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This was originally posted in the Wheelhouse forum to disabuse Steve (EC Newellman) of some misconceptions, but I think other in here that don't normally visit that section might benefit.
Now onto Commodity markets 101:
First of all it is important to understand that commodity futures markets are worldwide markets. The price of a futures contract on a barrel of oil on the New York Commodity Exchange will be exactly the same as the price of a futures contract on a barrel of oil on the Singapore or London commodity exchanges, except that the relative prices will take into account the quality differences for the product being traded. For Example, Brent Sea crude traded in London will have a slightly different price than West Texas Crude traded in New York due to differences in the processes needed to refine each different type of crude.
You may ask how the prices stay in equilibrium in all these different markets. The answer is that there is a group of institutional investors (investment banks, hedge funds, etc.) that insure that this equilibrium exists through arbitrage. Simply put arbitrage is a process where an investor buys a commodity futures contract in one market and simultaneously sells the same contract in a different market. They do this to earn a profit on any small differences between prices in one market and prices in another. The arbitrageurs are not generally referred to as speculators.
Aside from the arbitrageurs, there are two basic types of investors in the commodity futures markets, hedgers and speculators. A hedger is an investor who actually produces or consumes the product and wishes to lock-in a price for his future sales or purchases. These two types of hedgers are rarely balanced in the market, so enter the speculator. The speculator is someone willing to take the risk of future price movements while never having any need to receive or deliver the commodity. However, given the fact that the commodity markets are not restricted in the number of future contracts that can be traded, there will almost always be some speculators entering into contracts with other speculators placing different ?bets? on which way the price of the commodity will move.
So lets review; there are three possible type of commodity future transactions: 1) a producer of the commodity can sell a contract to a user of that commodity (hedger to hedger) or a user of a commodity can buy a contract from a producer (hedger to hedger), 2) a producer of a commodity can sell a contract to a speculator (hedger to speculator) or a user of the commodity can purchase a contract from a speculator (hedger to speculator) or 3) a speculator can buy or sell a contract to another speculator.
The speculators in a commodity are risk takers that use all available information to continually evaluate their risk. That is why a hurricane in the Gulf of Mexico can influence the price of crude oil on world markets. The speculators are acting on the chance that crude oil production will decline for a period of time. An earthquake or war in an oil producing region will cause the speculators to believe that there will be an increase in the price (shortage in supply) of oil in the future.
It is very important for everyone to understand that, in general, the amount of futures contracts for any particular commodity is far in excess of the expected production of that commodity. In other words the type 3, speculator to speculator contracts will account for a large volume of the trading activity. It is equally important to understand that for every risk assumed by a trader there is an equal and offsetting risk assumed by another trader. In other words you can?t buy a futures contract for deliver 6 month hence if no one is willing to sell one. So if you want to ?bet? that the price of a commodity will rise in the next six months you either have to find someone who is willing to ?bet? that it won?t.
This simple fact belies all the rhetoric we have been hearing about the ?evil speculators.? For every ?evil speculator? that is ?betting? that the price of oil will rise, there is another ?evil speculator? that it ?betting? that the price of oil will stay the same as it is today.
Why isn?t the commodity delivered? Well it?s easy to see why the speculators don?t want to take delivery of the commodity, what?s he going to do with it? But why don?t the hedgers take or make delivery? One reason is the logistics of taking or making delivery. All future contracts are for delivery in the city of the exchange. So contracts for West Texas Crude traded on the New York Mercantile exchange are for delivery in New York. Contracts for Brent Sea Crude traded in London are for delivery in London. A second reason is that a great many hedgers are using a specific commodity future to hedge against a different commodity, sometimes called a synthetic hedge. So in your example of an airline buying crude oil contracts, they aren?t really hedging against the price of crude oil, they are hedging against the cost of jet fuel, which they expect to move in lock step with the price of crude. There is no way Southwest Airlines is going to take delivery of crude oil in New York, what would they do with it? What they will do is sell an offsetting contract to turn their profit into cash and then use the cash to buy jet fuel in their local markets. Even if the hedge is not a synthetic hedge but a real hedge, the logistics of taking (or making)delivery in New York and then getting the commodity to (or from) where it is produced ( or needed) are more than most real hedgers want to cope with. It is much easier to buy an offsetting contract and turn the profit or loss into cash and buy the stuff locally. For example, Greg Mercurio, who we all know as the owner of the Florida, based Yankee Skipper party boat wanted to hedge against the price of diesel fuel. So last winter he bought a futures contract on diesel fuel on the New York Mercantile Exchange. When the contract neared the delivery date he simply sold the contract and turned his gain into cash which he then used to purchase diesel fuel locally in Florida.
I hope this helps you understand the commodity markets and why those snake oil salesmen want you to believe that the run-up in oil prices is all the fault of the ?evil speculators.?
Now onto Commodity markets 101:
First of all it is important to understand that commodity futures markets are worldwide markets. The price of a futures contract on a barrel of oil on the New York Commodity Exchange will be exactly the same as the price of a futures contract on a barrel of oil on the Singapore or London commodity exchanges, except that the relative prices will take into account the quality differences for the product being traded. For Example, Brent Sea crude traded in London will have a slightly different price than West Texas Crude traded in New York due to differences in the processes needed to refine each different type of crude.
You may ask how the prices stay in equilibrium in all these different markets. The answer is that there is a group of institutional investors (investment banks, hedge funds, etc.) that insure that this equilibrium exists through arbitrage. Simply put arbitrage is a process where an investor buys a commodity futures contract in one market and simultaneously sells the same contract in a different market. They do this to earn a profit on any small differences between prices in one market and prices in another. The arbitrageurs are not generally referred to as speculators.
Aside from the arbitrageurs, there are two basic types of investors in the commodity futures markets, hedgers and speculators. A hedger is an investor who actually produces or consumes the product and wishes to lock-in a price for his future sales or purchases. These two types of hedgers are rarely balanced in the market, so enter the speculator. The speculator is someone willing to take the risk of future price movements while never having any need to receive or deliver the commodity. However, given the fact that the commodity markets are not restricted in the number of future contracts that can be traded, there will almost always be some speculators entering into contracts with other speculators placing different ?bets? on which way the price of the commodity will move.
So lets review; there are three possible type of commodity future transactions: 1) a producer of the commodity can sell a contract to a user of that commodity (hedger to hedger) or a user of a commodity can buy a contract from a producer (hedger to hedger), 2) a producer of a commodity can sell a contract to a speculator (hedger to speculator) or a user of the commodity can purchase a contract from a speculator (hedger to speculator) or 3) a speculator can buy or sell a contract to another speculator.
The speculators in a commodity are risk takers that use all available information to continually evaluate their risk. That is why a hurricane in the Gulf of Mexico can influence the price of crude oil on world markets. The speculators are acting on the chance that crude oil production will decline for a period of time. An earthquake or war in an oil producing region will cause the speculators to believe that there will be an increase in the price (shortage in supply) of oil in the future.
It is very important for everyone to understand that, in general, the amount of futures contracts for any particular commodity is far in excess of the expected production of that commodity. In other words the type 3, speculator to speculator contracts will account for a large volume of the trading activity. It is equally important to understand that for every risk assumed by a trader there is an equal and offsetting risk assumed by another trader. In other words you can?t buy a futures contract for deliver 6 month hence if no one is willing to sell one. So if you want to ?bet? that the price of a commodity will rise in the next six months you either have to find someone who is willing to ?bet? that it won?t.
This simple fact belies all the rhetoric we have been hearing about the ?evil speculators.? For every ?evil speculator? that is ?betting? that the price of oil will rise, there is another ?evil speculator? that it ?betting? that the price of oil will stay the same as it is today.
Why isn?t the commodity delivered? Well it?s easy to see why the speculators don?t want to take delivery of the commodity, what?s he going to do with it? But why don?t the hedgers take or make delivery? One reason is the logistics of taking or making delivery. All future contracts are for delivery in the city of the exchange. So contracts for West Texas Crude traded on the New York Mercantile exchange are for delivery in New York. Contracts for Brent Sea Crude traded in London are for delivery in London. A second reason is that a great many hedgers are using a specific commodity future to hedge against a different commodity, sometimes called a synthetic hedge. So in your example of an airline buying crude oil contracts, they aren?t really hedging against the price of crude oil, they are hedging against the cost of jet fuel, which they expect to move in lock step with the price of crude. There is no way Southwest Airlines is going to take delivery of crude oil in New York, what would they do with it? What they will do is sell an offsetting contract to turn their profit into cash and then use the cash to buy jet fuel in their local markets. Even if the hedge is not a synthetic hedge but a real hedge, the logistics of taking (or making)delivery in New York and then getting the commodity to (or from) where it is produced ( or needed) are more than most real hedgers want to cope with. It is much easier to buy an offsetting contract and turn the profit or loss into cash and buy the stuff locally. For example, Greg Mercurio, who we all know as the owner of the Florida, based Yankee Skipper party boat wanted to hedge against the price of diesel fuel. So last winter he bought a futures contract on diesel fuel on the New York Mercantile Exchange. When the contract neared the delivery date he simply sold the contract and turned his gain into cash which he then used to purchase diesel fuel locally in Florida.
I hope this helps you understand the commodity markets and why those snake oil salesmen want you to believe that the run-up in oil prices is all the fault of the ?evil speculators.?
