Traders Taking Us For Another Ride

Commodities index (RBA) and oil barrel (WTI) i...

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A few years ago I was intrigued by an argument I heard linking the housing debacle and great recession to the spike in gasoline prices.  I wish I could remember the source of this theory, but I can’t. The logic went this way: as urban sprawl continued in cities, people bought homes further and further away from where they worked. When gas prices spiked 3 years ago (rising to above $4 per gallon), then suddenly those people found that their cost of driving to work spiked as well.  Some could no longer afford to live where they had bought homes.  The value of their house went down because of the rising cost of commuting, and so they were stuck with homes they could no longer afford.

I acknowledge that there were many causes for the housing crash and great recession, but I think there is something to be said for the idea that rapidly rising gas prices have far reaching negative consequences to our economy.  I am reminded of this because we are seeing the beginning of another spike in the price of gas.

If you listen to the news, people will tell you that the price is going up because of the unrest in the Middle East in general, and unrest in Libya in particular.  That answer reveals the reason that oil prices are being bid up, but it doesn’t really do justice to the degree to which our current system of setting commodity prices is prone to wild swings because of the wagering going on in the trading pits.

When one thinks of the price of goods, one tends to think of the simple relationship between buyers and sellers.  If there are more buyers than sellers, then the price of a good rises, and vice versa.  Yet, the price of oil is not set by buyers and sellers of oil.  It is set by buyers and sellers of oil contracts (“futures” and “options”).  I can buy a contract from someone in which they promise to sell me oil at some future date at a certain price.  Such a contract seems hardly of interest to someone who is not in the business of refining oil.  Yet because these contracts are so liquid,  I can buy one today and sell it tomorrow and try to make a profit even though I have no interest or capacity to deliver or receive the underlying product of the contract.

Oil prices today go up and down based on folks on Wall Street trading such contracts rather than on the purchases of people who are actually interested in buying oil or gasoline (commodities trading is based in Chicago).  The price we pay at the pump has little to do with the supply of gas compared to its demand; it has everything to do with the latest price bid by the traders.

I can buy and sell “futures” for all sorts of commodities like oil.  If I bet correctly about the direction of the price of a particular commodity, then I can make a lot of money.  If I bet wrong, then I lose money.  It sounds an awful lot like a casino.  I can legally bet on all sorts of things.  I can even place a bet on the weather.

The globalization of the world’s economies give more and more power to these futures and options traders to influence prices.  As measured by the FAO Food Price Index, food prices are also headed up. Like oil, they spiked three years ago, but unlike oil, their current run-up has already surpassed that past spike. One of the reasons that food prices are going up is because last year we had droughts and floods that wiped out many crops around the world. But like oil, food prices are also heavily influenced by options and futures traders.

And this brings us back to the unrest in the Middle East. Rising food and energy prices are two of the reasons that people–who have been enduring oppressive regimes for years–recently took to the streets.  So rising commodity prices begets turmoil that begets rising commodity prices.  It turns into a chicken or egg question, but squarely in the middle of the equation are money managers who are making plenty of green for their clientele from the volatility of the price or oil and food.

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