Q&A
From the August & September AD 2008
Our Lady of the Rosary
Parish BulletinNOTE: This is an advanced publication,
and may be modified after the Parish Bulletin is printed in final form
On the Morality of Economic SpeculationQuestion: I am still a bit skeptical of your claim that the gas stations aren’t pricing in an immoral manner-but the financial commentators on TV now seem to be blaming the “speculators.” What precisely does a speculator do, and is whatever he does moral?
Answer: It will help to distinguish those who participate in the forward commodity markets from those who participate in the commodity futures markets, which we will explain later in this article.
● By the “forward market” we mean the market in which a contract is negotiated by the buyer and seller, containing terms, including price, agreeable to both, with the transfer of goods at some specified date in the future. If the transfer is within a day or two it is called a spot transaction rather than forward. All such contracts must be carried to completion unless both parties agree to modify or extinguish them. The essence of forward and spot contracts is the actual transfer of goods. In this market, speculation, mixed with an attempt to protect one’s assets, can take one of three major forms.
● If the average person speculates that goods will soon be more expensive or difficult to obtain, he will stock up in advance. The prudent man stocks his pantry before the bad weather season in his locale-those batteries, bottles of water, and cans of food may be (literally or figuratively) worth their weight in gold when the power is out after the hurricane or snow storm. He may also speculate that gasoline will be more expensive next week, and therefore fill his car’s tank and all of his little red utility cans this week. Note that it costs the prudent man something to do this. He pays for the gas and the groceries with money he has now, giving up that opportunity to use that money for something he would like to have now-he does so, even though he knows that he will not use what he buys for weeks or even months, and may not particularly like canned green beans or wieners. He is simply being prudent, not immoral.
● The owner of a business (or a government, or a charity) may speculate that petroleum products he needs to run his machinery and vehicles will become more expensive or difficult to obtain. Shutting down or cutting back will probably not be an option. His product may be important or even essential to the people he serves-the electric company, for example, or the water works, or the companies which make or deliver food, gasoline, and materials needed in the aftermath of a disaster. Shutting down means laying off workers at one of the worst possible times. Shutting down may mean defaulting on loans and mortgage payments and going out of business permanently-producing nothing and employing no one ever again. Like the prudent average person, the prudent business man will spend money now to provide for the future, even though he has other uses for his money, or even though he may have to borrow that money. He is simply being prudent, not immoral.
● The idea of buying a large lot of a commodity like oil and taking delivery on it, now or in months yet to come, suggests someone who is already in the oil business. Very few others are likely to have the storage capacity and the ability to comply with safety and environmental requirements. The utility companies might have such facilities, but they will need the oil for their own purposes, and will not want to sell it, even at a good profit, if they will have to turn around and buy it back at a higher price. The oil company may purchase oil for storage because it is obligated contractually or morally to furnish product to its wholesale and retail affiliates-if Exxon, Shell, Sunoco, or other such companies failed to supply their gas stations, the results could be catastrophic. The oil company buying above current needs will have to spend money or make contracts now for future returns. Again, it is being prudent, not immoral.
● Does buying now on the assumption that goods will soon be more expensive or difficult to obtain contribute to the current rises in price? Of course it does!-an imperceptible amount when the householder buys batteries, beans, and a tank of gas-a barely measurable amount when Exxon and its competitors fill up their huge tanks (we are talking about marginal purchases not total consumption).
But all of these speculations-small, medium, and large-contribute to the general well being in several ways. Perhaps most importantly, they serve to guarantee that life will go on more or less as normal: with enough to eat and a flashlight to see the food; without bankrupt businesses, unemployed workers, and no goods on the shelves; and without the nation running on “Empty.” This guarantee is bought with the carrying charges actually or hypothetically required to finance these purchases.
If it is perceptible, the initial price rise will discourage further immediate increases in demand, and the future demand will be offset by the reserved goods as they are used up.
Free-market entrepreneurs know that they will do best in an economy that is operating at full production-one in which all factors of production are optimally utilized-land, labor, capital, and entrepreneurial ability. Extreme conditions benefit no one in the long run. A rapid movement to either high or low prices will destabilize the economy, putting people out of work and destroying businesses. The only people who thrive on chaotic markets are those who view martial law as an opportunity to show off their new uniforms and boots, and those who make their living financing both sides of the wars they expect the chaos to start. The widget maker selling at $4 might be happy to see $5 or even $6, but would be terrified to wake up one morning to see in the paper that it was $17. Such a rapid up-tick would probably signal a market collapse or extreme government intervention.
In the spot and forward (not futures) market examples we gave above, it is difficult to distinguish a profit motive from a self protection motive. Even the householder might describe his actions as “profitable” if they get him through a difficult time in relative comfort. Things are a little different in the futures market.
● ● ●
The reader may have noticed that we kept referring to goods that are “more expensive or difficult to obtain.” Of concern to prudent householders and businessmen is the possibility that government may intervene in the market with price regulations or rationing. Price regulation will cause shortages by lowering supplier incentives to produce and bring goods to market. Rationing may make required quantities of goods unavailable at any price.
Recall the odd and even days for getting on line to buy gas in 1973 under Richard Nixon, and in 1979 under Jimmy Carter. The ration coupons (above) were printed but, thankfully, never issued. Economic ignorance is bipartisan.
“As the average vehicle of the time consumed between 2-3 liters (about 0.5-0.8 gallons) of gasoline (petrol) an hour while idling, it was estimated that Americans wasted up to 150,000 barrels (24,000 m³) of oil per day idling their engines in the lines at gas stations.” (Wikipedia s.v. “1979 Energy Crisis”[1])
● ● ●
Morality of the Futures Market
The “futures market” deals exclusively with exchanges of goods that will take place are some specified date in the future-no contracts are made for the immediate present (no “spot” contracts), and contracts cannot be called ahead of time. The futures market is primarily concerned with the management of risk to buyers and sellers, both of which are called “hedgers”-the buyers being assured an adequately low price, and the sellers being assured an adequately high price-both sacrifice the possibility of great profit for adequate profit and low risk. Futures contracts are set in standard terms specified by the exchange-things like how many items per contract, their quality, place of delivery, last day to complete the contract, and so forth.
It is important to note that while there is the appearance of sellers selling to buyers, all contracts are between the exchange and individual buyers or sellers, and may be extinguished by either buyer or seller by obtaining an offsetting contract at the exchange. (If I have a contract to buy 10,000 rutabagas, and I make a contract to sell 10,000 rutabagas, one contract offsets the other, and I have no contract any more.) As the primary reason for the futures market is obtaining a predictable price at the end of the period, most hedgers offset their contracts, and then buy or sell on the spot market, rather than take or make delivery of the futures contract.
All participants in a futures market must cover their contracts with a percentage of the total value of the contact. This performance bond, a demonstration of their ability to pay what is expected of them, is called “margin.” As the value of a contract increases relative to the market price, the difference is added to the margin account, or taken away if the contract decreases in relative value. Margin accounts must always be maintained above an amount set by the exchange, investors will be “called” to add to their margin accounts if they fall below the specified values.
No participant in the market-hedger or speculator-may make a contract farther from the market price than a daily limit set by the exchange. Remember that the purpose of the exchange is to keep prices relatively stable. For example, if a commodity future is trading around 20, nobody will be able to make a contract on the exchange at 7 or at 38. This allows the market several days to adjust to real changes in the availability of goods, and keeps anyone from bidding the market very far above average prices. Limits are also set on the quantity of commodity that any one hedger or speculator may control-it is not possible to “corner the market.”
There may be brokerage and exchange fees to contend with, government taxes on transactions in certain markets, and other incidental expenses that must go into the process. The investors known as “speculators” enter the market, not to hedge trades, but to profit on changes in market prices.
● The speculator may offer a contract to sell goods he does not yet own. If the price is down at the end of the contract he offsets this contract with one bought at the lower price, and receives a profit; if the price goes up he offsets with a more expensive contract and looses the difference. If selling what one does not yet own seems strange, consider that the farmer sells a contract for crops that he has not yet grown-this is a futures market.
● The speculator may buy a contract to acquire goods at a fixed price with the hope that the market price will go up by the end of the contract, allowing him a profit. He loses the difference if the market price goes down. Even during the period of the contract, he will be “called” to pay additional margin if the price drops and decreases his margin account below the exchange limit, probably causing him to offset the contract immediately, losing the amount of the decrease.
● The speculators serve the useful purpose of bringing liquidity to the market-In markets with few trades, a trade or two can move the market price to the limit-the speculators add a few more trades to the mix so that no one trade is overly significant.
● The speculators’ position is the same as that of the hedgers, with a substantial possibility of loss as well as gain. The losses of the speculators can be viewed as the way in which market liquidity is financed.
An Example of a Hedger
All of this will make a little more sense if we describe a typical hedger. He is someone with business to run and a concern that the business will be hurt or fail if some necessary commodity suddenly becomes too expensive. He might be concerned about the cost of some necessary major material: wood, gold, plastic, cement. He may be concerned with labor costs (not normally thought of as a “commodity,” but a contract with a labor union to provide labor is similar to a forward commodity contract). He may be concerned with the ability to exchange one currency for another, foreign or domestic. He may be concerned with the cost of powering his business with water, coal, electricity, or, in our case, petroleum. The operative idea is that the hedger wants to make futures contracts with people for the things he needs but believes to be risks beyond his control. He is willing to pay for such contracts as the cost of doing business, and as insurance against damage or failure. He takes most of the risks himself, letting contracts only on those things better managed by other people. Again, in our case, the hedger is worried about the availability of petroleum products, and their availability at a price that is no more than his specified percentage above the current market price.
By way of illustration, our hedger operates a widget factory. He employs a thousand workers who are happy with their jobs. The factory requires three pallets of copper plated zirconium widget blanks each day, which he is sure his brother-in-law will supply. The employees are paid in Italian lire which he is sure will be available at or below the current dollar exchange rate. Sales are in euros, which seem to be rising relative to the dollar. Our man’s biggest concern is that the plant needs five-hundred gallons of No. 2 diesel fuel each day, six days a week. His operation will run and prosper at the $4.75 per gallon he is currently paying, will have to lay off about half of his workers at $7.75, and will have to shut down completely at $9.35. Market analysts predict prices around $6.50 or lower for the next six months, but he doesn’t feel comfortable with their predictions. What our hedger will do is buy futures contracts (perhaps several contracts with staggered dates) for No. 2 diesel. In the six month window he will probably get the ≤$6.50 price predicted, and when the contracts come due, he may or may not wish to take delivery, but will be assured of having adequate diesel fuel to run his business.
The businessmen producing oil products are in much the same position as our widget manufacturer. They too are dependant on regular shipments of oil or partially refined products from those who actually produce these commodities.
The fellow who actually has the oil well may have different but similar concerns. He is not so concerned with the demand of the market for his product, but may be very worried about the value of the currencies in which he is paid. He may be looking for a contract to guarantee that his euros and dollars are actually worth something in gold a few months down the road.
● ● ●
It is difficult to impossible to find anything unjust in any of the examples we have examined. No one is expected to participate without knowing the risks or the general expectations of the market. Research is encouraged. No one is forced to do anything. What we do find is the hope that life for everyone involved will go on pretty much as normal-that employment will be stable, that businesses won’t fail, and investors will be secure.
Even if nothing goes wrong-even if prices remain stable and goods remain obtainable-the money spent to protect the home or the enterprise was as moral as buying automobile insurance. The fellow who buys the commodity outright gets some return for his money, for he will use what he purchased eventually. The hedger who bought a futures contract bought peace of mind if nothing else. The speculator pays a lot of the insurance premium on stability. We all hate paying for insurance, but we hate it a lot more when we have the “opportunity” to collect on a claim!
● ● ●
So What is Wrong With the Speculators
As the futures markets are traditionally conducted, the speculator plays a useful role, as we have seen. But a few things have taken place, changing the character of the market.
No longer completely self regulating, the US futures exchanges are now regulated by the Commodity Futures Trading Commission (CFTC), an agency of the federal government.
In addition to its role in debasing the dollar and thus inflating the price of oil and everything else, the Federal Reserve System (Fed) has been pursuing a policy of abnormally low interest rates in order to make credit easily available. Doing so has lowered the rate of return on the traditional stock and bond markets, prompting investors to seek higher yields elsewhere.[2] Large banks and hedge funds have entered the futures market as speculators, and have been give permission by the CFTC to hold oil contracts in numbers above the normal market limits, in competition with the traditional large oil buyers like airlines, shipping and delivery firms.[3]
The futures market is intended to stabilize prices to allow continuity of industry-exempting transportation companies from the exchange limit makes sense, but introducing an enormous volume of speculation beyond the usual limits does not. In view of their special relationship with the Fed, there is also the question of the propriety of exempting the large commercial and investment banks. And in light of the Bear Stearns bailout, it is questionable that they should be given free rein in a volatile market.[4]
The CFTC has also lifted large contract restrictions on those who trade in foreign markets, allowing additional speculation on the lesser regulated and sometimes secretive exchanges of foreign countries. The New York Mercantile Exchange (Nymex) is now doing business in Dubai, where it will be under foreign regulation exclusively. The New York based Intercontinental Exchange (ICE) does business in London, beyond US authority, but with an information sharing agreement with the British government
Congress is considering a “slew” of bills to limit speculation and to demand greater information from foreign exchanges.
“In two days, the price of oil rose $16,” said Sen. Richard Durbin, D-Ill., at a joint hearing of two Senate panels on oil speculation Tuesday. “Did I miss something, was there some war in the Middle East?”[6]
In fact, the $16 rise came over two days, with $11 being attributed to a “loose cannon” Israeli official, threatening to obliterate Iran, the world’s fourth largest oil producer.[7] When one thinks of the way the Administration, Congress and the Fed mismanaged the Great Depression, perhaps we ought to begin gathering firewood to run the furnaces of family, industry, and society.
NOTES:
[1] http://en.wikipedia.org/wiki/1979_energy_crisis; http://en.wikipedia.org/wiki/1973_oil_crisis
[2] Steve Hargreaves, CNNMoney.com , "Oil Prices: Wall Street's Game, May 16, 2008 http://money.cnn.com/2008/05/16/news/economy/oil_speculator/index.htm?postversion=2008051615
[3] David Cho, Washington Post, "Investors' Growing Appetite for Oil Evades Market Limits: Trading Loophole for Wall Street Speculators Is Driving Up Prices, Critics Say" June 6, 2008 http://www.washingtonpost.com/wp-dyn/content/article/2008/06/05/AR2008060504322.html
[4] http://www.rosarychurch.net/answers/qa062008.html#Bank
[5] David Cho, Washington Post, ibid.
[6] Steve Hargreaves, CNNMoney.com , "Congress takes aim at oil speculators. June 17, 2008 http://money.cnn.com/2008/06/17/news/economy/oil_trading/?postversion=2008061714
[7] Dave Lindorff: "Oil, Israel, Iran, America and the High Cost of a Single War-Like Remark" http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=389x3403819
and Reuters, June 10 2008 http://uk.reuters.com/article/stocksNews/idUKHOL02445120080610
