Understanding Oil and Gas Speculators – Why Do We Need Them?

Oil and gas speculation is in the news:
Lately we have been reading about Congress and their desire to regulate speculation in the oil and gas market. What is this speculation? Who are the
speculators and how do they work?

What is an oil/gas speculator?
A “speculator”, in this sense, is an investor in the futures market who buys or sells futures contracts on oil or gas. In general, an investor will buy a futures contract (called going long) if he or she feels the price is going up. Alternatively, if the price is assumed to be going down, the investor will sell a futures contract (going short).

What is a futures contract?
There is an article on the Telegraph’s website (a Brittish newspaper) that does a good job describing the futures market. Also, the Chicago Board of Trade (www.cbot.com) website has a good brochure that describes the futures process mostly about agricultural products, but the principles are pretty much true for oil and gas futures contracts as well.

Bottom line – a futures contract is a legally binding contract between a buyer and seller to deliver a standardized quantity of the underlying product at a specified price on a specific future date. What this does is allow a seller and a buyer to agree on a set price to transact the trade of a item in the future, oil or gas in the case of this article, while shifting the risk of price changes onto the investor who buys the contract as a futures contract. The buyer could be a airline company who uses lots of gasoline and must be able to predict what the cost will be on a future date when they need to purchase enough quantity to fly their planes. The seller could be a refiner that produces jet fuel from crude oil for airlines and agrees to the future date and price. The seller is also able to project what future revenues will be from the sale of fuel on a future date. In fact, the seller may actually contract to sell fuel that is not yet in inventory. In this case, the refiner may also have a future contract with a crude oil supplier for deliver of oil on a future date at a future agreed price. In this case, there is a chain of contracts, all vulnerable to dramatic changes in actual market price for oil (or similarly for gas).

How are prices determined?
Both parties, the airline and the refiner, will negotiate the future price based on estimates of what the price of fuel will be trading at on that date using the best available data today. This estimate may be close or way off, either higher or lower. World events can occur during the time of the contract to dramatically change the price. If prices increase dramatically over the agreed price, the seller loses potential profits that would have been made at the higher market price. If prices go down dramatically, then the buyer could end up spending much more for the fuel than a competing airline who buys at the lower market price. Therefore, without a means to mitigate the risk of price changes, both parties may hesitate before entering a contract and both will not be able to accurately project future revenues and costs.

What is the role of a speculator?
This is where a speculator can help. The futures speculator takes on this risk of price changes during the time of the contract. The buyer and seller can feel confident to enter their best estimate for prices on a future date knowing they can then pass the contract to a futures trader, “speculator”, to take on the risk. The speculator that feels the price will increase to the contracted price buys the contract, which is known as “going long”. The speculator that feels prices will not reach the agreed price will sell the contract before it expires, known as “going short”. In fact, short sellers can make money as the price decreases by forcing someone to buy back the contract at a lower price than they sold at it. This is beyond the purpose of this article, but is one strategy that speculators use.

Strategies speculators use:
There are many strategies speculators use to hedge their long or short bet on the future price of oil or gas. Some involve buying or selling more than one contract and different strike prices (the agreed contracted price the underlying oil or gas will be sold at in the future). Some involve buying both a long and short position at different prices. Some involve buying or selling multiple contracts at the same strike price. Then there are options that can be traded on these futures contracts, which again is a topic for another article.

Futures markets support strong business:
The futures market provides buyers and sellers with a world-wide trading platform using standardized contracts that are easily traded and understood by futures traders. Buyers and sellers can feel confident to enter these future contracts knowing the risk is easily passed to future traders. This is a critical tool for business to accurately project future revenues, costs, and earnings in a volatile market. Businesses can move forward transacting business in unpredictable market conditions. Without the futures market, businesses would not be able to accurately project their costs and revenues. They may be forced to be overly conservative and hold off investments for future growth, which could lead to less jobs or even loss of jobs. It could mean missed business opportunities due to being too conservative on investments for future growth.

Prices are not determined by the speculator, but by market conditions:
Speculators are also guessing what the future price will be when the contract expiration date comes. They are subject to world events that can dramatically change the current trading price of oil and gas for past futures contracts that end each day. Buying and selling futures contracts does not change the price, the demand and supply of oil and gas each day does. I don’t disagree there may be some large groups who could manipulate the supply or demand for oil or gas each day (OPEC, emerging country growth – China & India, etc.).

Summary:
These are my personal thoughts on the wonderful benefits provided by the futures market and associated futures traders, also known as speculators. I don’t claim to be an authority on such markets, but these are my personal observations.

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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Past articles can easily be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content