Tuesday, July 08, 2008

Hussman on oil speculation

This is excellent:

"It's sometimes suggested that hedge funds, commodity pools and speculators don't actually drive up the price of oil, because they don't actually take delivery of the physical product – instead rolling their futures contracts over indefinitely or until they close out their positions. From an equilibrium standpoint, however, this argument ignores the zero-sum nature of the futures market.

Producers have an interest in selling their output forward to lock in a predictable price. Similarly, bona-fide hedgers (such as transportation and industrial companies) have an interest in buying their oil forward so they can plan without concern about future fluctuations.To the extent that the speculators begin to take one-sided trend-following positions, their purchase of a futures contract crowds out the purchase that a hedger would otherwise be able to make from a producer.

It doesn't matter that the speculator has no intent to take delivery. What matters is that if the speculators are unbalanced on one side, the producers will have satisfied their need to pledge future delivery. Moreover, because they can lock in a high price, they will be inclined to sell more for future delivery than they otherwise would. Meanwhile bona-fide hedgers will be inclined to buy less on the forward market than they otherwise would. You can see this combination of effects in the commitments data, as a tendency for commercials as a group to become net short following significant price increases in oil.When it comes time for the speculators to roll the contracts forward, they have to sell their existing contracts either to someone who is willing to take delivery, or to a producer who sold the oil forward and can now clear that liability without actually producing the stuff. Given relatively high spot demand and tight supply, these rolling transactions have worked fine to this point, without driving prices lower."

The crowd-out factor is the key; producers only have a finite amount of production to sell.

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