Speculators are among the most reviled people in history. When they were members of ethnic minorities, they have been easy targets for economically illiterate people who were jealous of their success.
McCain wonders "whether speculation has been going on." He needn't wonder. Speculation always goes on. Speculation means to take a risk on what the future holds in hopes of making a profit. The world's stock and commodities markets are based on this principle.
I doubt that speculators are responsible for much of the run-up of oil prices. Why didn't they run them up sooner? Besides, there are too many other explanations: increased demand from China and India, the declining dollar and Middle East tensions.
In fact, the hated speculator is a good guy because his buying and selling reduce volatility and uncertainty in an unpredictable world. He may only be out for his own profit, but that doesn't matter. As Adam Smith wrote, "It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest".
The prices of commodities often change unexpectedly, making business risky. The speculator brings a degree of certainty to otherwise risky ventures. When supplies of a commodity are plentiful and prices low -- but speculators expect the price to rise later -- they buy -- cushioning the collapse of prices. When supplies become scarcer and prices rise, they sell -- easing the shortage and lowering the price. Also, speculators may agree to buy a commodity in the future for a price locked in today. This reduces the risk for an oil producer or farmer who fears investing because he doesn't know what price his product will sell for next year.
As a result of these activities, volatile supplies and prices are evened out over time. Occasionally, speculators increase volatility. Markets are never perfect. (Although they are better than government regulation.) But in general, speculators increase liquidity and keep the market on a more even keel. This makes long-term planning easier for everyone.
This is a great, simple explanation of what speculators do and why they're important. They're the current whipping boy of Congress, so you really don't hear much about them that isn't bad, but the facts are that they are doing what they've been doing for years and years, and that is actually a great service to the rest of us. It's Congress that has the problem when it comes to oil and gas prices.
Last week on the Rush Limbaugh radio program, Jason Lewis -- a substitute 'professor' -- took a question about how speculation works, and how gas prices go up and down. His explanation was very simple to follow, so I wanted to paraphrase it for you.
The question: if you buy oil at today's price, it's actually going to be some period of time -- let's say two years -- down the road before they actually refine it into gasoline. By that point, it'll be at a higher price; so, it's likely that the barrel of oil they're refining today was purchased two years ago for $60-70 a barrel. So, when we see the price of oil go up, we also see the price of gas at the pump go up with it, even though that oil won't be refined for another two years. Why is that?
The answer: the first thing to do is separate the oil companies from the gas retailers. Most retailers are independent of the gas companies, and they are essentially gasoline wholesalers. The key question these wholesalers (gas retailers like BP, Conoco, QuikTrip, etc.) have to answer is whether they're going out of business or trying to make a sustainable profit. If they are going out, they can sell the gas they previously bought for a small markup until it's gone regardless of the current market price. If, however, they want to stay in business, the only cost they need to pay attention to is the cost of replacing their inventory today, and here's why: if they don't sell enough to replace their inventory, they'll soon be without any inventory at all.
So, let's put some numbers to it; let's say you're the gas retailer. You have a station with a huge underground tank that was filled when the cost was $75 per barrel; now the price has gone up to $105 per barrel. You can't sell it at $85 per barrel because you can't refill the tank at the current cost of $105 - your inventory would only be replenished as much as the $85 per barrel will allow you to purchase. Over time, you would eventually drain your inventory. So, you have to sell gas for the current replacement value (because you have to replace your inventory at current prices) rather than at a markup on what you originally paid for it. Make sense?
The caller then asked a follow up question: how quickly do prices go down, and what causes that?
According to Lewis, nothing drives prices down except competition - if the station across the street is willing to take a lower profit margin, they will mark it down, forcing the competition to either match or beat them. That's essentially what happened through most of the 90s - there was a plentiful supply of gas, and a price war broke out between stations, which resulted in consistently low prices. The dirty little secret is that many retailers have actually lobbied state legislatures to set a minimum gas price. They want to lock out big volume retailers like Sam's Club that can come in and undercut their prices. Where this has happened, the cost has remained artificially high because retailers can't legally sell gas lower than that price, even if the market allows it. The bottom line is that the market itself will always balance out; the only time it gets screwed up is when the government gets involved.
Here's another simple way to think about speculators that I've heard in any number of places. Let's say you hear about another hurricane heading toward the Gulf of Mexico, and it's supposed to hit land tomorrow. What do you do? Based on your experience with previous hurricanes, you suspect gas prices will spike after the storm comes through, so you go to the gas station to top off your car and maybe fill up your spare gas can, too. Guess what? You're speculating that the price of gas will be higher in a few days than it is right now. Or, how about when you need to buy school supplies for your kids? Do you buy all your stuff in July, or do you wait until mid-August, when the back-to-school specials come out? If you're one of those who waits for the sales, you're speculating that the price in the future will be lower than it is today.
The point is that speculators are a critical part of the free market structure - they forecast the price of commodities, allowing investors and producers to increase or decrease their participation to best take advantage of their situations. Every day people speculate all the time on just about everything they buy. We just don't do it with millions (or billions) of dollars like the oil speculators do. The market needs speculators, despite what our loser Congress says about them.
There's my two cents.
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