Speculators and the Oil Markets

Previously, I discussed futures contracts in the context of agriculture (wheat and corn). But, they are generic instruments that can work with any commodity. In the case of oil, people speculate on the future supply and the future demand.

We all know the litany of variables in supply: war, strikes, unrest, natural disasters, success in exploration, decline in existing fields, technological advancement, etc.

Likewise, there are demand variables: chiefly the world's economic growth.

At the moment, Southwest Airlines is making money where others aren't, because they used futures to buy all of their jet fuel years in advance. They recognized fuel prices as a large variable in their profitability that they could not control. Further, they may also have suspected coming increases. At any rate, they made a very sound decision to take that risk out of their business, and they are now being handsomely rewarded for it.

Speculators are currently predicting that oil will continue to stay about where it is for the foreseeable future. I will make two points.

First, if there turns out to be more oil available at the beginning of next year than the futures prices today imply, a speculator who bought a contract to receive that crude will have to get rid of it, and the more of it there is, the lower the price that a desperate speculator will have to accept. (It is another form of speculation to not buy a futures contract, but to wait until they come due to look for deals. In speculation, there are always two participants and one of them is wrong.)

Secondly, this prediction should not surprise us. On the one hand we have billions of new people coming into the middle class. They want air conditioning, cars, electric shavers, televisions, light bulbs, computers, etc., etc., etc. That means higher energy demand. And, on the other hand, we have supply growth that is not keeping up.

It may still prove to be wrong, but at this moment it appears we aren't "out of oil" (a lot is still coming out of the ground), but effectively, we are out of oil (there isn't enough). And, that is no fault of speculators.