10 July 2008

Speculating about the price of petrol

I’ve heard a few rumblings recently about the price of petrol, which has often surpassed $1.60 per litre in Sydney (that’s US$5.68 per gallon). Several people have commented that the speculation in the oil futures market is somehow the cause of these price increases. Even our government is pursuing this idea:

Kevin Rudd told Parliament there were increasing concerns in the international community about the role of excessive speculation by financial institutions trading oil as an investment like shares and currencies.

The Economist has a good article which debunks this myth:

Neither index funds nor other speculators ever buy any physical oil. Instead, they buy futures and options which they settle with a cash payment when they fall due. In essence, these are bets on which way the oil price will move. Since the real currency of such contracts is cash, rather than barrels of crude, there is no limit to the number of bets that can be made. And since no oil is ever held back from the market, these bets do not affect the price of oil any more than bets on a football match affect the result.

In fact, because hedging in the futures market allows both oil producers and consumers to provide security around their future income or expenses, it helps maintain the liquidity of the oil market:

Despite their dismal reputation, the oil speculators provide a vital service. They help airlines and other big oil consumers to hedge against rising prices, and so to reduce risk—a massive boon amid the economic turmoil. By the same token, they provide oil producers with more predictable future revenues, and so allow them to expand more confidently and borrow more cheaply. That, in turn, should help to lower the price of oil in the long run. Any attempt to curtail speculation, by contrast, is likely to make life harder for firms and oil more expensive.

The speculators and futures market exist as an open market which improves the flow of goods and services within the economy. Don’t buy into the idea that these important markets are responsible for unjustified movements in the price of oil.