Oversimplifying for brevity so you get a primer on oil and futures: there are 3 parties: 1) manufacturers/producers, 2) buyers (users, consumers), and 3) speculators. Manufacturers and consumers have opposite price risk.
Manufacturers Exxon (XOM), Chevron (CVX), ConocoPhillips (COP), Hess (HES) find/make the oil to sell it. Their risk and worry is the price of oil decreasing. Naturally these companies wouldn’t care if oil prices went to $500 per barrel as they would have richer profits the more they could sell their oil for.
Oil consumers buy oil to actually use it. You buy oil/gasoline to drive. Refiners, Sunoco (SUN), Tesoro (TSO), Valero (VLO) buy oil and transform it into gas to sell to you. Municipalities buy oil indirectly to repave roads because asphalt is a byproduct of oil. A large industrial company like DuPont (DD) buys oil to as a raw material (burns Natural Gas) so they can make plastics etc. Their risk and worry is the price of oil increasing. As they are buying oil they don’t worry that the price could go down as it would be cheaper for them to buy (good) but if oil goes up they have to pay more (bad).
The producers and buyers have opposite risks and worries. One party’s worry is the price of what they sell decreases. The other worries about prices going up of what they buy. They therefore must hedge in the futures market to offset their risk by doing the opposite of where they are sitting. The oil producer is holding oil (long oil), the worry/risk is prices go down as they will have to sell their oil for less and make less profit. Everyone must hedge in order to make a profit and smooth out the fluctuating price of oil. Producers therefore short oil futures (opposite of where they are sitting) in the event oil prices go down. The money they make shorting oil futures will offset the loss they have by selling their oil at cheaper prices. Hopefully the hedge will perfectly more or less make up for money lost on the other side. If oil prices increase they lose on the shorting of futures but they make up for it by being able to sell oil for more. This is the hedge; the futures contract and the price they sell the oil for wash each other out (but profit is still made in the sale of the barrel of oil but the risk of loss is eliminated). Their profits are made in selling the oil for more than their cost of ‘manufacturing’. They need to make a profit but can’t risk selling oil for less than what it costs them, so they must hedge.
Conversely industrial oil consumers will hedge their price risk (oil increasing in price) by doing the opposite of their position. Since they have no oil (their position is not owning oil) they buy oil Futures Contracts (go long) in the event that oil prices increase. They will pay more for the oil barrel but the higher price they pay will be made up by the profit made in the futures contract. If oil prices drop they pay less for the barrel but they lose money in the long futures contract (one washes the other out netting zero) but the original profit from their business is still achieved. Hedging essentially removes risks of fluctuating prices of the raw material that is being bought or sold by both parties.
Enter the speculator. His role is to add liquidity (greater volume of trading), price discovery and more efficient pricing, all which can possibly reduce volatility in prices. They take risks that hedgers want to reduce.
On appearance the speculator is the secondary player to the producers and buyers. This is the way it’s supposed to be, but isn’t necessarily. The speculators are running the show now.
How prices are driven.
If an entity (consumers, industries) need a million barrels of oil they would bid up the prices accordingly to feed their need for use. Prices would adjust accordingly to the demand for oil usage. However there is another driver of the price of oil that has a correlation to the use of oil but has a stronger correlation to money itself. Oil isn’t traded cash for an actual oil barrel but trades via a derivative (Futures Contract). The derivative is what’s now driving the price of oil, not the demand for oil itself. The futures contract should, in a perfect world (which we don’t live in), match the demand for oil consumption, but in reality it really doesn’t necessarily.
The demand is for the financial instrument Futures Contract (to make money), not the actual underlying commodity. The price of oil is up nearly 100% since February. Has demand to consume oil at every level really gone up this much? But the demand for the Futures Contract to make money never went out of fashion (and yes this demand did go up.) The tail is wagging the dog. The demand for oil consumption should be the main factor in the price. The main factor now in the price of oil is the demand for the piece of paper futures contract. Speculators have demand for the paper contract not the actual barrel of oil. The price of the paper derivative will in the short-medium term drive up the price of the actual oil. How is this possible? Speculators need only put up a fraction (margin) to control vast quantities of oil. The possibility to make fortunes in oil speculation is tremendous. Hedge Funds, newly created commodity Index Funds, Proprietary Trading desks, all want in the game to make big money trading oil contracts. Nowhere in that list was anyone who’s actually making, buying, or hedging actual crude oil.
Two years ago oil went to $147. The myth was surely sold to the world the price was because of global demand. Yes, global demand for the Futures contract drove prices this high. Speculators drove oil prices that high and pushed it as far as they could go. There was some correlation to the demand for the oil barrel but it’s the demand from Hedge Funds, Wall St proprietary trading desks, traders on the NYMEX, and money managers that drove prices this high. It was a commodities bubble. Most people have already forgotten this 2 years later. Just as there was demand to buy homes to make money than to actually have a roof over one’s head, there was demand to buy oil futures to make money rather than use or hedge oil. The demand wasn’t for actual use of the house or oil, but the demand was to make money speculating/gambling in prices going up making the buyer rich. If the demand was just for actual utility, home prices would not have skyrocketed to the where they did.
The demand to make money will always surpass the demand for the actual utility of the good itself. If the demand for oil was just for industrial use and consumers, oil prices would have never gone to $147. Sure, oil prices would have increased as there was economic growth and China had demand, but the demand for the chance to make money on oil far surpassed the demand for oil to drive to Bed Bath and Beyond to buy scented candles. If demand for housing was so people could have a roof over their heads and own instead of renting, home prices never would have gone to the levels they did. Home prices went to the levels they did as it was driven by speculation and the desire to get rich fast from buyers. History has shown the demand to get rich fast will always be greater and drive prices more than then actual utility demand.
There was, and is, an insatiable demand to make money trading oil Futures Contracts and energy stocks that exceeded the real demand to consume oil.
If people are hungry and starving they will have the increased demand to purchase food. The amount of food available will be a significant factor in the price they pay. But if there was a way they could make money speculating/gambling on food prices (like a contract) this need and greed to make money will far surpass the hunger in their stomach. That alone would drive food prices far higher than people’s need to satisfy hunger.
Say there was a pastrami sandwich contract. People can only eat so many sandwiches just as people and industries can only consume so much oil. With no pastrami sandwich contracts you would just go buy enough sandwiches until you aren’t hungry anymore and the price would be relative to how many people are hungry for the sandwich. Now say you could sit at a computer and ‘trade’ this phantom sandwich instrument (derivative) that gave you the chance (as in a game of chance) to make money (just like what a casino chip can do for you in Vegas). All of a sudden pastrami sandwich prices would fluctuate from people gambling on the sandwich contract. Oil prices blasted higher from people gambling on the oil contracts. This pastrami sandwich contract would trade wildly as people are buying a delegate of the sandwich not so they could someday buy the sandwich to eat it, but just to move the paper back and forth in the hopes of making money on it. This wild speculative trading would drive up the cost of the sandwich at the store greater than people’s hunger would. Given the resources (margin to trade) people’s desire for money will drive prices far more than the actual need for the product itself. The demand to make money is greater than the demand to satisfy hunger in this example. The demand to make money in oil trading was, and remains, larger than the demand to consume oil.
Speculation drives a significant portion of prices and this can’t be underestimated. Naturally the oil industry told you differently saying oil prices at $147 were from “global demand” and the outrageously high prices were legitimate and reasonable. Just like the NAR (National Association of Realtors) told you home prices were from actual demand for housing and speculation never entered the equation. NAR said they aren’t building more land and the oil industry posited that we are running out of oil. The point is the industry trade group will always sell the myth to drive prices higher. The pastrami sandwich lobby will tell you that the entrancing pastramapus (where pastrami comes from) is soon to be an endangered species just so the price of pastrami would be driven higher.
Learn to read between the lines and who is telling you the reasons why prices can only continue higher. CNBC and Wall Street will always tell you that stock prices can only continue higher and the lofty prices are legitimate. They said this at DOW 14K. The NAR said the same for home prices. The oil industry said the same for oil prices. In this example pastrami prices would be outrageously high from speculating on the sandwich contract and the industry trade group selling the myth that prices can only continue higher. It will always be this way.
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