How do speculators affect the price of crude oil?

BY busadmin  August 15, 2008 at 12:34 PM EST

Markets; AP
Question/Comment: I would like to understand how speculators affect the price of crude oil. I’d like to know who these people are (in general) and how they operate.

Paul Solman: I’m on record on this page (and elsewhere) as saying I think speculation is a factor, perhaps a large factor, in the price of oil lately. And indeed, the price of oil has dropped by almost 20 percent since I wrote that, in response to an e-mail here.

But I should warn you: lots of very thoughtful economists consider me all wet. OK, that’s out of the way, so on to your questions.

1. Who are the speculators? Anyone who has bought or sold a commodities contract involving oil. If there’s more demand for oil at a given price, the price rises, like it does for anything else, say your house. Less demand means the price goes down. An economist friend and I are actually speculators, betting the price will go down, though I confess it’s more to learn how the market works through actual experience than to make money.

2. Speculators generally operate by buying either futures contracts or options. (We bought options.) With futures contracts, you lock in a price for a given date in the future and either get or owe the difference between that price and the actual price when the date arrives.

Options cost money. They entitle you to a payment if oil falls below – or rises above – a given price by a future date, depending on which way you’re betting. If oil doesn’t hit the price, you simply forfeit the cost of the option. You make money if the price of oil falls (or rises), compared to the price you bet on, by more than the option’s cost.

There’s another way to speculate, one could argue. If you have oil, you could keep it in the ground, waiting for the price to rise. If you believe speculation is part of the current story, this should be happening. And from people I’ve talked to in the industry, it is.