Friday, July 25, 2008

Why Speculation Is Needed

Talifaitasi W. Satele

Many see market speculation for oil as the real culprit behind rising gas prices. Although economists point to global demand and supply as the primary drivers behind prices at the pump, some analysts believe at least 60% of the price of a barrel of oil today is pure speculation. Whatever the case may be, speculation does serve important market functions.

When pundits talk about speculation, they’re referring to the actions of investors on the futures exchange. A futures contract is a standardized contract to buy or sell a certain underlying instrument at a certain date in the future, at a specified price, according to Wikipedia. Through such contracts, traders can buy commodities such as oil at a future price believing prices may go even higher (which is the speculation aspect of all of this).

Buying a futures contract thus provides a hedge against inflation. That means buyers “speculate” that oil prices, for example, are going to be higher than the specified price of their oil futures contract. A trader would be willing to buy oil for August in July for, let’s say, a $160 a barrel when prices in July were, at the most, around $150 a barrel. They are willing to do so because they believe prices will be higher than $160 in August.

The other purpose the futures market serves is to provide some predictability in a volatile environment. ABC’s John Stossel explains quite well in his article, Bless the Speculator, how speculators help to “reduce volatility and uncertainty in an unpredictable world” and provide liquidity through their buying and selling.

Predictability and confidence extends beyond the futures exchange to purchasers themselves. Hawaiian Airlines, for example, can know what its fuel costs are going to be next month by purchasing their jet fuel on futures contracts. Even car drivers are getting in the act by buying fuel in advance through prepaid accounts locking in today’s prices in anticipation (dare I say “speculation”) that prices will be higher tomorrow.

But the most important market function speculation serves is to send resources to where they are needed most through the price mechanism.

Let’s imagine for a second that the Commerce Commission were in charge of the nation’s oil industry. All of their nifty statistics indicate that oil supplies are drying up and that the country will soon run out of gas. What will entice this government agency to act upon this information? How will the Commission marshal the resources necessary to address this emergency? From whom will the ASG tax in order to acquire this capital?

Speculation reflects what supply constraints are today and in the future, and by helping to drive up the price, it is focusing the nation’s attention and resources on the problem through free market incentives.


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