Thursday, July 10, 2008

Of Onions and Oil: Don't Blame Speculators for Supply and Demand

Two seemingly unrelated reports--one on onions, one on oil--from frequent contributors fit together perfectly to destroy the popular notion that nasty, brutish speculators are to blame for big price fluctuations.

You may be forgiven if your first reaction to this story (sent by Michael Goodfellow) is to reckon it parody: but it is the real pungent deal:

What onions teach us about oil prices Onions have no futures market, yet their recent price volatility makes the swings in oil and corn look tame.

(Fortune Magazine) -- Before the U.S. Commodity Futures Trading Commission starts scrutinizing the role that speculators may have played in driving up fuel and food prices, investigators may want to take a look at price swings in a commodity not in today's news: onions.
The bulbous root is the only commodity for which futures trading is banned. Back in 1958, onion growers convinced themselves that futures traders (and not the new farms sprouting up in Wisconsin) were responsible for falling onion prices, so they lobbied an up-and-coming Michigan Congressman named Gerald Ford to push through a law banning all futures trading in onions. The law still stands.

And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings. Since 2006, oil prices have risen 100%, and corn is up 300%. But onion prices soared 400% between October 2006 and April 2007, when weather reduced crops, according to the U.S. Department of Agriculture, only to crash 96% by March 2008 on overproduction and then rebound 300% by this past April.

The volatility has been so extreme that the son of one of the original onion growers who lobbied Congress for the trading ban now thinks the onion market would operate more smoothly if a futures contract were in place. "

Please go to to view the charts.

Now consider this report from the Commodity Futures Trading Exchange (sent by Harun I.) which dismantles the claim that speculators are the cause of oil's recent spike in price.

• The 70% figure includes swaps dealers in the speculative category and includes only the long side positions of both swaps dealers and speculators, without showing, or netting against, short positions of almost equal size.
• It is important to note that much of swaps dealer activity involves commercial hedging and risk management.
• According to CFTC data, swaps dealers as a whole are close to flat in the crude oil markets – meaning they are almost equally long and short in the marketplace. (As seen in Charts 1 and 3 below.)
• Traditional speculative positions (in this case, “speculators” minus the swaps dealers positions) include long and short positions – in fact, there are almost as many short speculative positions as there are long positions. (As seen in Charts 2 and 3 below.)
• Speculative positions have not been increasing during the past year. The net-long positions of non-commercials is currently around 100,000 (as seen in Chart 2), which is at the low end of the range of the past year.

As we can easily see in this chart, net speculative positions have remained in a narrow band, and were actually considerably higher in 2006 than they are now.

Consider the role of "speculation" in securing predictable prices of fuel for airlines. Southwest Airlines reaps benefits of fuel hedging strategy:

What would it be like to pay $2 for a gallon of gasoline when everyone else is paying twice that much?

Southwest Airlines Co. knows, and that’s why many analysts believe it may be one of the few U.S. carriers – if not the only one – to post a profit this year while still offering bargain fares.
The airline, one of the largest at Los Angeles International Airport, locked in more than 70% of the fuel it expected to consume this year at about $51 a barrel, far below Thursday’s closing crude price of $126.62 a barrel.

But because of a calculated risk the airline took last year – essentially betting correctly that fuel prices would escalate – Southwest "may be the only one left standing" by the end of 2008, said Terry Trippler, an industry analyst who expects most major carriers to post a loss this year with perhaps a few even going into bankruptcy.

The cost difference between Southwest and other carriers that don’t hedge as much can be dramatic. Fuel costs were up 20% for Southwest in the first quarter whereas American said its fuel costs were up nearly 50%, which wiped out profit for the nation’s largest airline. On average, Southwest paid about $1.98 for a gallon while American, which hedged about 27% of its fuel use, paid $2.74 a gallon.

Southwest Treasurer Scott Topping, considered the guru on hedging for the airline, said the carrier jumped into hedging in "a big way" in 1999 when oil was at $11 a barrel.

Since then the airline has hedged 70% to 80% of its anticipated fuel use every year, more than any other airline. The airline said it saved $727 million last year by locking in lower fuel prices in prior years.

So the net effect of banning speculation in petroleum products would be to force huge losses on Southwest, and possibly push them into bankruptcy. Good thinking, politicos--ban one of the few tools airlines and other transport companies have to lock in fuel prices.
Speculation is a healthy and necessary part of any market. Outlaw it and you get 400% price swings--in onions, and everything else. If you want to finger the cause of $145/barrel oil, try the millions of autos in China (25,000 more added each day) that didn't exist five years ago, or the millions of new scooters and motorcycles tooling around India and other countries, and the profligate waste of fuel in oil exporting nations like Venezuela and Iran which heavily subsidize their citizens' gasoline prices.

Or maybe the 21+ million barrels of oil we consume in the U.S.--fully 25% of total global demand--70% of which is burned for transportation.

Thank you, Tom S. ($50), for your amazingly generous contributions both financial and intellectual to this site. I am greatly honored by your on-going support and readership.

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