In Defense of Speculators

Looking good, Billy Ray! Feeling good, Louis!

One of my friends tonight decidedly told me that we “have to stop these speculators.” I respectfully disagreed. While nobody argues against sensible regulation of this practice, Congressional Democrats are pushing have been pushing for nonsensical regulation.

No one wants the Dukes to corner the FCOJ market. Similarly, nobody should want politicians trying to make new rules on speculation based on their supposed expertise in price fairness for commodities futures. Keep in mind that since commodities are sold on a world market, politicians trying to preserve “fair” prices for a commodity will likely result in others getting more of that commodity and us getting less. How’s that for fair?

But, my question was “why hate on speculators? Don’t they serve a purpose?” They do. Absent speculators, how would you get the goods you want to get? Would you negotiate directly with the farmer, toy maker, tool maker? Of course not? Maybe in the middle ages you would have, when everybody pretty much “bought local” and was poor you would, but in today’s economy, would you? Probably not.

Fact is, you rely on speculators every day to provide you the service of not having to make speculatory decisions. Everybody speculates. People who buy stock or gold buy it because they think it will increase in value, not decrease in value. People do not typically make investments or purchases that will not serve to benefit them. To those so morally opposed to speculators, would you be alright with a law preventing you from investing — ever?

I did joke with my friend that, if it’s true that all speculators do is drive up prices, wouldn’t everybody do it? Or, would gas prices never ever fall? Clearly, we know that gas prices fall — and could speculators be to blame for falling gas prices? Say it ain’t so!

Speculation takes many forms, but in the case of oil, we are talking about commodities. Why do speculators exist? There is a simple reason. Say you’re a farmer of something. You don’t know how the weather is going to go this year, just as middle eastern oil barons don’t know what the political climate is going to be this fall. Either the oil baron or the farmer might have some reasonable knowledge of what the supply and demand is going to be, but odds are it will be general. This is where speculators come in. Speculators are flak men, in that they take the risk away from both the farmer and the oil baron.

We are 'commodities brokers', William. Now, what are commodities? Commodities are agricultural products... like coffee that you had for breakfast... wheat, which is used to make bread... pork bellies, which is used to make bacon, which you might find in a 'bacon and lettuce and tomato' sandwich.

He or she looks at the supply and demand, researches potential future outcomes and bids on tomorrow’s goods at today’s fixed prices. In effect, invest on the likelihood that they know the potential future for a commodity better than those that produce it and they are willing to guarantee that with money. I think most of us can agree that those focused on producing a commodity best focus their efforts on producing it, rather than get into some philosophical debate whether they should be both the producer and the middleman. Absent speculators, I can see the government doing a “Know your oil refiner, know your oil” program.

Some people compare speculating to gambling. While this makes sense to some, it is wrong. Speculation is about allocating risk to those who are best able to bear that risk. That makes sense. Imagine if we used the force of law to ban middlemen in the fur-trading days of the early Americas, essentially forcing fur trappers to sell their keep directly to consumers.

What would happen? Would more people have access to fur, or would less people? Of course, the obvious answer is that less people would, because producers would be more conservative in their efforts to ensure the likelihood of a profit to provide for their families.

Speculators make it easier to have things like oil, farm commodities, or fur. Why? Because they offer the producer of that good a guaranteed price in advance, rather than the producer having to speculate and sell their products at the price of the day whenever their product is ready for sale.

In a sense, speculators make a profit as a middle man because they elect to be the one who carries the risk. Some producers may make more if they have the market knowledge and whether they’re schooled in economic and statistical analysis. But as we’ve examined, information is costly.

Do producers elect to take a potentially lower profit because they deal with speculators? Yes. They do so because they get to decide whether the offer is worth their time. And, they’re not the only farmers out there, just as there aren’t one or two speculators. Competition decides who will make what profit, and producers decide if they’re willing to outsource the risk of producing to speculators. Farmers also can gain from speculators if the future price is far below what they were offered in advance. It works both ways.

Put another way, if we elected to outlaw middle men, we’d all be forced to shop at farmer’s markets or grow our own food. How would that best serve society? From your 7-11, to your Whole Foods, to your locally owned grocer, to Wal-Mart — one thing is clear. All are “middle men” and to some degree, all are speculators.

Would you be better off shopping exclusively at farmer’s markets? Speculation, believe it or not, reduces risks for the  economy as a whole.

Speculation grows the pie, ensuring that (for the most part) we don’t have shortages where people cannot get commodities like gas.

That’s a good thing. 

 UPDATE: A friend pointed out that I  confused speculators and commodities brokers a bit in the post. I apologize for that. You can see his clarification in the comments.

He notes:

But I do think there’s a problem when the number of the contracts to buy/sell (remember every buyer has a counter-party looking to sell) is several times the size of the actual market of that commodity.

That’s when gambling comes into play. When the fundamentals of the commodity aren’t reflected in the trading of the commodity.

The hard part, at least to me, is how we regulate appropriateness when it comes to the amount of buyers versus the commodity’s size? I’m not sure we could do that in a fair way, nor I am sure we should even try.

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3 Thoughts on “In Defense of Speculators

  1. Pingback: » Blog Archive » Tuesday Tax Day Links

  2. Your article confuses speculators with commodity brokers.

    There’s not a fine line between them, but the middlemen you describe are largely the commodity brokers. But a real broker has little interest in where prices go – they don’t take positions either way. No one is suggesting taking them out of the loop.

    I don’t even like the term speculators. But I do think there’s a problem when the number of the contracts to buy/sell (remember every buyer has a counter-party looking to sell) is several times the size of the actual market of that commodity.

    That’s when gambling comes into play. When the fundamentals of the commodity aren’t reflected in the trading of the commodity.

  3. Tom K on April 18, 2012 at 3:46 pm said:

    Speculators, like myself, provide liquidity to the market. We only accept risk that others are willing to forgo in the hopes of a profit. Speculators make money, hopefully, when the market goes up and when the market goes down. They do not take delivery of the product they are speculating. The most important aspect of speculators is the ability to keep the market in line. Any successful speculator will tell you that their main job is risk management, in doing so they will not take overwhelming risk trades. This means that when the price skyrockets and goes way outside the mean, they are the some of the first to sell the product thus pushing prices back. They are also inclined to stay with an upward or downward trend based upon recent or upcoming geopolitical and economic news.

    Glancing at my quote board I can tell you today that there have been more contracts traded in the S&P500 futures, 10yr Note, NASDAQ futures, Euro, and the 30yr bond than Crude and corn is only 13K contracts behind it. It is the inelastic nature of crude that will continue price volatility in both the short and long-term.

    Also, around 15% of those who participate in speculation actually make a profit. It sounds strange, but the fact is that most people who try their hand at speculating fail miserably. This is mainly due to stubbornness (I’m right & the market is wrong), improper risk management aka gambling (let it ride!), knowing when to step aside or out completely (trying to play when one of the big houses puts on an order), and many other reasons.

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