[Marxism] how are (oil) prices set?

Joaquín Bustelo jbustelo at gmail.com
Tue Jul 8 16:03:36 MDT 2008


On Tue, Jul 8, 2008 at 3:38 PM,  <bauerly at yorku.ca> wrote:
> Are you saying that the $260 + Billion investing in commodity futures are not
> making any profit?

Futures markets are by their very structure zero-sum games. That
doesn't mean that speculators don't make profits because they aren't
the only market participants. Supposedly the real economic purpose of
futures markets are price discovery and price protection, i.e.,
hedging against disastrous rises or declines in the prices of
commodities by the actual producers and consumers of those
commodities. In addition to the costs of trading in the market
(brokers fees and so on, which can be looked at as in essence the
premium for a price insurance policy), supposedly hedgers tend to lose
money in futures markets and speculators tend to make money. But the
money hedgers lose in the futures market they "make back" in the
physically market in relation to the price they sought to lock in.

So when you integrate the physical market into the model, speculators
wind up with some/most/all of the difference between the price the
hedger sought to lock in and the final market price.

For example, (these figures are completely made up), say you're a
wheat farmer and want to lock in the current expected price of $1000
for 1,000 bushels. So you take a position in the futures market,
promising to sell 1,000 bushels for $1,000 dollars, and someone else
agrees to buy it for that amount. That's the futures contract, it has
two sides, someone offering to buy, someone to sell.

At the end of the contract, a few days before the notional delivery
date, the actual price has moved to $1,200. The farmer loses $200 on
the contract, the buyer gains $200.

The contract normally is settled like that, by making up the
difference in money (the oil market at least in fact carries out the
operation every day as prices change). As you can see, this is, of
necessity, a zero-sum operation.

But then look at what happens when you factor in the physical market.
The farmer takes his 1,000 bushels, sells them on the spot market for
$1200, and, subtracting his future trading losses of $200 from his
income, he nets $1,000, which is what he set out to do to begin with,
lock in that price.

The other party, say it is a bakery, goes to the physical market, buys
for $1200, but subtracting from his overall cost the $200 he made in
the futures trade, also gets the price they wanted to lock in --
$1,000.

Now, if instead of a bakery, the holder of the contract were a
speculator, they would have made $200 on that contract. The farmer
"loses" $200 to the speculator, but that is extra profit the farmer
was willing to forgo in exchange for the guarantee of getting at least
$1,000 a bushel.

If instead of rising $200, the price had dropped $200, to $800, the
farmer would have made $200 on the futures contract, which, together
with the $800 he would get for his 1000 bushels on the spot market,
would bring his price back up to the $1000/bushel. The bakery, in
addition to the $800 they have to pay for the physical product, lost
$200 on the future contract, bringing its cost up to $1000. Again,
whether up or down, the effect has been to lock in the price.

Because contracts are settled in the cash difference on the price,
rather than in delivery of the physical commodity, a speculator can
just as well take the part of the farmer or the baker. Presumably, the
speculator is better informed about market trends and conditions than
the hedgers (who are, after all, baking or growing wheat for a living,
not following any/everything that might change price levels, like what
the weather in the Argentine Pampas has been and what that says about
wheat crops and demand). Supposedly, this means that, on average,
speculators as a group will make money and hedgers as a group lose
money in the futures market, with a net result of zero overall.

Now, what happens if the day before closing the physical spot market
is at, say, $1200 but the futures market is at $1100? Speculators
swoop in to buy the cheap wheat, bidding the price up to the spot
market level. In that case they buy the long position (offer to buy at
$1100) which get bid up in price due to demand. If it is reversed
--the contract price is $1200, the physical market $100 less) then
speculators carry out the reverse transaction. As a rule, the futures
market final price and the spot price are going to be the same, any
divergence between the two is simply free money that speculators will
immediately try to get a lock on through arbitrage (i.e., buying and
selling positions to take advantage of a difference in price for
essentially the same commodity in two different places or markets)
which will bring prices to the same level.

I believe --but am not sure exactly how-- in these future markets
there are mechanisms for actually making and accepting delivery of the
physical commodity specified in the contract, which is the ultimate
guarantee that the futures market has to converge with the physical
one, because at the end of the contract, even if only in exceptional
or special cases, the futures contract winds up with the actual
physical market transaction. That being the case, if the price at the
end is "too low" people who actually want wheat right then will swoop
in and buy the promise to purchase at that lower than market price and
take delivery, and if the price is "too high" people selling wheat
will swoop in and buy the obligation to sell at that
higher-than-market price and actually deliver. Again, I don't know the
mechanisms and conditions through which contracts are settled by
delivery, In just know from various readings that the link and
therefore convergence is said to be there.

Joaquín


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