Speculators have become too much of a good thing. Not just oil speculators. Commodities speculators in general.
Speculators serve a very useful and necessary purpose, but they have wreaked havoc in the markets since the beginning, and they were regulated for that reason.
Ever since, speculators have sought ways to relax the regulations which keep them in check. Our regulations do not keep up with their innovations. The infamous "Enron loophole" is but one example.
I will explain exactly how speculation works using very simple examples, and then I will explain how they can abuse their role in advantageous moments. I have used these examples with a roomful of kids and they were able to immediately grasp what speculators do. So you should be able to, too.
In one corner, we have Farmer Jones, who grows apples. In another corner, we have Grocer Smith, who buys apples from Farmer Jones to sell to his customers. Grocer Smith is an "end user".
In another corner, we have Speculator Adams. Under normal conditions, Adams buys and sells excess apples in the market.
Adams does not have any storage facilities for apples. He never actually takes delivery of apples. Therefore, Adams can in no way be mistaken for an end user.
Farmer Jones has been subject to the whims and fortunes of Mother Nature. Some years, there is a bountiful harvest. Other years, floods and hurricanes have resulted in reduced output. Then there are the bumper crop years.
Because the output of the orchards vary, Jones can never be certain how much he will get for his apples come harvest time. If the supply of apples is low, apples will rise in price. If there is a bumper crop, apples will be cheap.
Therefore, at the beginning of growing season, Jones has no idea what his income will be at harvest time.
On the flip side, Grocer Smith does not know how much he will have to pay for apples at harvest time. If the apple supply is low, he will have to pay higher prices, which means his customers will have to pay higher prices, and that could result in lost customers.
This is why the futures option was invented.
Long before the apples are harvested, Smith and Jones enter into an agreement. Smith will pay Jones a nickel for each apple. Smith also agrees to buy up to a million apples from Jones, as long as Jones has a million apples to sell. So this is a $50,000 futures contract.
Then let's say it is a bumper crop year. Apple farmers bring in a record number of apples. So apples drop to three cents apiece.
The futures contract has worked out well for Farmer Jones as he sells one million apples to Grocer Smith for five cents apiece.
Since it was a bumper year, Jones actually harvested a million and a half apples. After selling one million of them to Smith, he still has half a million apples left.
This is where Speculator Adams serves a useful purpose.
Farmer Jones could expend a lot of effort trying to find more customers, but Grocer Smith owns a whole chain of stores and finding another customer as big as Grocer Smith could be quite a challenge. Jones will more likely need to find several customers upon whom to unload his extra apples.
Well, Speculator Adams is wired into the entire apple market. He knows every producer and every end user. He can take Jones' extra apples and find buyers for them much more quickly than Jones can. For a price.
Jones and Adams enter into an agreement where Adams buys the apples from Jones for two and a half cents apiece. Adams then sells them to end users for three cents apiece.
Adams makes his living doing these deals for many, many growers, not just Jones.
And so everything works out just fine, and we see how a speculator keeps the wheels of commerce moving smoothly.
Now let's say there is a bad year for apples. The price of apples therefore rockets up to 7 cents apiece. But Farmer Jones only brings in 700,000 apples.
Grocer Smith gets a good deal. He is paying 5 cents for apples when the market price is 7 cents. However, he needs one million apples and Jones only provided 700,000.
Grocer Smith then goes to Speculator Adams for the remaining 300,000 apples he needs. And he will probably pay 7.5 to 8 cents apiece for them.
So once again, Speculator Adams provides a very useful service.
But what if Adams decides to interject himself between Farmer Jones and Grocer Smith?
All these years, Grocer Smith has been paying Farmer Jones 5 cents for his apples. Suppose Adams approaches Farmer Jones and offers him 7 cents for each apple he grows for the next three years? Suppose Adams approaches every apple grower out there and offers all of them 7 cents apiece for the next three years?
Farmer Jones is not an idiot. He clearly would be better off selling to Adams, and so he agrees.
If Adams is able to get enough producers to sell him all their future apples, he can "corner the market". All of the end users will have to come to him to buy their apples. And since he owns all the apples, he can name his price.
So the price of apples which have not even been grown yet skyrockets. This is exactly what happened in the grain markets before the Commodities Exchange Act of 1936.
Grocer Smith panics. He sees the price of apples is going to go up, and so he seeks out Adams to lock him into a set price for which he can buy apples from Adams before they go up again. This panic becomes a self-fulfilling prophecy and every other end user begins upping the amount they will pay in order to ensure their supply does not vanish.
And that is one way speculators drive up the price of commodities regardless of the law of supply and demand.
Another way is to imagine that Farmer Jones is one of the biggest apple producers in the world. He's a 100 million apples/year producer.
Jones is kind of tired of the ups and downs of the apple business and he is thinking about going into walnuts. Or at least that is the rumor which some pundit somewhere spreads.
Jones has a lot of buyers, and they panic when they hear the rumor. Their usual supply might suddenly disappear. They are snapped out of the complacency and begin to panic. A Goldman Sachs analyst puts out a report which says if Farmer Jones gets out of the apple business, the price of apples could double from the current price of a nickel.
Speculator Adams is besieged by panicked end users to get locked into new futures contracts.
Adams is in the catbird seat.
Seeing the advantage to the panic, Wall Street dealers do everything they can to keep the fear alive.
As I explained this to some 9-year olds, one of them interrupted. "ON A RUMOR?"
I had been using her as Farmer Jones, and a boy as Grocer Smith, and another girls as Speculator Adams. So I quickly pointed to her and said, "YES! If there is a rumor of an upcoming war with Iran (pointing at her, instantly changing her from Jones to Iran), then any country that buys oil from Iran (pointing at the boy, who had been Grocer Smith) will panic and go to the Speculator (pointing at other girl) to get locked into a future price for their oil."
All three instantly understood.
