at the end of the specified month. If a trader wants to hold on to his positions at the end of the month, he has to 'roll over' the contracts by exiting the near month contracts and shifting exposure to future months. Because of this need to roll over contracts, volumes in the futures market are high and create the impression of excessive trading. Though futures contracts are available for months many years down the line, they are thinly traded or, on most days, not traded at all.

Another 'concern' about the oil futures market is the increasing participation by large institutional investors like pension funds. Lawmakers, especially in the US, are appalled that such long-term investors have also become 'speculators' and are driving up oil prices. But, such investment funds may have a very valid reason for trading in oil or any other commodity futures. Think of a large investment fund, which invests for the very long-term in stocks across different industries like airlines, automobiles, shipping and so on. The price of oil is one of the most significant factors affecting the fortunes of most of these industries. For the investment fund, other than exiting those investments, oil futures are the only way to protect its investments from higher oil prices.

When politicians rail against speculators, it appears as if every so called speculator makes money. They often forget that, every trade has two parties who take contrary positions. It is not as if all traders are betting on rising oil prices, some are betting against it. Most recently, Morgan Stanley made a contrarian bet against oil prices going up and lost heavily. Those who bet on rising prices can also net huge losses if the market corrects even modestly, like the hedge fund Amaranth, which lost billions of dollars in natural gas trading last year and went bust.

Speculation and prices
It is an accepted and proven fact that in any market, physical or futures, efficiency in price discovery increases and price volatility declines as the number of participants increase. Just think of a vegetable market, prices are always lower in a large market with many traders than a smaller market with a handful of traders. Hence it is specious to argue that lower margin requirements and higher volumes invite speculation and always lead to higher prices, as the writers of the editorial mentioned earlier did.

Traders react to the fundamental demand-supply equations at any given point of time. If there is a supply shortfall, or if supplies are forecast to be insufficient to meet future demand, more traders will look to bet on prices going up. There may be contrarians who bet against such forecasts, but most traders in such a scenario will take long positions, which will push up prices as sellers are fewer in number.

This is what is happening in the oil futures market. Here is a highly essential commodity, with no ready alternative, and the production of which is controlled by a handful of countries – many of them prone to unrest and violence. In recent years, demand for this commodity has proven to be far less elastic than earlier thought because the lifestyle and habits of a large percentage of consumers rely on consumption of fossil fuels.

To top it all, it is an exhaustible resource and the development of a viable alternate energy source may be many decades away.

When that is the market reality, it is futile to expect traders not to bet on rising prices. Call it herd mentality or whatever, but a majority of traders will follow the most widely accepted perception about market fundamentals at any given point of time. All efforts to prevent traders from doing so will be like treating the symptoms rather than the disease itself.

There will be a price correction if financial traders are asked to exit because there will be a mad rush to cover existing positions. But, that will be only a temporary relief.  Commercial traders – producers and end-users of the commodity – will bid up prices as long as the market fundamentals remain the same.

Policy makers should be concentrating on changing the demand-supply dynamics as it exists today. Traders, or speculators if you prefer, will follow the cues and start building short positions which will bring down prices.

Devil or the deep sea?
Policy makers in major consuming countries should also consider what will happen in the market for commodities if non-commercial traders are restrained. Most likely, a cartel of producers will set the prices. Such cartels will be very powerful in commodities where the number of producers and exporters are limited. When price cartels control the market, price increases in times of supply constrains can be even more devastating. Ask the Chinese steel producers who agreed this week to the price increase demanded by big mining companies for iron ore. The price hike was no less than 96 per cent, which has been fixed for the next one year with no possibility of a decline – even if steel demand turns weak. (See: China's steel mills may boycott BHP's ore; dismiss price rise)

In the crude oil market, there is already a formal price cartel in the form of OPEC, formed by the major oil exporters many decades ago. The last big oil price spike was in the '70s when OPEC used oil exports as a political tool and threatened to cut supplies. Since then, the influence of OPEC has steadily declined as its share of world production declined.

There was another major reason behind the decline in OPEC's ability to influence prices - the expansion of futures market in oil. The oil sheikhs of the Middle East gradually ceded their pricing power to the commodity markets in New York and London. So, in the '90s when the demand outlook for oil was weak, oil producers watched helplessly as traders beat down prices to as low as $10 per barrel. Can any policy maker argue that the world did not benefit from low oil prices for many years, before the current up trend started? If it was not for the 'speculators' in New York and London, OPEC would have never allowed prices to remain low for such a long spell!

On most days, consumers will be better off in the deep sea that is the excesses of free markets than facing the devil in the form of price cartels. With the devil you don't stand a chance, he will extract his price. The deep sea may turn turbulent once in a while and hurt you, but its behaviour is more predictable and hence more manageable.

Any day, governments of oil consuming countries should prefer to trust the thousands of faceless oil traders in New York and London than pleading before the oil sheikhs in Riyadh!