That makes it difficult for producers of commodities to make long-term investments. They have no idea how an investment today might pay off tomorrow. Will large investments today yield significant profits tomorrow? In just a few hours of one day—July 15th, 2008—the price of a barrel of crude dropped $10. From the point of view of somebody deciding whether to invest billions of dollars in a new oil drilling venture, the prospect of significant declines in the price of oil looks both real and frightening. Same goes for farmers buying new farm equipment, or mining companies investing in a new mining venture.
Of course if they can lock in a price for the delivery of their goods at some time in the future producers will be more willing to make investments in future production, because they have a pretty good idea of what the return will likely be. And that is what happens in futures markets. Producers sell the rights to take delivery of their product at some specified time in the future in exchange for a certain price today.
And who buys those rights? Speculators. They are making a bet that the product they are buying at a certain price today will be worth more tomorrow. Sometimes they win, and sometimes they lose. Often they sell off their rights to another speculator who has a different bet on what the price in the future will be of the product they are buying. (For a great short lesson on who speculators are visit the blog Market Power written by economist Phil Miller).
That’s what futures markets do, and that’s why they—and the speculators who make them work—are so important. Farmers will farm less if they are less sure of their profits. Oil companies will seek less oil if they worry that oil to have another price collapse—as happened in the 90s after the peak prices of the 1970s and 80’s. (No, high prices as far as the eye can see are NOT inevitable, history tells us).
It’s the futures markets that make being in the commodities business stable enough to function relatively efficiently. Without futures markets, fewer commodities would be produced and prices would be, on average, even higher than without futures markets. It is the futures markets that provide the necessary stability (most of the time) to the commodities markets to keep producers in the business of selling risky goods.
The government taking more control over futures markets would do nothing to hold down the price of oil or food—in fact, such a move would almost certainly make things worse in the long run. And I am willing to bet that the folks behind Stop Oil Speculation Now KNOW that it would make things worse for consumers.
But they aren’t worried about that. I think they are hoping that getting the government into the oil pricing business will lead to more explicit price controls and supply management, putting their “vital” businesses at the head of the line for cheaper fuel and avoiding the inevitable fuel shortages that price controls would bring.
We’ve been down this road before: in the 1970s the government got into the business of price and distribution controls for fuel, and it was not a pretty sight. For those of you who don’t remember, government interference in market in the 1970s brought us gas lines, fuel shortages, and eventually stagflation.
Markets always work better than government, so let me hear from you all: three cheers for speculators!
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