So, you want to speculate in commodities.

Speculators are what are causing the rise in oil prices.  We hear that every time they go up, and to some degree, this is correct.  Speculators make a lot of money whenever any commodity changes price.  Of course, some lose money also.

Speculation in commodities is kind of like betting on a red in Vegas. You can win big and you can lose big. But the start of the selling of future deliveries of a product is an old practice that generally helped get things done.  It was a way of hedging bets. Literally.

The most basic example is the corn farmer who has to buy the seed, insecticides, fertilizer, fuel for the tractor, and so on to grow the crop, which, when harvested, is only able to be sold for what the market then offers. If everyone has a good crop and everyone is literally up to their ears in it, the price falls, and no one makes any real money. If almost everyone has a bad crop, the ones with good production make out. (Think Forest Gump’s shrimp business after his was the only boat to survive the hurricane.)  It’s basically supply and demand – the more of something there is, all things being equal, the less it is worth.

The farmer has to borrow money to pay for everything and the banker, knowing the price of corn may or may not provide enough money to pay off the loan, tells the farmer he has to enter into a contract to sell the crop before the loan is made. As it so happens, General mills needs train loads of corn to make its cereal and need to be sure it is going to come in and be able to budget the cost.

So, the farmer could go directly to General Mills and agree to sell so many bushels at an agreed-upon price when the crop comes in. The farmer has a market at a price sufficient to cover the loan, which the banker then makes and everyone gets what they need.

In the real world, brokers put together buyers and sellers for a commission.  They usually will not “go naked” or have what is called an uncovered position.  That is, before they agree to  buy, they have a place to sell it, and vice-versa.

This is where speculators come in. Anyone can enter a contract to buy or sell almost anything.  You may buy a thousand bushels of corn to be delivered to you in six months, at a price certain, say $6 a bushel.  Any time between now and the delivery date, you can sell the right to receive the corn.  If it is a terrible season, and the price goes up to $8, you make $2 a bushel. If everyone is up to their ears in the stuff, and the price falls to $5, then you lose $3 a bushel.

Now to oil.

I am involved with a company that produces about 8,000 barrels of oil per month. We all know how volatile oil prices are. We lock in the price on some of the production so we have some general idea of what revenues will be next year and the year after— just enough to comfortable ensure costs can be covered.

Let’s say we sell 6,000 barrels a month for the next year at $85 per barrel. For those barrels, we get the contracted price. The rest float at the market, which lately has been above $85, but can slip below that amount. So the un-contracted volumes are the only ones subject to market price fluctuations.

Is this a good deal? Depends on what happens in the market. Kind of like that show Deal or no Deal, you are not sure until the last case is opened.

Why not forward-sell the entire 8,000 barrels? Because if our production were to fall, we are responsible for providing the volumes, which means we have to go out and buy oil at the then prevailing market price and sell it at our contract price.

The speculators, the people who trade in commodities without producing the commodity (whether it is a hydrocarbon, feedstock, there are even weather commodities), make the real money, but they can also lose real money.

Let’s say the person we contracted to sell to can buy from us at $85 and sell to a third party at $95, they made a quick $10 per barrel on 6,000 barrels each month – a slick $60,000. However, if the market fell to $50 per barrel (don’t laugh – it ain’t been all that long when $15 was the price), then they lose $270,000 per month.

In the case of natural gas, it is bought and sold half a dozen times between the well and the end user.

Does this invariably mean the cost of the underlying commodity will go up.  No. Look at the price of natural gas, which has been bottomed out for so long, one wonders how it can cover the cost of finding and production.

But the presence of speculators does create uncertainty in the market and will have the effect of creating short-term volatility.  In the long run, the very long run —I am talking years here—it is supply and demand that determines the price at which a commodity trades.

One thought on “So, you want to speculate in commodities.

  1. Rampant, unregulated speculation is wrong and they should be held accountable. Just because it is legal doesn’t make it right. Thank you Enron.

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