FUTURE IDIOCY

Yes, I know, we shouldn't expect much in the way of intelligent discourse from grandstanding politicians on Capitol Hill and windbag pundits on cable news.  But is it really too much to ask that their bloviations have at least some connection to reality, however tenuous that may be?

What is sticking in my craw is the utter stupidity of blaming speculators for the high price of oil.  These blowhards are railing against traders of oil futures because their alleged speculations are bidding up the price of crude.  First of all, let's get straight what a future is.  It isn't a barrel of crude oil, a bushel of wheat, a head of cattle, or anything else tangible.  It is a contract to buy or sell a commodity at a set price at a certain date in the future.  So if oil-futures traders are pushing up the price of anything, they are pushing up the price of the contractual right to buy or sell oil, not oil itself.

Second, the oil futures market, like all futures markets, is a zero-sum game.  That means for every oil futures contract sold, one has to be bought.  There is nothing mysterious about this.  It is as obvious as it sounds.  Once a contract exists, it can be traded again and again until it expires.  So that contract to buy oil at a set price has its own price that will go up and down.  Thus, an oil futures contract acquires a market dynamic of its own that can closely track or wildly deviate from the actual price of oil depending upon the objectve, insight, mood, or, often, folly of traders.  Whatever the case, this trading remains a zero-sum game, so that for every trader making a bet that the price will go up, there is another betting that it won't.  In other words, these "evil" speculators are collectively placing as much money on one direction as the other -- and even then, it is on the direction of the oil futures contract, not oil itself.

Third, is everyone making trades in a futures market a speculator?  No!  Futures markets are an efficient way to trade risk for certainty.  For example, a farmer wants to lock in the price he will sell his wheat for at harvest.  A baker wants to lock in the price he will pay at that time to buy wheat.  They both want to eliminate the uncertainty of their revenues and costs in the future.  With a futures market the farmer and the baker do not need to find each other to make this transaction.  The futures traders will do that for them.  More importantly, they will do that when there is an imbalance between buyers and sellers of commodities.  In that case, they will speculate.  But their speculation comes with the risk the farmer and the baker traded away for certainty.  That risk means, if they are wrong, they will either have to buy or sell the commodity contracted for at a loss or, as is usual, settle the difference in cash.

Finally, all of the above is the reason why an oil futures contract is called a "derivative".  It exists only because there is a market for the real thing, crude oil.  Thus, the futures market is parasitical to the actual market for oil.  It can not and does not drive that market.  The actual market is driven by the fundamental law of supply and demand (except for the periodic self-correcting euphoria and panic to which all markets are subject), and so the price of a futures contract for oil merely bounces up and down around the actual price for oil.  For the futures market to drive the actual market would be a defiance of the law of supply and demand, a law which not even the most vociferous demogoguery from Capitol Hill and cable news can repeal.

Comments

[Brandon]

Yes indeed, good old fashioned supply and demand is what's going on here. And the central equation -- boldly simple in its essence -- is that we want more oil (globally) than what exists and can be recovered from the ground cost-efficiently.

Clamor all you want about offshore drilling, ANWAR drilling, shale oil deposits, Canadian tar sands. Even if those areas were exploited vigorously and immediately, the short-term benefit would be virtually zero; the longer term benefit negligible.

And after we've invested ourselves in the most optimistic of these projections and gas prices come back down to, say, $3 a gallon (ahh, the good old days), what will be the national energy strategy for when ANWAR and offshore sites begin their inevitable downward slope into depletion? When the gaping wound of our insidious addiction to fossil fuel becomes a full blown hemorrhage, which useless metaphorical band-aid will we allow our leaders to placate us with while we bleed to death?

Life as we have long known it is on the way out the door. It's really that stark and dramatic. We can deny it and sugarcoat it or we can grasp on to some form of acceptance and try earnestly to make intelligent choices within the confines that nature and human endeavors will have granted us.

What we can't do (for very much longer anyway) is cling to the notion that making that midnight run to 7-11 in the air-conditioned, DVD-equipped monster sport utility vehicle is any longer a tenable form of American existence. We can realize this and begin making personal changes now, or we can have it foisted upon us by external events. What we can't do is make an intelligent case that it isn't going to happen at all.

[The Executive Director]

Hi, Brandon.

If an environmentalist is sincerely committed to the large-scale development of alternatives to fossil fuels, then he should be committed to letting the market freely determine the price of those fuels. The scarcer fossil fuels become relative to demand, the higher the price goes and the greater the incentive to use less (either through increased efficiency or the use of other types of energy).

Indeed, we saw that happen after the energy of crisis of the '70s. U.S. energy efficiency doubled over the next three decades. Because of that, oil consumption plateaued, while production increased and fossil fuel prices fell. I expect we'll witness the same cycle again. After all, for all the talk of oil prices hitting record highs, they have hit similar peaks (adjusting for inflation) in the past. For example, in the early '20s, the inflation-adjusted price of gasoline was more than ten bucks a gallon.

But it is true that none of these past run-ups in oil prices pushed the world away from fossil fuels to alternative energy. The reason is that the supply of oil, gas, and coal was huge, so increased production was possible to meet demand. And fossil fuels remained desirable, despite technological advances in other forms of energy, because they are very compact and readily transported sources of energy.

These factors remain the case today. The world is awash in oil. The doom and gloom of limited reserves is an artifact of the propensity of oil companies to only look for sufficient supplies a few decades out. It doesn't pay to explore for more. So increased production will be a consequence of the current oil spike along with greater efficiency and greater use of alternatives like nuclear and hydro-electric (but not solar, wind, and other gimmicky things that sound swell but cannot be scaled up to meet more than a few percent of the world's energy demand).

But let's say we really are tapping out our fossil fuels. Keep in mind that won't happen overnight, even with the most apocalyptic predictions of coming shortages. It will take decades for that to happen, and meanwhile the increasing market price of fossil fuels will make it profitable to develop effective alternatives to oil, gas, and coal. I suspect one such solution would be microwave energy -- i.e., the collection of solar energy by satellites which then beam it down to powerhouses on Earth in the form of microwaves to produce electricity. While there are big-ticket engineering problems that have to be solved to make that happen, the technology already exists and it is the one alternative to fossil fuels that can, like nuclear and hydro, work on the large scale. Plus, it is just as about as "green" a source of energy as an environmentalist could want.

So, one way or another, the market will, if we let it, make as much energy available to us as we want. Indeed, if history is any guide, that energy will continue to be cheaper and cheaper whatever its source.

Regards, Bill

[JGillman]

I wonder.. How bad the futures buyers who really have no interest, (as airlines, trucking, large fleets, etc) will be hurt if the greens were to back off, and legislation were to allow drilling where there is actually oil?

[Brandon]

Hi Bill,

The only aspect of your well-received points with which I might take issue is this:

While it may be technically correct that the world is still awash in oil, it is, by and large, no longer the easy-to-extract kind. At some point -- and no one really knows when, of course -- diminishing returns will require the use of more energy to extract oil than the oil that actually gets recovered. The Saudis, for example, have had to increase the use of salt water injection in order to maintain their production quotas, thereby diluting the crude, which in turn requires the use of more and more energy during the refining process. In other words, we're not talking about the end of oil per se; just the end of cheap oil.

Broadly speaking, perhaps that can be a good thing if it does indeed compel the free market to incentivize the proliferation of new technology. But as you yourself point out, many of the "alternatives" are gimmicky, and the ones that aren't (nuclear, hydroelectric) are nowhere near sufficient to keep pace with the lifestyles to which we've long been accustomed.

[The Executive Director]

Hello, J. Gillman.

It depends upon the bet the trader made. If he bet long on future oil prices, he probably loses as supplies increase faster than demand. If bet short, he probably wins.

Collectively, it is a wash for traders, because the futures market is a zero-sum game. For every wager made, someone wins precisely the amount that someone loses. So whatever happens, there'll be as much money gained as lost in trading oil futures.

That fact is why the futures market cannot drive the actual market for oil. Because there are equal sums of money going long and short on the future price of oil, there is no net effect ECONOMICALLY. Psychologically there can be, and often is, an effect upon traders in the actual market. But that euphoria and panic washes out quickly, snapping prices back to the norm of supply and demand.

Regards,
Bill Tingley
Executive Director, L.A.W.

[The Executive Director]

Hi, Brandon.

I agree that the days of "Clampett oil" where shooting at some food will stir up some bubbling crude are long gone, but today's drilling technologies make production in deep water and down down into the Earth profitable at a fraction of today's crude oil prices. The same for recovery technologies that revive old reservoirs.

Then there is modernization of oilfields in which capital improvements were neglected by sticky-fingered commissars of nationalized oil companies -- like those in western Siberia, Mexico, Venezuela, and elsewhere -- that have a bounty of fairly cheap oil still to be produced.

So I think it will be a long, long while before oil becomes too expensive to be a practical fuel for the world economy. But none of this is to argue that we should be complacent, believing that we can go along merrily with things staying the way they are.

This why we must let the free market. The free market through the price mechanisim is the most effective signal we have to warn us of impending scarcities. We need to let the market respond to scarcities by establishing prices that properly incentivize us to find new abundances and greater efficiencies in energy. Government intervention that artificially restricts supplies, subsidizes unprofitable alternatives, and coercively dampens demand only delays effective changes needed to respond to shortages.

That is why I find the current assault on one market, i.e. oil futures, assinine demogoguery that if acted upon not only misses its target, the actual oil market, but wrecks an effective mechanism for stabilizing the risk consumers have in an oil crunch -- while doing nothing to bring about any real solution to high oil prices.

Regards, Bill