I do not write this post to defend oil speculators, but to at least explain in layman terms just what they are doing. I just got through reading a couple of columns on if we could rein in those oil speculators we could bring down oil prices. Hey, even Bill O'reilly is on this bandwagon. If they are so bad , why does not someone just outlaw their trading.
Oil traders, speculators if you will, actually have a stabilizing influence on oil prices. Yeah, they bid oil up in situations like today, but trust me if not for oil traders oil would be even higher.
Oil traders use options to basically guarantee a price for future delivery of oil products, usually gasoline or jet fuel. What they do makes it possible for you to buy a airline ticket a month or more in advance. Here is how that works. An airline company's main cost is jet fuel, so as they plan flights they need to know how much jet fuel will cost so to know how to price a ticket so as to make a profit. And believe me here airline profits are thin. Little fact here, if you were present when the Wright brothers performed their first flight you would had wanted to get in on the future investment prospects there I bet. Well if you had you would have likely never made any money. Airlines since created have yet to make a profit long term, credit bad management and lots of competition, as well as government regulation. Anyway I digress. So airlines needing to make sure what price they will pay for future jet fuel purchase options on jet fuel from traders who say we will guarantee the future price of jet fuel, for a insurance/option premium now. In essence the trader takes the risk for future price. They survey the market and political considerations and decide on what they believe will be the future price. They do this by depositing securities and cash into an account that says they can buy and sell options using leverage. Leverage being they can buy more jet fuel deliveries with possible borrowings than they could buy with the total in the account. Ditto this for gasoline future deliveries, cotton, wheat, all kinds of commodities.
Take a wheat farmer in the midwest. The farmer goes out to plant wheat for fall harvest, he has a choice, plant the crop, pay the expenses, and hope the fall price will be enough to make a profit. Some do that. Other farmers, buy the seed and fertilizer, add up all other costs, and go buy options at a profit for fall delivery of wheat. Thereby guaranteeing a profit. Maybe a smaller profit than if they did not sell their delivery to traders already, but guaranteed nonetheless. If the farmer did not buy options and the price of wheat goes down they could post a loss on that year's crop. Generally not a good thing to do. Most large farmers take the option route.
Now with oil or wheat at noted above, traders actually keep the prices from going too high. First off there is competition among traders to get the deal. There is also the fact traders look ahead and survey the market and decide what price would net them a profit as well. Sometimes they lose, sometimes they win, but once a future delivery price is set they have to make it so. Secondly they price in the future, not knowing what might happen in between the date of the trade and the actual delivery. For instance for every trader who is especting to make money with future delivery of oil, there are many who are losing big right now since a few months ago no one expected Libya to blow up and oil price to be $100 plus per barrel. How would you like to have to be required to deliver oil for $105 a barrel, when you bought it for $75 per barrel. Not nice huh?
If you were a trader presently in oil, would you be willing to not price in a serious premium in your option bid if you were the one taking the risk. I know I would. So let's give commodity traders a little better reputation than the news media and others are doing right now.
Full disclosure, some elements of my trading technigue involves options and speculation.
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