Tue, 18 May 2004

Speculators in the oil futures market

According to NPR, one of the forces driving up gasoline prices are speculators in the oil futures market. From the way they said it, it sounded to me like they thought that speculation was a bad thing. It's not. Speculation is a good thing.

Prices do more than simply determine how much you pay for something. They also carry information. When something gets more expensive in a free market, that indicates that the demand for it has risen without a corresponding rise in the supply. This has two effects. First, it rewards the people who were careful to own the thing which is now in demand. Second, it causes people to husband their supply of that thing.

Everyone expects us to run out of oil. My entire lifetime people have been anticipating the day when we'll finally "run out of oil." That day has not yet come and never will. We'll never run out--we'll just run out of oil that anybody is willing to pay for. So, the price of oil will rise in the future because of increased demand and lessened supply. The trouble is "when".

The function of a speculator is to tell is when oil will get more expensive. If they think oil will be more expensive in the future, they'll buy an option to purchase oil in the future at a fixed price. If everyone chooses wisely, the price of the options plus the fixed price of the oil will be the future market price of the oil. The more people who want these options, the higher the price for them will be. So, when people think oil will be more scarce, more valuable, and command a higher price, they'll bid up the options.

A speculator brings the future into the present. Sometimes the future is unpleasant (higher prices for oil). This leads some people to call for laws limiting speculation. This is merely shooting the messenger. If the speculators are right, oil will be more expensive, and the sooner we start acting that way, the better. Speculators who have bought oil (or an option to buy oil) now when it's relatively cheap will make a profit by conserving it until it's more valuable later. If speculators are wrong, they'll lose money. Speculators who are consistently wrong will go broke. That's one of the pleasant effects of a free market -- people who screw up lose their chance to screw up in the future.

Now, imagine instead if the price of oil was controlled by a government. Governments are typically short-sighted, where "short" is defined as the period between now and the next time they have to get elected (term limits help ensure the short-sightedness of a legislator--no need to think beyond the limit on your term). If the government sets the price lower than a free market including speculation, then people would consume oil at a higher rate. That would lead to shortages, and radically higher prices. If the government set the price higher, then people would consume oil too slowly, and miss out on some of the value of present consumption.

Outlawing speculation is like trying to outlaw the future.

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