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How do speculators drive up the price of oil/gasoline? Explanation inside

Consider this a tutorial on speculation.  We all hear how speculators are driving the cost of oil more than supply/demand these days, but how exactly are they doing it?  It's pretty simple.  Keep in mind the basic principle of mass sell offs lowering prices and purchases will drive them up.


We'll use oil for this example, it works for any traded commodity.  I'll use simplified numbers to better explain it also.  Consider that there is a market for oil that is real time, the current price.  We call that the spot price or spot market.   Whatever price oil is trading at THIS moment is the spot price.   Speculators buy futures contracts; that is they contract to buy/sell oil in the future...six months, one year, whatever..for a price agreed upon.   These markets have a legitimate purpose, although they can also be used to manipulate prices, particularly by hedge funds.

One legitimate purpose would be to hedge (not really associated with what hedge funds do..this is a defensive measure).   Say for instance FedEx contracts with all of its corporate clients for two year contracts.   They make an agreement with Walmart to deliver all of their packages and important papers for the next two years for a flat price.   That price is negotiated by both parties and based on assumptions that fuel costs will fall inline with their estimates.  FedEx can hedge by signing the contract, and taking out a futures contract to purchase fuel at current prices, or within an acceptable margin.  Therefore they will be covered with affordable fuel one year from now, hedging the risk on a price rise.

Now, consider this scenario.  The spot price of oil is 100$ per barrel (it isn't but the math is easier) and the one year interest rate is 5% (ditto).    Lets say speculators with lots of cash  bid up the price of oil at one year from now to a price of 150$ per barrel.  There now is a mismatch in the prices.

If you owned oil physically, or bought it in the spot market at that time, you would have an instant risk free profit.   Buy one barrel for 100$, borrow the money to do it at 5%.  You owe 105$ in a year.  Then enter into a futures contract at that moment to sell that barrel at the 150$ per unit cost.  You've made 45$ per barrel, no risk (minus storage, transportation, etc).  

What would the market do?  Scramble to buy oil at the spot price, because it is too cheap relative to the futures price.  Billions of dollars flowing into oil would push the spot price of oil up, until it converged with the futures price...which by my rough calculation would be a spot price of 142.86 per barrel.  When it reached this price, if you borrowed 142.86 at 5% for a year, you'd owe 150, and only break even at best on the contract.

Now the assumptions are simplified, such as interest rates, cost of carrying the item and the terms, but the math is the same.   And hedge funds have billions at their disposal to invest, and complex computer programs written by highly paid computer wizards that monitor constantly real time futures prices, spot prices and interest rates.  When that imbalance occurs, they can execute with precision and lock in profits.

That's what is raising the price of gas, and there isn't a damn thing Obama can do about it.  But good luck explaining that to the lunatic part of America that hates him.