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Andreoli on Oil & Fuel: Can speculators profit from declining oil prices?

By Derik Andreoli
June 01, 2012

As a logistics manager, understanding that oil and fuel prices are a function of supply and demand rather than the rogue actions of “evil speculators” is important.

If speculators are driving prices above a level supported by the fundamentals, the solution is government regulation of futures markets. If, however, prices are supported by the fundamentals, mitigation through supply chain re-engineering is called for.

My motivation is not to defend speculators or their actions. Surely there are rotten apples among the bunch, and their existence justifies regulatory vigilance. Rather my goal is to show that speculators can profit from declining prices just as easily as when they rise—thus, the entire premise that speculators are to blame for high prices is called into question. 

Turning to the markets, we see that speculators have driven the price of crude futures down from $109 per barrel to just $94 per barrel in just a few weeks, and politicians have largely silenced their misinformed anti-Wall Street rhetoric.

Recall, however, that back in April, Senator Bernie Sanders (I-Vt.) said that “the function of these speculators is not to use oil, but to make profits from speculation, drive prices up, and sell.” Such a statement reflects a common misperception of how oil traders can earn a profit through buying and selling “paper barrels” (futures contracts).

While it’s true that speculators are driven by the profit motive, speculators do not need prices to rise in order to make a profit. They just need prices to change—to move up and down—preferably while following an identifiable trend.

To be clear, a futures contract is an agreement to purchase a defined quantity of a commodity to be delivered on a predetermined date for a specified price. “Going long” or taking a “long position” describes the act of buying a futures contract. Traders can, of course, earn a tidy profit by purchasing a futures contract, but only if the price rises above the level specified in the contract. If the market price falls below that level when the contract reaches expiry, the trader will lose money.

What seems to be lost on Senator Sanders and others is that traders can also profit from taking a “short position,” or by betting that prices will decline. If a trader believes that the price is going to fall, they will sell a futures contract; and if the price does indeed fall, the trader can then re-purchase an equivalent quantity of oil for less money, pocket the difference, and play another round.

In addition to going long and going short, oil traders have another option—they can take a spread position in which they simultaneously buy and sell futures contracts. There are a number of common spreads, including crack spreads, arbitrage spreads, relative value spreads, and time spreads. The vast majority of the increase in futures trading over the last decade has been concentrated in spread positions.

To understand how a spread works, imagine that you’re a trader and you believe the price of heating oil is going to rise relative to West Texas Intermediate (WTI) crude. In this case you would play the crack spread by shorting WTI and going long on heating oil. If the spread increases, you can then sell heating oil then re-purchase an equivalent amount of WTI for less than you sold it, pocket the difference, and play another round.

It is important to understand that this isn’t really a bet that heating oil is going to rise in absolute terms. Rather, a profit will be made so long as the price difference between heating oil and WTI increases, which can happen even if the absolute price of heating oil falls.

As you can see, traders can profit when prices decrease just as easily as when they increase. Furthermore, pointing the finger at speculators ignores the fact that there is a trader on both sides of every transaction; and as a consequence, whatever one trader gains, another loses. Only the trader that correctly forecasts the direction that the market is going earns a profit.

We can pull two important conclusions from this. First, Sanders insinuated that speculators are motivated to manipulate the market, drive the price up, and sell. Of course by the same logic, other speculators (i.e. those with short positions and many of those playing the spread) would be motivated to drive the prices down.

Think about it: If speculators could control the market, they could make just as much money by driving the price below the level supported by fundamentals, purchasing paper barrels at that time, and sell them when the price bounces back up.

This brings us to the second point. Prices are not random. Market fundamentals exert a strong pressure on every commodity. This is true even in uncompetitive markets.

Consequently, every trader has the incentive to gather, analyze, and interpret as much information about the market fundamentals as can be garnered.

The real problem with the oil futures market is that the information available to oil traders—hedgers and speculators alike—is often poor or incomplete, and sometimes the most important factors are unknowable, especially when you consider demand forecasts for the Eurozone or production forecasts for Libya, Iraq, Sudan, or any number of other unstable countries.

In short, every trader evaluates the information at hand to determine whether markets are set to tighten or loosen, and it’s in their best interest to correctly forecast the future balance of supply and demand. Over the course of May, the European economic outlook took a turn for the worse to a predictable result: oil traders have lowered their forecasts of future oil demand, and the price of oil futures has fallen.

Because every transaction requires a buyer and a seller, every transaction reflects the fact that the buyer and seller have opposite opinions regarding where the price is likely to go. Clearly some traders are more bullish about European demand than others, but an increasing number of bulls have become bears, and as they have shifted sides, oil prices have fallen.

Basing the price of physical crude on paper transactions made by speculators may sound crazy or chaotic, but this process ensures that the market price reflects the collective wisdom of the group. In a way, each purchase/sale represents a vote, and the price is set democratically. There is no better, more reliable, or more robust way to determine the value of oil to be produced and consumed at some point in the future.

About the Author

Derik Andreoli

Derik Andreoli, Ph.D.c. is the Senior Analyst at Mercator International, LLC. He welcomes any comments or questions, and can be contacted at .(JavaScript must be enabled to view this email address).

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