Where Rush Got it Wrong
Or - the other things that happen in the futures/commodities market.
Rush stated on his show:
“So once again, my friends, it falls to me, becomes my responsibility to give you a short course on speculators and speculation. We’ve done this a couple of times before, but let me try a different tack. What is speculation? What is the commodities market? It’s the futures market, by definition, speculating on what’s going to happen in the future, which means that people are betting on the price of whatever commodity in the future is going to be, be it soybeans, be it corn, be it oil. “
Right so far…
“Speculators are just bettors, and they make money both ways if they’re right. If they bet the price is going to go down and they sell their contract and it goes, they’ve made money. If they bet it’s going to go up and they buy a futures contract, they make money.”
Um… I think what he’s trying to say is that if you short or sell a contract and the price goes down you make money. Same if you are long or buy a contract and the price goes up you make money. But, if you are short and the price goes up you lose when you have to close out your contract. Same thing for the longs. If you buy and the price goes down you lose when you close your contract.
He goes on:
“But there’s nothing about futures or options that makes it any more attractive to bet that commodities will go up than to bet they will go down. If you guess wrong on the direction, you lose money. That’s all you need to know about speculation. When you speculate on the price of a commodity, what you’re doing is betting on whether the price will rise or whether it will fall. You’re not betting on whether you want it to rise or fall. This is the difference. Everybody thinks that the speculators are trying to drive the price up or trying to drive the price down, that’s not what they’re trying to do. They’re guessing. They’re betting. It may be educated guessing, educated betting, but they still are. You’re not betting that you want what you’re doing will cause the price to rise or fall, not whether you hope it will rise or fall. Your money is going to do nothing to cause the price of oil to rise or fall. It’s gonna base itself, all the results on the good old laws of supply and demand.”
Futures markets are a combination of futures contracts and options on those contracts. Suffice it to say that it gets complex. There are speculators in these markets but the biggest players are the suppliers and the consumers. In this market the suppliers are the oil drillers and pumpers, the consumers are the oil companies themselves. In some cases the oil companies can be the suppliers as well. An oil producer might want to be long or short depending on which way they think prices will go.
Let’s take a hypothetical oil producer - some guy in Kuwait for instance. He is trying to get the highest price for his oil that he can while trying to maintain a minimum dollar amount that he will get per barrel (bbl). So Kuwait guy decides to lock in a price of $80.00 bbl. He enters a contract to sell (shorts) one contract1 at $80 bbl. We’re going to assume that he will hold his contract until expiration. If the price of oil is $90 bbl he loses because his contract is for $80 bbl and that’s all he gets. If the price goes down to $60 bbl, he gets $80 bbl; the price he locked in. Shell Oil decides that they don’t want to pay any more than $80 bbl at the same time as Kuwait guy decides to sell and they buy one contract at $80 bbl. We’ll assume they hold their contract until expiration as well. If the price goes to $90 bbl, up Shell Oil only pays $80 bbl because that’s the contract they bought. If the price falls to $70 bbl they still pay $80 bbl.
Enter the speculator or investor. When the guy in Kuwait decides to short but Shell Oil isn’t ready to buy the investor enters the contract. He buys the contract for $80 bbl. If the price starts to rise Shell might decide they want to lock in their price at $85 bbl and buy a contract. The speculator decides to sell at $85 bbl and that’s the contract that Shell ends up with. In this case the speculator made $5 bbl2 the Kuwaiti producer makes nothing and Shell locks in their price at $85.
There are a couple of interesting things about commodities contracts. First the margin requirement - or amount of cash that you have to have in commodity trading account - is quite low when compared to stocks. It changes over time and by how much money you have outside of the account, but it can be as low as 10% of the contract amount and quite close to 100% depending upon the volatility of the market. If you have a contract and don’t close it out by buying when you are short or selling when you are long you are required to either deliver (if you are short) or receive (if you are long) and pay up if you happen to be long.
Where the speculators do can affect the price of oil (or other commodity) is if they believe that the price it too low and there is no one to short a contract (for each buy there is an equal and opposite sell). The shorts don’t get into the market until the price is too high. If there is no one to sell you a contract you can’t buy one. They don’t make the price go up or down.
Like I said, Rush got it partly right. I didn’t add the options on the commodities markets which adds that much more to the mix. If you want more, check out one of the many commodities brokers, such as Lind-Waldock
- 1000 bbl
- Times 1000 barrels = $5000.00
