Tuesday, June 24, 2008

In Defense of Speculation

"Speculators" have traditionally gotten a bad rap but the word has practically come to mean "baby killer" as fuel prices have spiralled higher during the past few months. What people don't realize is how much "speculation" we all partake in during our lives, anytime a person buys something due to expectation of higher prices or lack of availability or holds off selling expecting higher prices, or conversely sells or waits to buy expecting lower prices, that person is speculating.

The role of speculators in markets like the current oil market has a few facets, the first is one that seems counter intuitive, speculators smooth out volatile markets. That seems hard to swallow considering some of the intra-day moves that we have seen in oil, however my experience has been that futures markets are almost always deeper and more liquid than the underlying cash markets and even more so when markets go crazy. One reason is that futures contracts deal with the market in the future giving a hedger or trader more time to deal with the market as opposed to the underlying cash markets that deal with the market in the here and now. It is not unusual for the volume traded in a futures market to represent many times the volume traded in the underlying cash market. It is completely reasonable to say that the addition of speculators helps to make markets less volatile than they otherwise would be.

Another advantage that speculators bring to markets is foresight, professional speculation involves looking at the world as it may be in the future given what is known at the time. It is a very interesting exercise that does a great service even when incorrect. Working out scenarios for the future can make markets and interested parties aware of potential problems and also of potential advantages so that market participants are less likely to be taken by surprise. The exercise also smooths out market moves, a market move will occur as more participants become aware of a scenario, the likelihood of it's occurrence and the scenario's time frame. The alternative is dramatic moves in very short time periods, instead of seeing dime changes overnight in the price of a gallon of gas we could see 50 and 75 cent increases overnight.

Another advantage that speculators bring to markets is the transference of risk, the liquidity that speculators help bring to markets help both users and producers lower their own exposure to the risk of price movement. Commercial users of futures markets use those markets to hedge against either increasing or decreasing prices and often times those commercial users market interests do not occur at the same time or price and that is where the speculator often steps in. The fact that there is trade between the areas where commercial users want to trade increases the attractiveness of using the markets to insure against risk. Speculators help businesses large and small protect themselves from a major risk, that of price.

When I hear politicians and others talk about the need to raise the margins of oil futures to 50% I am shocked at their ignorance, I wrote about futures margins here and I should stress that margins are simply a down payment that insures that a party to a trade is good for any losses that could ensue from a particular trade. The reason that the level seems so low is that markets are primarily used by entities looking to insure against future price movement and it is unreasonable to force them to leave such large amounts of money on deposit, especially if their position is backed by a position in the underlying cash market. The reason that it is unreasonable to levy 50% margins on speculators is that they serve some very important roles, some of which I have likely missed in the above paragraphs. Congress or a government bureaucracy taking over the decisions on margin levels is the same as having the government take over the setting of insurance rates, it would lead to less use of and usability of futures markets and more risk for American business. Bottom line, it is an ignorant idea.

This deserves it's own post but a short synopsis fits well here. I have been doing some investigation of the now infamous "Enron Loophole" that allows energy markets that exclusively trade electronically to avoid US governmental oversight. The Clinton era loophole for energy markets clearly exists but surprise, surprise much of the commentary is misinformed. The story is that the West Texas Intermediate oil trade that takes place on the Intercontinental Exchange (ICE) is all electronic thus it is beyond all American regulation. Due to the current political posturing as the Feds deal with issue all of those I spoke to chose their words carefully, a friend who runs a US trading firm just rolled his eyes when asked about the level of federal oversight and replied that the US government regulator the CFTC definitely oversees the trade on ICE. One issue is that the oil trade on Atlanta based ICE takes place on ICE Europe because ICE bought the International Petroleum Exchange in London in 2001. When they closed the London trading floor in 2005 ICE retained the London market designation, meaning that they are overseen by British regulators. The CFTC has been in very close contact with the British regulators and they have open access to ICE Europe trading screens and open position books. Don't get me wrong, it is a good idea to correct the "Enron Loophole" but is just height of silliness to suggest that the demand led oil rally that we have seen has been due to a regulatory loophole.

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