Why the Futures Market Matters to Everyone Part 1

You know I have my opinions about energy policy. Everyone does.

In a nutshell, many of the conservatives/right/GOP focus on “Drill, baby, drill!” and nuclear power and believe that those on the other side of the argument want some kind of ‘watermelon’ world (environmental green on the outside, but socialist red on the inside; and I’ve still no answer about what the seeds represent, though they may refer to seedless watermelons because those are very popular nowadays since people like watermelon in fruit salad and hate seeds, but I digress). On the other side, many of the liberals/left/Democrats focus on renewable/green energy and conservation/efficiency and view their counterparts as greedy capitalists who care not about raping/plundering the Earth.

The truth is, both are right and both are wrong, but that’s out of scope here. I want to talk about something else. There is a more fundamental problem than what sources of energy we pursue. This problem is the futures market.

First, note that this problem doesn’t just apply to energy prices (oil). It also applies to food prices, as crops like wheat, corn, and soybeans are also traded on the futures market. It further applies to various commodities like gold, silver, copper, and other raw materials. The point is this is a very broad problem.

Ok, so what is a ‘future’? It’s basically a contract made between two parties. The buyer of the contract is buying the right, but not obligation, from the seller to purchase amount A of commodity C by date D at strike price P. The buyer pays the seller a certain price for this right/contract. This contract price X is set by the bid/ask prices in the futures market. The bid is the highest price somebody will buy the contract at, and the ask is the lowest price somebody will sell the contract at. These bid/ask prices are dynamic, meaning they change in real time. They also vary based upon the aforementioned variables A, C, D, and P. The varying contracts create what’s called a futures curve for a given commodity. I’ll save the mechanics of futures curves for another day.

This is also commonly referred to as an option. For example, say you’re a homebuyer and you find a willing seller. In theory, you two could write and sign a contract. You pay the seller say $10,000 for the right (but not obligation) to buy the house at $100,000 by the end of this year.

The futures market was designed to give commodity producers (farmers, miners, drillers, refiners, etc.) and consumers (average people and businesses) a means of forecasting future prices to aid in business planning. Being able to forecast future prices helps with production planning, hedging of risk, locking in prices, capital expenditure planning, and so on. With this, fundamental supply and demand drives the market.

But, things have changed. No longer is fundamental supply and demand driving the futures market. Enter the investment class. These are the speculators we hear of, the people and firms who buy and sell commodity futures. The speculators aren’t evil despite what the liberal media would have you believe. They’re just trying to do their jobs, which is to make money for themselves and their clients.

It’s not that they shouldn’t be allowed to speculate. They should be. I’m a speculator myself, but like the overwhelming majority of people, I’m more of an end consumer of commodities versus a speculator. After all, I drive and I eat. Rather, the problem is there is too much speculative money at work.

Look at 2008 when oil (measured by West Texas Intermediate Crude, or WTIC), surged to $150/barrel. The fundamentals of the oil markets didn’t justify that. At best, I argue the fundamentals justified about $80/barrel oil, give or take a couple bucks based on short-term conditions. That surge to $150 was driven by speculators.

Or look at this week. In the past week, silver has dropped 25% and Thursday, WTIC dropped 8.5% in one day. That’s not fundamentals. That’s margin buyers getting blown out of the water. Margin buyers use leverage to buy more of something. So, if you lever up at say 25-1, you own 25x what your money could buy. Leverage is great when it’s working in your favor, but not so great when it’s working against you. In a 25-1 case, a 4% decline would wipe you out.

The futures market needs to be repaired. In Part 2, we’ll look at that.