Here we go again. Gas prices are back on the front page and they are literally going up before our very eyes.  Naturally, people want to know why. The high school economics explanation of supply and demand seems inadequate in describing what’s been happening to gas prices recently.  After all, U.S. demand for gasoline has fallen along with the economy since 2008.  So why are gas prices spiking and why now? 

There is no shortage of possible explanations. Political tensions and economic sanctions in Iran threaten to reduce oil supply while signs of life in the U.S. economy signal a potential uptick in demand for oil.   Political opportunists will point to the energy policies of the Obama administration as a contributing if not primary factor in rising gas prices.  But according to many pundits at least some of the blame for high gas prices should go to Wall Street speculators for helping to drive oil prices higher in the futures market.  According to some analysts as much as 80 cents goes into the pockets of speculators for each gallon of gas. 

Although most people don’t follow commodities markets closely what happens there has a real impact on the wallets of every consumer and sometimes in some not so obvious ways.  Everyone knows that oil prices to a large extent determine gas prices. But many may not realize that the natural gas market, for example, has a direct impact on electricity bills.  Electricity rates in Texas are very highly correlated with natural gas since a large portion of Texas electricity comes from natural gas burning power plants.  Even the price you pay for a pizza reflects the commodities markets for cheese, pork, beef, corn, and wheat among others. 

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Despite their reputation as risky endeavors, commodities futures markets were formed as a way to help producers and users of commodities reduce their risks.  Wheat farmers, for example, can use the futures markets to lock in a certain price for their product ahead of time.  In this way they know exactly how much money they will receive for their product even if the market moves against them before they can deliver it. 

Likewise, the baker who needs wheat for his business can use futures contracts to lock in the price he will be paying for wheat at harvest time.  If prices for wheat spike before he takes delivery of the product he is protected.  These types of market participants are often called hedgers because they are using futures contracts to hedge their risk.

The Speculator

Speculators are market participants who are neither producers nor consumers of a commodity. Rather, they are people who look to profit if the price of wheat goes up or if it falls.  They risk their capital in hopes of making a profit.

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There is nothing inherently bad about speculating. Indeed, speculators serve a vital role in the market.  The commodities market like any other marketplace needs liquidity in order to operate efficiently.  Liquidity simply means that there are enough of both buyers and sellers at any given time for the market to function.  

Having speculators in the market also allows participants to offload risk.  When the farmer uses the futures market to lock in a price for this wheat he is removing the risk of prices falling before he can actually deliver his harvest.  As part of the deal he is also forgoing the upside if the price goes higher.  The speculator on the other side of that transaction takes on the risk of prices falling but he will make money if prices go up. 

The problem, some contend, is when speculation becomes excessive.  Historically, producers and consumers of oil have made up the bulk of trading in the oil futures market with pure financial speculators being in the minority.  By contrast, in today’s market the producers and end users comprise only about one-third of the market with speculators now being the dominant players.

The concern is that this can create a bias on one side of the market that isn't necessarily related to the fundamentals of the underlying commodity.   The price action can then be driven by the amount of money competing for the futures contract and not necessarily the underlying commodity.  It's a tail wagging the dog scenario.

Buyers That Don’t Buy

When someone buys a futures contract they are technically obligating themselves to actually take delivery of the commodity upon the expiration date of the futures contract.  However, the vast majority of people who buy oil futures never intend to actually take delivery of the oil. This means unless they want to find themselves with a tanker full of crude oil they need to get out of the contract before the expiration date. 

Large hedge funds and institutions that want to make longer-term bets on a commodity simply roll the contract into the next expiration month avoiding having to take delivery of the product.  They repeat this process at each expiration date as long as they want to stay in the market.  This means they could, in essence, be a perpetual buyer without ever actually really buying the oil.  In a situation where a market is moving up additional deep-pocketed speculators like hedge funds and pension funds may jump in also as phantom buyers of oil.  The result can be a complete distortion of the true demand for commodities.  Of course, the same thing can play out in the other direction when speculators jump into the market as sellers of a commodity that they will never actually deliver. 

There is nothing really new about this technique of making longer term bets on the price of a commodity.  It isn't necessarily market manipulation unless there is some kind of collusion among speculators to affect the market.  However, some people believe that regardless of intent excessive speculation is harmful to commodities markets and harmful to consumers. 

While this is a controversial notion, it’s certainly not a fringe believe. One of the most vocal opponents of excessive speculation is Bart Chilton commissioner of the U.S. Commodity Futures Trading Commission (CFTC).  The CFTC is the organization that oversees commodities markets in the U.S. 

According to Chilton there is a “new” class of futures investor.  These are large hedge funds and institutions that have massive sums of capital that they need to invest somewhere.  As returns in other asset classed became harder to come by they began injecting unprecedented amounts of money into the speculative commodities market distorting the normal market signals.

Chilton has been given the mandate by lawmakers to control excessive speculation in futures markets (section 737). Chilton is calling for immediate trading limits that would restrict how much a single trader or institution can trade in futures contracts for next-month delivery of commodities such as oil and natural gas.  This would be a temporary step as the commission finalizes a broader set of rules to limit the size of futures positions for speculators. 

For their part, Wall Street is not accepting trading limits without a fight.  Two Wall Street trade groups have sued the CFTC to prevent the imposition of position limits.  They reject the notion that excessive speculation is responsible for higher oil prices and high gas prices. 

In fairness, there are so many factors that influence gas prices it's impossible to isolate one cause.  It might be difficult to make the argument that gas prices are up “because” of speculators.  On the other hand, it could very well be that the huge amount of speculative capital relative to the size of the futures market serves to exacerbate moves to the upside or downside.

As dramatic as the 2008 run up to $145 a barrel oil was, the subsequent price collapse was equally impressive as massive amounts of speculative capital headed for the exits. Crude oil on the New York Mercantile Exchange fell from a high of around $145 a barrel in July of 2008 to just over $30 by the end of that year – a remarkable 79% fall.

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