The Futures Thread

[brucemacneill]

As an extension of the GAS thread, I think we should discuss how markets work since there seems to be some misunderstandings on why prices aren't logically controllable.

I see that oil is quoted at $108/barrel this morning and still going up. Now, that's for the low quality oil North America produces. Higher quality, light oil, is around $120. Both numbers have nothing to do with what oil costs today. You can probably buy existing oil today at a somewhat lower price called the spot price. You never know the spot price 'cause it's what you can get someone to sell you a commodity for right now and is like haggling at a furniture store.

The prices you see quoted are what a producer is willing to contract with a buyer for delivery sometime in the future. Say you're an airline and you're going to need gas in 3 months or you're a refiner and you're going to need oil in 3 months, you find a producer and make a "Futures Contract" whereby the producer agrees to deliver x amount . or product on such and such future date. Neither you nor the producer know what the spot price is going to be on that future date but you're going to have a need and the producer is going to be able to fill the need so you both take a guess and make a contract. If the producer price falls, you get screwed. If the producer price rises the producer gets screwed. It's a bet and it's a contract. That's the simple explanation. We can discuss speculators later. Speculators are people who take futures contracts never really expecting to take delivery and they do muddy the waters.

So, what drives futures prices? The expectations of the people making the contracts. It's all a guess. If there is an expectation that supplies will go up, prices come down because there's competition. If there is an expectation that supplies will go down, prices go up as the competition goes away and buyers who are going to need the product get nervous and are more willing to agree to a higher price just to have the product under contract.

Anyone want to disagree with that description, leaving out the speculators for now?

[Deleted]

Although it's a few years old, this Senate report seems to explain stuff fairly comprehensively.

www.hsgac.senate.gov//imo/media/doc/SenatePrint10965MarketSpecReportFINAL.pdf?attempt=2

In another lazy cut and paste (sorry), someone makes interesting points in response to another guy who is wondering how much speculators on oil futures affect pricing.

(Speculation accounts for some of the price, but certainly not 2/3 of the price.)

The way it was explained to me is that various sources of oil cost different amounts to extract, and the price of oil doesn't depend on the average cost of production, but instead on the cost of production of the most expensive barrel of oil produced.

For example, suppose we lived in a world where there were two sources of oil:
Source A: Costs $25 to produce a barrel of oil. Can produce 100000 barrels per day.
Source B: Costs $94 to produce a barrel of oil. Can produce an arbitrary amount per day.

Assume also that oil is freely traded on an open market, and there are many non-colluding producers extracting from each source.

So long as demand stays below 100000 barrels per day, the price of oil will hover a little above $25, and only producers extracting from source A will do anything. At that price, extracting oil is a money-losing proposition for anyone extracting for source B, so they'll shut down production. Conversely, if any producer on source A tries to raise the price, they'll immediately be undercut by some of the other A producers and have to lower their price back to the market price.

But as soon as demand hits 100001 barrels per day, the price on the market will rise until one of two things happens.
Someone on the demand side says, "I can't afford to pay that for oil", and stops demanding oil.
The price hits $94 and a source B producer can make a profit on filling the demand by producing one barrel per day.

Oil being the foundation of modern industry that it is, the first scenario is less likely than the second, so the price goes up to $94. It doesn't matter that nearly all of the oil is extracted at a much lower cost, that last barrel drives the price up to its cost, and the producers from source A get a $69/barrel windfall.

Even if one of the producers from source A was willing to give up its windfall (out of the goodness of its heart) and still sell its oil for $25, someone would jump in and buy the oil for $25 and sell it into the market for $94 and pocket the windfall for himself.

Moral: Yes the Saudis are making a killing, but it's not entirely because of speculators and price gougers -- the market kind of works that way.

[brucemacneill]

I think that what many people misunderstand is that commodities aren't like groceries at a grocery store, they're more like vintage guitars at an auction. The price of production is not part of the equation. The equation rests upon emotions and expectations, quality and availability. Real buyers and speculators share one common interest, getting the best price they can get although their ends are different. real buyers actually need the product whereas speculators are believing that they will be able to resell the product before they actually would need to have a place to take delivery. Either way, they're bidding on a product with known qualities, with their bids dependent upon what they expect the future to do to the product price. The futures price is largely controlled by perceived likely future events that may or may not occur. Among futures traders there are winners when their perceptions turn out to be correct and losers if future events don't match their expectations. You hear of people with 50,000 pounds of hog bellies on their front lawn because they bought a contract, not expecting to take delivery, expecting to be able to resell the contract at a higher price to a real buyer because they expected hog belly prices to rise but when they fell instead and the real buyers could get a much better price elsewhere, delivery occurred. Actually that probably doesn't happen, the speculative buyer just winds up refusing delivery or selling the product back to the producer at a much lower price than was paid losing the money.

Now, are we still agreed that commodity prices are largely controlled by F.U.D. (fear, uncertainty and doubt)? If so, then we can move on to what effect governmental actions have on commodity prices.

[Fingerplucked]

Feb 24, 2012 10:03:26 GMT -5 brucemacneill said:

If so, then we can move on to what effect governmental actions have on commodity prices.

Thread jumper.

To a greater or lesser extent, government action or inaction may or may not cause a rise or fall in commodity prices unless they stay the same.

Thread done.

[Supertramp78]

Bruce, the problem is the 'reason' for prices change from year to year. When the prices were going up in 2008, people were blaming the speculators. Other people said, nuts, it is the increased demand in China and India. When prices go down, some said it was due to a recession and a massive drop in demand. Other people said nuts, it was Bush talking about drilling more (even though we are actually producing more now than then). Now that prices are going back up you are saying it is speculators again and not supply and demand. Now the unrest in the middle east and the folks on the right screaming to attack Iran play a part but you don't hear that much. Everyone has an idea as to why prices do what they do and they are all probably right to some degree. Iran says they will stop selling to Britain and the price goes up. But Britain isn't buying oil from Iran anyway so what difference does it make? Iran talks about a blockade of the Straits and the price goes up. The fact that their own military said there was no way they could pull it off was ignored. Some people want to blame it all on Obama because they blame everything on Obama. Some blame oil companies because they blame everything on oil companies. Others blame the speculators. Eventually someone will blame Taylor Guitars and the truth will come out.

I guess I'm just getting tired of the politics and the percentage of time I spend thinking about it. Jeff likes to say that when the only tool you have is a hammer, everything looks like a nail. true. But if you don't believe in hammers, nothing coudl be a nail too. If you believe everythign is the fault of democrats and liberals, then it doesn't matter what reality is because it will be folded into that viewpoint. If you believe the problem is Wall Street or Washington or who knows what, then all problems will be folded into that viewpoint. If you believe the government can't do anything right then you will never accept government actions in a positive light. if you believe the markets can solve everything, well, and so on and so on.

It is all just the same thing over and over. Political proof is based on an endless series of post hoc ergo procter hoc logical falacies where X happened then Y happened so therefore Y was because of X. We will ignore all the times X happened and Y didn't happen and all the times Y happened after something else. Over and over and over.

Sorry to dump on your thread. You make some good points.

[Dub]

I was under the impression that when you buy a futures contract you are buying an obligation to deliver a commodity at some time in the future. If the future price drops, no one will want to buy your contract and you could be stuck having to deliver the promised commodity. Or you can sell your contract to someone else who may actually have some of the commodity at a loss. But, profit or loss, when the contract is due, someone has to deliver the commodity.

[brucemacneill]

Feb 24, 2012 10:41:26 GMT -5 Supertramp78 said:

Bruce, the problem is the 'reason' for prices change from year to year. When the prices were going up in 2008, people were blaming the speculators. Other people said, nuts, it is the increased demand in China and India. When prices go down, some said it was due to a recession and a massive drop in demand. Other people said nuts, it was Bush talking about drilling more (even though we are actually producing more now than then). Now that prices are going back up you are saying it is speculators again and not supply and demand. Now the unrest in the middle east and the folks on the right screaming to attack Iran play a part but you don't hear that much. Everyone has an idea as to why prices do what they do and they are all probably right to some degree. Iran says they will stop selling to Britain and the price goes up. But Britain isn't buying oil from Iran anyway so what difference does it make? Iran talks about a blockade of the Straits and the price goes up. The fact that their own military said there was no way they could pull it off was ignored. Some people want to blame it all on Obama because they blame everything on Obama. Some blame oil companies because they blame everything on oil companies. Others blame the speculators. Eventually someone will blame Taylor Guitars and the truth will come out.

I guess I'm just getting tired of the politics and the percentage of time I spend thinking about it. Jeff likes to say that when the only tool you have is a hammer, everything looks like a nail. true. But if you don't believe in hammers, nothing coudl be a nail too. If you believe everythign is the fault of democrats and liberals, then it doesn't matter what reality is because it will be folded into that viewpoint. If you believe the problem is Wall Street or Washington or who knows what, then all problems will be folded into that viewpoint. If you believe the government can't do anything right then you will never accept government actions in a positive light. if you believe the markets can solve everything, well, and so on and so on.

It is all just the same thing over and over. Political proof is based on an endless series of post hoc ergo procter hoc logical falacies where X happened then Y happened so therefore Y was because of X. We will ignore all the times X happened and Y didn't happen and all the times Y happened after something else. Over and over and over.

Sorry to dump on your thread. You make some good points.

I'm actually trying to take the spin out of the thing and have the adult conversation some say they want. The political spin, from both sides, is just that, political spin. Neither side wants to talk about the way the markets actually work because it's nasty, it's just a gamble and it is affected by human emotion more than by any rational sense. We see these swings all the time for no apparent reason so each side dreams up a reason and tries to get us to believe them. They're both wrong on what causes the swings and in spinning things instead of being honest, they cause some of the swings. If you or anyone else thinks I spun something, tell me about it and why it's spin.

[Doug]

[omaha]

The only spin I see in any of this is when politicians try to blame "speculators" for the price of gas/milk/bread/whatever.

Sure, speculators can move a market, but only for a short moment. If Warren Buffett went nuts and decided to spend billions on May oil futures, there would be a blip. But since there is no inherent demand behind his purchases, eventually his position would have to be liquidated...and the blip goes away. The only thing that moves commodity markets in the long term is intrinsic supply vs intrinsic demand. It is metaphysically impossible for mere price speculation to result in a persistent change in the market price.

Politicians, who have at least some control over intrinsic supply and intrinsic demand, blame speculators who have none? Please. Its just scapegoating.

[brucemacneill]

Feb 24, 2012 11:55:28 GMT -5 Dub said:

I was under the impression that when you buy a futures contract you are buying an obligation to deliver a commodity at some time in the future. If the future price drops, no one will want to buy your contract and you could be stuck having to deliver the promised commodity. Or you can sell your contract to someone else who may actually have some of the commodity at a loss. But, profit or loss, when the contract is due, someone has to deliver the commodity.

Like taking a contract for windows in your house, you as the buyer have a contract for a producer to deliver. In the case of a commodity like oil or gold or pork the buyer contracts with a provider to deliver something at some time. When that time arrives, the price may have changed but the supplier still has to deliver and the buyer still has to pay the agreed price. If, to continue the window analogy, you have agreed to purchase 10 windows in 2 weeks for $200/window and have a signed contract, you're expected to take possession of 10 windows 2 weeks from now and give the supplier $2000. So, then a major window supplier offers the same window to you for $150 ea. What can you do? You can try to get out of the contract and probably pay the original supplier a restock fee but if he won't do it, you pay $2000 and get 10 windows. You can see if a friend wants 10 windows at $175 ea. and cut your losses. Whatever, you're on the hook for 10 windows because you contracted to buy 10 windows at $200. Same thing for oil. When you take a futures contract for so much oil at so many dollars a barrel, you hope the price doesn't drop before delivery but if it does at least you had the knowledge of where you were going to get oil from and how much it was going to cost. You might have done better taking the spot price the day you needed oil but it might not have been available and you'd be out of business or the price might be twice what you could have contracted for. You don't know what's going to happen in the future, so you have to guess and make a decision then live with the decision. Airlines frequently buy their oil 6 months or more in advance of need because they can't live with uncertainty. Anyone selling 6 months in advance doesn't know what is going to happen either so has to figure the price he paid for the oil plus his minimum margin plus profit and then add how much he figures the risk that oil might go up or might go down and from all that set a price at which he's comfortable contracting to deliver oil in 6 months. There's a lot of uncertainty figured into all this and that's where the F.U.D. factor comes in.

[RickW]

I don't think it's really supply and demand at all. It's the emotional reaction of purchasers, coupled with the ability of those evil speculator types to know that that will happen. It can be any of the above reasons that create the emotional swing. A smart buyer knows that when he hears Mr. Butthead in charge of Iran say something like he's going to close the straits of Hormuz, the buyer puts in a buy order immediately, along with all the other smart buyers, because he knows the price will bump up, partially because there are a lot of folks like him, and partially because oil purchasers start to gather it up because they are afraid it will go up. It goes down for the reverse reason.

Whether any of it makes sense is moot.

[brucemacneill]

Feb 24, 2012 13:18:47 GMT -5 RickW said:

I don't think it's really supply and demand at all. It's the emotional reaction of purchasers, coupled with the ability of those evil speculator types to know that that will happen. It can be any of the above reasons that create the emotional swing. A smart buyer knows that when he hears Mr. Butthead in charge of Iran say something like he's going to close the straits of Hormuz, the buyer puts in a buy order immediately, along with all the other smart buyers, because he knows the price will bump up, partially because there are a lot of folks like him, and partially because oil purchasers start to gather it up because they are afraid it will go up. It goes down for the reverse reason.

Whether any of it makes sense is moot.

I think you're right. The one thing government action can do though is increase or decrease the F.U.D. factor. If government actions makes buyers, real or speculative, think that supply is likely to fall, up goes the price. If government actions make then think supply is going up, prices fall. If the price has been unreasonably high and government action makes speculators think supply is going up, they have to run for the exits and prices fall precipitously. The legitimate price of oil, last I heard, was about $70/barrel, that's production and delivery costs plus margins. Any price above that comes from F.U.D. Buyers fear that the price will rise, speculators believe the price will rise and there's a bidding war between the 2 kinds of buyers. Additionally, suppliers, fearing that their costs will rise, raise the asking price, the buyers still buy, out of fear, and the whole thing spirals up while nothing real has happened. Killing the pipeline or putting a moratorium on drilling or increasing taxes on suppliers, increases F.U.D. Opening drilling along the coasts, or even saying you're going to open drilling along the coasts, makes F.U.D. decrease and increases fear of a glut within the speculator community and they head for the exits, causing a glut and driving down prices when nothing has really happened. There's unrest in the middle east, up goes F.U.D along with futures prices although nothing has actually happened. Tensions settle down and down goes F.U.D and prices and nothing has really happened. The thing that governments can do is try to avoid screwing with F.U.D. If buyers thought that supply was stable, which is it, and was likely to remain stable, which is under government control since they can cut off supply at any time, oil prices would fairly quickly arrive back at fair price, about $70/barrel. If refinery capacity was sufficient and stable, which in the U.S. it is not for various reasons listed in the GAS thread, gas prices would settle to their "Fair Price" range which is probably $2.50 or so. If that doesn't happen this summer, it will be because the current administration doesn't want it to happen because they could set conditions favorable to refiners, or at least say they were going to set favorable conditions and if they could get buyers and producers to believe them, down comes the price. I don't think anyone is going to believe the current administration though. I'm fairly sure they'll try. Wait for it.

Tramp, I don't think that's spin, conservative viewpoint sure but not political spin just an understanding of the market which unfortunately is driven by human emotions. Anything else controlling it is artificial and can't last, IMHO.

[epaul]

It is tough to make money speculating in futures contracts.

If there was only a market for purchasing past contracts. Much more of a sure thing.

[brucemacneill]

The EIA says the spot price for oil at N.Y. harbor yesterday was $106. The futures price was above $109 and according to Bloomburg the one year estimate is $126. So, if you checked the price on the news yesterday, you would have seen $109+ but if you had actually bought oil for immediate delivery yesterday the price was $106. Analysts think in a year it will be $126, according to Bloomberg. There is no known change in supply although it appears to be rising and demand appears to be falling just now. Why do analysts think the price is going up another $20? F.U.D. Why are they afraid? Middle east tensions? Possible supply disruption? Who knows? It's somebody's guess. However, if you are sure you're going to need oil a year from now it will probably cost you $126, or close, per barrel to get someone to contract to deliver it a year from now. A lot can happen in a year and we have no way of knowing what the spot price will be in a year but if you know you're going to need oil to stay in business, you pay the price for the contract. If you're a speculator and think the analysts are wrong on the low side and it's going to be more than $126, you take a contract and if a year from now the spot price is $130, you sell your contract to someone who needs oil for $129.50 and make $3.50/barrel for nothing more than paperwork. If you're wrong though and the price drops below $126 you start looking for a buyer as fast as you can find one to cut your losses. Welcome to the casino of the world commodities market. That's how it works.

[aquaduct]

Feb 24, 2012 13:18:47 GMT -5 RickW said:

I don't think it's really supply and demand at all. It's the emotional reaction of purchasers, coupled with the ability of those evil speculator types to know that that will happen. It can be any of the above reasons that create the emotional swing. A smart buyer knows that when he hears Mr. Butthead in charge of Iran say something like he's going to close the straits of Hormuz, the buyer puts in a buy order immediately, along with all the other smart buyers, because he knows the price will bump up, partially because there are a lot of folks like him, and partially because oil purchasers start to gather it up because they are afraid it will go up. It goes down for the reverse reason.

Whether any of it makes sense is moot.

I think the "emotion" excuse is bullshit. There's a lot of real, hard money changing hands and I don't think there's enough flaky asshats with spare change to waste on pure speculation to make even a dent in the price.

I work in manufacturing where commodity puchasing and the risk it entails is very real and life or death. Ain't any room for emotions to rule the day.

[brucemacneill]

"spare change to waste on pure speculation "

Oh, I don't think it's spare change to waste. I think it is reasoned investment in the interest of profit, on the speculator side. On the need based buyer side, it is reasoned hedging against the fear of not having supply. The 2 sides feed each other's fears though and cause a much greater price swing, either up or down, than is justified by the actual variability of supply. Back in the 70's there was a supply shortage. You could tell by the "No Gas" signs at the stations. that hasn't happened since. All this other price instability, when there was no shortage, is caused by fear of shortage. The market mechanisms enable the unjustified swings. If I were to recommend a regulation for the oil/gas markets, I'd make buyers demonstrate that they had the capacity to accept delivery. If I was a politician just now, I'd be talking about increasing refining capacity and if necessary increasing supply capacity but that's not necessary now because there is no supply problem and demand is falling anyway. It's end product capacity we need to lower the price of gas. Oil just needs assurance that supply will continue to not be a problem. If I was a politician trying to get re-elected, I'd not only talk about it, I'd make it happen by suspending the EPA rules for a couple of years at a time until things were stable. Let the refiners refine usable gas pick one blend any blend the refineries can easily make and tell all the states that that's what they get to have for now. That wouldn't make any friends for me among the speculators but there aren't that many votes there. I'm really expecting something like that to happen by May or June since it takes a couple of months to work through the system. The Dems need gas below $3 by October and IMHO they'll go "Damn the ideology, Full speed ahead" to have it. Geitners thing about releasing oil from the reserve won't do any good because it's not a supply problem, Nice try though and a tip of their hand.

[epaul]

I don't know the oil market, but speculation by traders unassociated with the "real" grain trade can definitely move the grain markets. Whether these moves have a long term effect or just cause big up and down waves within the overall sea trend, who knows. I expect (strongly) that they are just big waves, but a big wave can wipe someone out in a hurry.

Anyway, if you follow grain markets, it is common to hear "wheat up thirty today due to fund buying" or "soybeans down forty due to funds liquidating their positions". Funds in/Funds out is right up there with rain in Kansas as a daily market mover. There is a lot of free money in the world, a lot of free money, and a lot of this money goes into commodity funds (funds that invest in commodities like grains, minerals, gas, oil, lumber, & metals), especially when interest rates are low and the stock market is dodgy. Commodity markets are seen as a sensible hedge against uncertain financial times (and as a way to make a really big return with your "play" money).

Can't speak to oil, but outside money can swamp the effect of actual farmer/grain buyer trades (unless China is the buyer and Cargill is the seller). Ultimately, fundamentals (the sea) prevails, but there is a lot of wave action going on within the tide. Conventional wisdom has it that speculators exaggerate the waves but they don't control the tide.


.

[omaha]

"There is a lot of wave action going on within the tide"

I think that's about right.

Its also worth noting that speculators (using the term casually...what I really mean is the guys who are the opposite of what you call the "real" grain trade) have the positive effect of ensuring continuous liquidity in the market. If the CBOT was limited to physical buyers and sellers, there wouldn't be a market.

[epaul]

Feb 25, 2012 19:51:12 GMT -5 @omaha said:

...

Its also worth noting that speculators (using the term casually...what I really mean is the guys who are the opposite of what you call the "real" grain trade) have the positive effect of ensuring continuous liquidity in the market. If the CBOT was limited to physical buyers and sellers, there wouldn't be a market.

And that's about right.

(and I'm glad there is more to the market than just Cargill and China)

[brucemacneill]

Anyone who still believes the Democrat stuff about the President having no control of oil prices should re-think that. At 11:21 this morning a news report said that Obama was going to release oil from the SPR and within 2 minutes the price of a barrel dropped $2. Then at 11:25 the White House announced that the report wasn't true and by 11:27 a barrel was back up close to what it was at 11:20. Obama now knows that he does have control of oil prices. Whether he'll try to use it or if anyone would believe him now if he did say something about increasing supply, I don't know but there was an object lesson in F.U.D. this morning. Just note that no actual change in supply or demand happened, just the perception of supply and the price swung $4 in 5 minutes. Happy motoring.