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Americans are concerned about high gasoline prices.   John McCain has blamed “speculators.”   The only truth to this argument is that the speculators are the bearers of bad news.   Not only is John McCain playing the part of the tyrrant who shoots the messenger and so will only be told what he wants to hear, it is he and his hawkish allies in the Bush administration who are creating much of the bad news that results in higher gasoline prices.   Watch the news, every threat of a new preemptive war, this time against Iran, leads to you paying higher prices at the pump.

Politicians have derided speculation as gambling, and there is some truth to their charge.  With the development of modern futures exchanges, speculation has become very much like gambling, but not like a lottery or roulette wheel.  It more like betting on a sporting event.   No one knows the score of the big game when they place their bets, but it isn’t just a matter of chance.   Just like being informed about the teams helps when placing a bet, being informed about likely supply and conditions in the future is the key to speculating on futures contracts.     

The key element of a futures exchange is that speculators who buy a futures contract (the bulls) are betting that the actual price of of the good in the future will be higher than agreed price of the futures contract.  However, for every buyer of a futures contract, there is a seller.  And the speculators who sell the futures contracts (the bears) are betting that the actual price of the good in the future will be lower than the agreed price of the futures contract.   

Always, the “bets” of the speculators for a higher price are exactly balanced by the “bets” of speculators for a lower price.   Why?  Because the price of the futures contract will either rise or fall until there is a buyer for every seller, and creating the balance.   It is ”speculation” that causes both price increases and price decreases on the futures exchanges.

Suppose a December 2008 oil futures contract trades at $140 today.   The buyer of the contract is speculating (betting) that the price of oil in December will be greater than $140.  The seller of the contract is speculating (betting) that the price of oil in December will be lower than $140.  

Consider what will happen in December.  If the actual price of oil is $135 a barrel, then the buyer of the future will pay $5 to the seller for every barrel they contracted at $140.  The seller’s speculation, his bet, paid off.  While the buyer’s speculation, lost.    If, on the other hand, the price of oil is $150 in December, then the seller pays the buyer $10 for every contracted barrel.  The seller lost his “bet” that the price would be below $140.   The buyer won his “bet” because the price turned out to be greater than $140.  

Anyone who has any reason to believe today that the price of oil in December will be higher or lower than $140, has a personal financial incentive to buy or sell a futures contract.  If there is an additional buyer, who has some new reason to believe that the price will be higher than $140 in December, the increased demand for the contracts raises the futures contract  price until there is someone willing to sell.  The new information brought to the market by the buyer raises the price of the December futures contract,

However, speculation can also lower prices.   If someone discovers some reason to expect the price of oil to be lower than $140 in December 2008, that person has a financial incentive to sell futures contracts.    The increased supply of futures contracts will result in a lower price until there are buyers.   This new information that supply and conditions for oil will result in a price less than $140 in December, then results in a lower price of a futures contract.   

People can talk all they want about what will happen to the price of oil in the future.  Talk is cheap.   But to the degree that people are willing to back  their talk with money, “to put their money where their mouth is,” the price of a futures contract in December 2008 reflects the best available information about what the price of oil will be in December 2008. 

This speculation, this “betting”, generates a market forecast for the future price of oil, which then impacts the price of oil today.   This is the element of truth in the charge that “speculation” is “raising” the price of oil (and so, gasoline) today.    The price today always depends on supply and demand, but supply and demand today are greatly influenced by the prices of the future contracts. 

If the price of a December future contract is $140, and the price of oil today is $130, then there is a risk-less profit available for anyone who sells a December future contract for $140 and buys oil today and stores it until December.   As people take advantage of that “hedging” opportunity, the demand for oil rises today.  The increase in the demand for oil today causes a higher price today.  The price of oil today will increase until it is nearly $140.   Today’s price can only be less than the December futures price by the cost of financing the purchase and storage of the oil between today and December.   Because a cheap way to store oil is to leave it in the ground and pump it out later, much of the increase in today’s price will be the result of a decrease in current supply.   

So, the gambling of the speculators determines the price of a December 2008 oil futures contract, and then, the risk-less hedging of oil producers results in today’s price reflecting the price of the futures contract.    However, suppose someone has information that suggests that the price of oil will be lower in December of 2008.  They are motivated to “speculate” or “bet,” by selling contracts, resulting in a lower price for a December 2008 futures contract.  Those oil producers who had been leaving oil in the ground take profits on their futures positions, produce and sell more oil, and the price of oil falls today.   In that scenario, speculation  lowers today’s price of oil. 

So, it is almost always true that when the price of today’s oil goes up,  it is because of speculation in futures contracts about what will be happening to the supply and demand for oil in the future.  But, it is equally true, that when the price of oil goes down today, it is because of speculation.  

If oil producers always produced and sold as much as possible now, producing like there was no tomorrow, then speculation about the future would not influence today’s price of oil and gasoline.   Think about it.  To complain about speculators manipulating today’s price of oil and gas implies an alternative policy of always producing (and therefore, consuming)  Like There is No Tomorrow.  While irresponsible Democrat and Republican politicians often are unable to think beyond the next election, surely, everyone must realize that ignoring the future is terribly irresponsible.  And thankfully, the market economic system creates an incentive system so that profits are created for those who correctly use every scrap of information about the future and also generates personal incentives to act on that information today.

Complaining about speculation raising the price of oil is like shooting the messenger.   Speculators cause increases in the future price of oil when information has become available that creates a reason to believe that less oil should be used today because it will be needed even more in the future.

For example, suppose  John McCain or his allies in the Bush administration launch a preemptive war against Iran.    A nightmare scenario could develop for the world economy.   The Iranians retaliate, closing the Straits of Hormuz at the mouth of the Persian Gulf to oil tankers.   Iranian ballistic missiles might damage port facilities in the western Persian Gulf.   The largely Shia populace of the western Persian gulf region might help their fellow Shiites in Iran against their U.S. allied Sunni rulers by sabotaging oil production.   What might happen to the price of oil?  $200 a barrel? $300 a barrel?  $400 a barrel?     

Those who had purchased oil futures contracts at $140–those who had speculated or “bet” that the price would be greater than $140–would make huge profits at the expense of those who had bet that the price would be less.    Even if the probability of this nightmare scenario is small–that the U.S. starts a new preemptive war and the Iranians respond by greatly disrupting the oil market–it makes it more attractive to buy futures contracts.  Every time one of McCain’s allies in the Bush administration threaten a new preemptive war against Iran, the perhaps small probability of the nightmare scenario rises, prices of oil futures contracts rise, the current price of oil rises, and you pay more at the pump.  

Of course, McCain doesn’t like it when the “speculators” point out that he and his war hawk allies are playing with fire.   He prefers more rosy scenarios.   Threatening war leads the Iranians to back down and do what McCain wants, without there being a war.   Or, U.S. military forces destroy the ability of the Iranians to retaliate.  Perhaps this time our troops will be showered with flowers as they liberate Iran and create a new shining model of democratic capitalism.   

But there are people willing to bet their own money that the nightmare scenario is a real possibility.   The price of oil rises with every threat made by Bush or McCain.   And all of us pay for it at the pump.

Do you want to pay less at the pump?  Elect a candidate for President who rejects preemptive war.   Choose a candidate who will seriously engage in diplomacy with Iran, and who will seek to reduce the tensions between our nations.   Choose Bob Barr in 2008.