Idle speculation

Great post from Paul Krugman explaining why speculators aren't causing the runup in oil prices.

Suppose I were to bet you $10 that oil prices would be lower in one year than they are now. Would you take that bet? If so, you'd be...DUM dum DUMMMMM...an oil speculator.

But our little bet wouldn't have changed the price of oil, would it? What if there were a million people just like us making bets with each other? Would the oil price change? Think about that for a minute.

Anyway, here's how speculation is supposed to raise prices:

Step 1: Speculator Bob thinks that the oil price will go through the roof in the next year. So Bob buys an oil futures contract from Supplier Ahmed, who owns an oil field. The contract stipulates that, exactly 1 year from now, Bob must buy 1 million barrels of oil from Ahmed for $200 a barrel. Bob thinks he's going to make a killing next year, because he predicts oil will rise to $220, and he'll be able to take his $200 oil and turn right around and sell it for a profit.

Step 2: The current price of oil is only $140 a barrel, and Ahmed bets that the price will be the same in a year. So instead of selling his oil on the market right now, Ahmed keeps it in the ground, knowing he can sell it to Bob for the extra-super-high price of $200 in a year, because Bob bought that futures contract.

Step 3: Because Ahmed keeps his oil in the ground (waiting for Bob's contract to come due next year), there's less oil on the market, so oil prices go up today.

So if people say "speculators are pushing up oil prices," this is what they think is happening. There's just one little problem with this: Speculators are betting that the oil price is going to fall!

As the graph (borrowed from Krugman) indicates, the oil futures price has been below the oil price ("spot" price) for a long time. That means there's no incentive for Ahmed to keep his oil in the ground - he'll take a loss if he waits and sells to the speculators when their contract comes due.

Bottom line: Speculators can't push up oil prices if they are betting on oil prices to drop.