First, some facts about oil. (Speculators-part 2)

I've been harping on the idea that facts are important, so I think I need to begin with a few facts about oil. These are from an article titled "Speculation explains more about oil prices than anything else" which appeared May 13 in the McClatchy newspapers.

1) "There is no shortage of oil stocks by historical standards. There's an estimated 3 million to 4 million barrels per day (bpd) of excess oil production capacity in the world today."


2) "The U.S. consumed 20.68 million barrels per day in 2007. Then came the financial crisis, and consumption dipped to 19.5 million bpd in 2008. Last year the number was 19.5 million bpd. This year's projection is 19.28 million bpd."


3)"Could it be that refineries aren't able to produce enough gasoline? No. Refiners are running their plants at below cruising speed, and they've got lots of room to produce more if consumers need it. The latest data from EIA on the rate at which refineries are utilized showed a rate of 79.8 percent in February. That's 20 percent below full-blown production, and it hasn't been that low since 1986. If demand for gasoline were soaring, these plants would be cranking at a higher rate."

4) "Some 70 percent of contracts for future oil delivery are now bought by financial speculators — largely big investment banks and hedge funds — who never take control of the oil. They just flip the contract for a quick profit."

To understand what's going on, we need to step back a bit and understand how the commodities markets work. It's really very simple.

The commodities market is simply a place where someone who produces a commodity (e.g. wheat) can meet a buyer for that commodity (e.g. cereal makers) and make a deal.

Sometimes a buyer or producer can protect themselves against possible future fluctuations in price by entering into what's called a "futures contract." Southwest Airlines enhanced their bottom line because they had purchased futures contracts on jet fuel at what turned out to be prices much lower than current prices when the fuel was actually delivered. (This is really a kind of bet entered into by buyer and seller. In this case the buyer won.)

There is one more player in this market: the speculator. Sometimes when a farmer has wheat to sell, the cereal maker has full grain storage facilities. Sometimes when a cereal maker needs grain, it's the wrong time of year for a crop.

The speculator buys grain from the farmer and holds it until the cereal company has a need, then hopes to sell it to the cereal company at a small profit. Speculators are a necessary part of the functioning of the market.

In the early part of the 20th century, to say that there were a lot of "shenanigans" in the commodity markets would be an understatement. During the FDR era, in the 1930's, the Commodity Futures Trading Commission was established to regulate the commodities market, and the market functioned quietly for the next 50 or so years.

Speculators were regulated to be a small part of the market. There were limits on how many speculators there could be, and how big a share of the market they could control.

Then came the era of deregulation, but that's our next post.