The flawed case against oil speculators

27 June 2008

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.