Speculators and Oil Prices

In his recent tirade against the free market, Socialist senator Levin, of Michigan, gave birth to the following puff of rhetorical flatulance:

Much of this increase can be attributed to speculators, who buy and sell futures contracts for crude oil and leverage them just to make a profit, creating an artificial 'paper demand' that does not accurately reflect actual market conditions.

First off, it should be pointed out that *ALL* productive activity, including (of course) investing in commodities and anything else, is carried on "just to make a profit". The purpose of production is to provide an output which is more valuable than the inputs -- land, capital, raw materials, and labor -- required to produce it. This difference is called profit.

In the case of commodities traders, the principal is the same. The difference is that their 'input' is a commodity at one point in time, and their 'output' is the same commodity at another point in time. Like any entrepreneur, their business is prognostication, and they make money if -- and only if -- they reach the correct conclusions about the future.

The need for 'speculators'

The specter of 'speculators' is too frequently raised by the economically ignorant to be ignored. Most people do not understand their function, nor the service they provide, and they are therefore easily used as scapegoats, as Marx and Stalin used 'the bourgeois', and their spiritual brother Hitler used Jews. In their defense, I will therefore explain, in a simplified way, the service that 'speculators' provide to consumers.

There are two types of trade which an 'evil speculator' can engage in. These are called 'short' and 'long' trades.

A long trader believes that the current price of a good is lower than the future price of the same good. He therefore buys the good now (raising the current market price), and sells the good later (lowering the future market price). Assuming the 'speculator' is right, the consumers will pay a higher price now (when prices are relatively low), but will pay a lower price later (when prices will be relatively high).

A short trader believes that the current price of a good is higher than the future price of the same good. He therefore borrows and sells the good now (lowering the current market price), and later buys the good to repay the lender (raising the future market price). Assuming the 'speculator' is right, the consumer will pay a lower price now (when prices are relatively high), and will pay a higher price later (when prices will be relatively low).

The short trader cannot operate, of course, without long traders from whom to borrow the good. Also note that when I say 'short trader' and 'long trader', I am speaking about an individual's role in a given transaction. Traders execute both short and long trades.

In either of these cases, of course, the trader makes money if and only if he correctly predicts the market. Money is made by buying cheap and selling dear. If a long trader is wrong, he will be stuck with a good for which he paid dearly, and must either store indefinably (which costs money) or sell cheap. If a short trader is wrong, he will have to replace a borrowed good which he sold cheap with the same good, for which he must pay dearly.

This explanation of commodities trading is somewhat simplified, there are actually a great variety of contract types and terms, but it illustrates the principals behind commodities trading, the benifit which these 'evil speculators' provide to society, and why they must be permitted to continue to provide those benifits.

The alternative is a 'lobotomized market', in which people burn wheat instead of coal in the winter, since they can save money by doing so, and then starve -- or eat the seeds of their future havests -- in the summer, since the wheat which the 'evil speculators' would have saved for them has been -- quite literally -- thrown into the fire.

What Levin Should Do

If Levin truely belives that there are too many people trading long, and that the current price of oil is higher than the future price of oil, there is an action he can legitimately take in order to correct their error. He can sell oil short. As stated above, this will lower the current price of oil, and raise the future price of oil. Of course, if he is wrong, he will be doing harm, not good. The beauty of the free market is that he will automatically pay for any harm he does out of his own pocket, and if he is consistently wrong, he will blow through his considerable wealth, leaving him with nothing to harm us with in the future.

It is sad that politics does not have similar automatic and unavoidable penalties for being consistently wrong.