Oil Speculation and Apple Pie

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There have been many accusations about speculators driving up the price of oil. This of course implies that a handful of people can manipulate prices outside of the laws of supply and demand. Perhaps it is also possible that the world is flat and the moon is made of cheese.

A simple analogy can explain why this is incorrect.

Dear Aunt Ethel decides to open a booth at the county fair making her wonderful apple pies. Every pie costs her $2 to make so she sells them for $2.50. Almost immediately, her pies are a hit, and a line grows in front of her booth. Her sister Eileen is running the cash box and suggests to Ethel, who is making and baking the pies, that they raise the price to $3 since the pies are so popular. Ethel agrees and they raise the price. The line continues to grow. They raise the price again to $4, then to $5, yet the line continues to grow and customers are starting to get impatient.

Eileen, being the better businesswoman, then suggests to Ethel that they sell tickets that promise to deliver a pie later that day. This will shorten the line and limit the number of people standing and waiting for their pies to be finished. The line indeed gets much shorter as Eileen sells the tickets and Ethel feverishly cranks out more and more pies. Ethel and Eileen are making plenty of money and everyone is happy. Well, except bitter Betty at the bratwurst stand who complains to the fair chairman of “excessive profits”.

Now Jacob runs the tilt-a-whirl and notices how many pies Ethel and Eileen are selling. He hears someone say, “Her pies are so good I would pay $10 for another.” Jacob gets an idea to buy the tickets and resell them later, at dinnertime, for a higher price. He’s going to speculate on the price of pies. He heads over to Ethel’s booth and starts buying up pie tickets. A little later, he starts selling them for $7, then $8, and then $10.

Other ride operators notice what Jacob is doing, so they get in on the gig as well, knowing that soon Ethel can’t possibly promise too many more pies. They start buying up the remaining tickets. Of course, Eileen is no fool. She raises the prices to $12, to $15, to $20, and all the way up to $25. The speculators keep buying the tickets, pouring more and more money into the apple pie market at the county fair.

There is a problem here. What will happen if no one wants to buy the pies later for $25? What if no one is willing to pay even $10 for a pie? The pies are coming whether the speculators can sell them or not. People attending the fair have to buy the pies from the speculators or the speculators will be left holding a bunch of pies that nobody wants. Unless the speculators are complete idiots, they know this too. The price can crash, as well as the value of their investment, because they may have paid Ethel to produce way too many pies.

Imagining that ride operators at the county fair are not so wise may not be difficult, but to suggest that Wall Street analysts would be so foolish and not realize that this was possible is a stretch. If they bid up the price of oil much higher than refineries are willing to pay they will likely face catastrophic losses.

Even if they are this foolish, this is good for the consumer in the long run. The price will eventually crash and oil will be cheaper than ever before. When prices are high, oil companies spend more and more money building oil rigs and pipelines, and they will find more and more oil. They are just like Ethel, churning out more and more pies. If the price plummets this new capacity doesn’t go away, because the costs are sunk costs. There will be a huge glut of oil for a long time. If the speculators are really driving up the price of oil, our current pain will soon be alleviated with years of cheap gasoline.

Leave the speculators alone. If they are right, they will make money. If they are wrong, they will lose money. Either way it doesn’t change what we have to pay at the pump. Just because Jacob foolishly bought a pie for $25, doesn’t mean that visitors to the fair will pay $25. Just because Jacob and the speculators paid Ethel to bake 500 pies, doesn’t mean people want to eat 500 pies. When a speculator pays $140 a barrel for oil months in advance, it doesn’t mean that refiners will be willing to pay $140 when that oil arrives. When speculators pay drillers to pump a trillion barrels of oil, it doesn’t mean that we will want a trillion barrels of oil. Supply and demand still rules the retail market.

Brian Shelley has a Master’s Degree in Economics from Texas A&M University and works as an Actuary. He writes a weekly newsletter found at FreedomIsTheSolution.blogspot.com and can be contacted at b-shelley@hotmail.com
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