Speculation

SEARCH BLOG: OIL

Much has been made of the term speculator. In April, I printed an email from Sen. Carl Levin [D-MI] that said, in part:

"On September 17, 2007, I introduced the Close the Enron Loophole Act (S.2058). This legislation would help to prevent price manipulation by directing the CFTC and electronic exchanges to police energy commodity trading. This bill would help prevent excessive speculation and price manipulation by providing the CFTC with the authority needed to monitor and regulate electronic exchanges, something it already does with futures exchanges like the NYMEX. I worked to insert language from the Close the Enron Loophole Act into the Farm Bill that was passed by the Senate on December 14, 2007 (H.R.2419). Before it can be signed into law, the Farm Bill must be reconciled with similar legislation passed by the House of Representatives. If this measure were to be enacted by Congress and signed into law, it would significantly strengthen the federal government’s ability to police our energy markets."

Go back a little farther to November, 2006 when I wrote:

Clarity of thought requires clarity of speech. If we use terms intended to obfuscate, we begin to think in obfuscated terms. Our arguments become transparently weak or false. The good will and support you might have gained and sustained with honest, clear language will be lost.

The next time you hear "they just don't understand", consider that the speaker might not understand... how to think and speak clearly... how to communicate and defend what he actually means.

From Investopedia:

[speculator] "A person who trades derivatives, commodities, bonds, equities or currencies with a higher-than-average risk in return for a higher-than-average profit potential. Speculators take large risks, especially with respect to anticipating future price movements, in the hope of making quick, large gains."

From Merriam-Webster online dictionary:

[manipulate] "1: to treat or operate with or as if with the hands or by mechanical means especially in a skillful manner 2 a: to manage or utilize skillfully b: to control or play upon by artful, unfair, or insidious means especially to one's own advantage 3: to change by artful or unfair means so as to serve one's purpose"

While one does not preclude the other, neither does one necessitate the other.

Speculators are simply specialized investors who are willing to take much higher risks than common investors... such as you and me. They bet the short-term trends. For prices to go up, someone has to be willing to buy and someone has to be willing to sell. Other investors... you and me... are also speculators, but just not as risk-tolerant.

From Wikipedia:

"The economic benefits of speculation

Let's consider some of the principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. [is this "bad" speculation?] Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus. [is this "good" speculation?]

Another service provided by speculators to a market is that by risking their own capital in the hope of profit, they add liquidity to the market and make it easier for others to offset risk, including those who may be classified as hedgers and arbitrageurs.

If a certain market - for example, pork bellies - had no speculators, then only producers (hog farmers) and consumers (butchers, etc.) would participate in that market. With fewer players in the market, there would be a larger spread between the current bid and ask price of pork bellies. Any new entrant in the market who wants to either buy or sell pork bellies would be forced to accept an illiquid market and market prices that have a large bid-ask spread or might even find it difficult to find a co-party to buy or sell to. A speculator (e.g. a pork dealer) may exploit the difference in the spread and, in competition with other speculators, reduce the spread, thus creating a more efficient market.

Some side effects

Auctions are a method of squeezing out speculators from a transaction, but they may have their own perverse effects; see winner's curse. The winner's curse is however not very significant to markets with high liquidity for both buyers and sellers, as the auction for selling the product and the auction for buying the product occur simultaneously, and the two prices are separated only by a relatively small spread. This mechanism prevents the winner's curse phenomenon from causing mispricing to any degree greater than the spread.

Speculative purchasing can also create inflationary pressure, causing particular prices to increase above their true value (real value - adjusted for inflation) simply because the speculative purchasing artificially increases the demand. Speculative selling can also have the opposite effect, causing prices to artificially decrease below their true value in a similar fashion. In various situations, price rises due to speculative purchasing cause further speculative purchasing in the hope that the price will continue to rise. This creates a positive feedback loop in which prices rise dramatically above the underlying value or worth of the items. This is known as an economic bubble. Such a period of increasing speculative purchasing is typically followed by one of speculative selling in which the price falls significantly, in extreme cases this may lead to crashes. Overall, the participation of speculators in financial markets tends to be accompanied by significant increase in short-term market volatility. This is not necessarily a bad thing, as heightened level of volatility implies that the market will be able to correct perceived mispricings more rapidly and in a more drastic manner." [oil price correction?]

Sen. Levin's arguments imply that speculation is equated with manipulation and, therefore, oil price increases are due to manipulation which must be managed by the government.

The next time you hear "they just don't understand", consider that the speaker might not understand... how to think and speak clearly... how to communicate and defend what he actually means.

Maybe our senators also should sue Saudi Arabia for not pumping as much oil as we want to consume because our senators won't let domestic companies have access to U.S. oil reserves.

Oh, wait, they are already on that. Good job!

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