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If You Are Fed Up With Traders Speculating On Oil Prices, Wait Til Traders Speculate This Commodity!

3 July 2008 6 Comments

It is hard to watch the news these days without hearing about excessive oil prices. It’s also difficult to listen to the oil crisis rhetoric without hearing somebody blame it on the NYMEX traders who speculate on the price of crude oil. Before you can make your own opinion, it’s important to understand why the price of oil is determined through such a mechanism. After we fully understand this, let’s compare oil to another commodity which may be priced in a similar fashion in the future: water.

How Futures Contracts Work

Most commodities are priced through traders buying and selling a futures contract on that commodity. Through a futures contract, I can say that I want X number of units of a specific product at a specific price at a specific date; for example, if I think the price of corn will continue to go higher, maybe I will buy a futures contract on corn that says I want 100 units of corn at $20.00 each set for delivery by August of this year. I will never follow through with actual delivery (what am I gonna do with all that corn?). What is the purpose behind this transaction? Well, the buyer purchases the contract to hedge against an increase in corn prices, and the seller sells the contract to guarantee a customer for his product. Hopefully, by the time August rolls around, corn has risen to $30.00 each and I can offset my futures contract and make a nice little gain.

This buying and selling of contracts results in true market forces pricing the actual commodities that are a part of your day-to-day life. What commodities are priced this way? Well, gold, silver, ethanol, corn, soybeans, wheat, oil, rice, and more.

The Importance Of Futures

Unfortunately, most people don’t understand the actual reasons behind a market pricing strategy for a commodity like oil. It allows people like farmers to engage in hedging activities that allow them to focus on farming products and not on speculating whether corn or wheat prices are going to go up and down. The hedging activity is very underestimated by the uninformed public with regards to how important it is to someone like a farmer.

Consider the following scenario: a farmer spends a great deal of money on crops, equipment, and labor to produce a very large crop of corn. He will not realize any revenue on that corn for some time, but he will be incurring costs along the way. If between the time of beginning the process of producing corn and the time when the crop is harvested and sold, the price of corn plummeted, the farmer could lose a great deal of money. To prevent such a scenario, the farmer will hedge against a drop in prices by taking out a futures contract on the price of corn. If corn drops, he will make money on his futures contract and it will cancel out the lose taken on the actual crop. If corn prices go up, he will lose money on the futures contract but make more money on the crop. Being able to hedge against price fluctuations allows him to have a consistent, profitable business. It allows the farmer to focus on the operation of producing food rather than trying to predict the future price of corn. Hedging helps farmers sustain a level of profitability and ensure they will make a living off producing crops.

Similarly to farmers, many other entities engage in the same type of hedging. Airlines will hedge against an increase in fuel prices (Southwest Airlines has been the biggest hedger and one of the few profitable airlines recently), natural gas producers will hedge against a drop in gas prices, and more. You see, hedging activities as described above are crucial in many U.S. businesses in their day-to-day operations. Futures contracts and the trading of them are extremely important to the entire economy.

So Keep The Market For Hedgers But Get Rid Of The Speculators!

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Unfortunately, this wouldn’t work either. Speculators actually serve an important purpose in this whole game. The constant buying and selling of these instruments by the speculators helps achieve a level of liquidity in the futures trading market that is necessary for the important companies and individuals to be able to successfully engage in hedging activities. It turns out that those bastard speculators aren’t so bad after all.

Margin requirements are a different story. Currently, speculators only need to put up 10% of a trade, allowing them to assume large positions with little capital. It is likely, we’ll see the margin requirements raised in the near future.

Extending This Controversy Into Water

Many consider the current environment for water to be similar to that of oil in the past. Like we did for lengthy times in oil, we enjoy cheap water and assume it will always continue. As oil prices have shot up, it is worth considering if a similar situation in water might occur in the future.

Let’s look at the current environment in water. Most water prices are subsidized by local governments resulting in very cheap water. Furthermore, it is important to note that about 70% of global water consumption is for agriculture. Within the agriculture industry, there are efficient water consumers and inefficient consumers. Those using mechanized irrigation systems use water very efficiently and waste very little of it. Those that use other forms of irrigation systems can waste a great deal of water.

Unfortunately, the current pricing system for water encourages irresponsible consumption. Having set water prices (at a low level) results in higher demand and inefficient use. Proper pricing (higher pricing) would result in more responsible consumption. Higher pricing encourages investment into newer and better irrigation systems as well as new technology to help millions have access to clean water.

Many wonder if the water will soon begin to be traded in an open market similar to other commodities resulting in market-efficient pricing. A water futures contract would allow market pressures to price water. It would most likely increase the price of water, but also result in beneficial things like innovation and more responsible use of water.

One example is ethanol. Producing ethanol is very water-intensive. It takes an ungodly amount of water to produce ethanol. Perhaps, if water were higher priced, it would end the ethanol story and make us focus on other alternative energy solutions.

It remains to be seen whether or not we will live in a world where the most basic necessity of life, water, is priced by traders and speculators in an open market. Imagine the controversy if water prices skyrocketed in a similar fashion to current oil prices. The anti-speculator rhetoric you hear today regarding oil traders would be nothing compared to the same situation with water! Wouldn’t that be fun!

Before You Go Nuts, Continue Reading

I can already see the comments flowing in utter fury in reaction to such an idea.  Here, I’ll write a comment for you: “You would force billions to pay more, money they don’t have, to consume the most basic necessity of life just so speculators can make more money!!”  Well, if you write that, then you obviously haven’t read this article in detail.  But, I will respond to such a reaction anyways.

The reality is that billions already do not have access to clean water even though water is relatively cheap around the world.  In China alone, hundreds of millions do not have clean drinking water.  Innovation and new technology is needed to secure a future where everyone has access to water.  Unfortunately, in many cases, the business case does not work out for large corporations to invest in new technology.   Imagine if  easy and inexpensive ways to desalinate water became possible?  We have plenty of salt water!  While higher water prices could result in temporary pain, it could also help achieve a world with better technology and infrastructure which results in a better world when it comes to water.

Investing In Water

I have talked previously about building positions in companies poised to benefit from the increase in water-related spending around the world. The possible future described in this article only intensifies the likelihood of water companies doing well down the road.

I like Veolia Environment (VE), the PowerShares Water Resources ETF (PHO), and the Claymore S&P Global Water ETF (CGW).

6 Comments »

  • theWild1 said:

    Wow. How crazy could things get if we begin to worry about the price of water. I bet that would be 100x worse than the current oil condition.

    Truly a scary but interesting thought.

  • danny said:

    I’m 22 and an avid investor myself and I really like your pick of the etf CYB I hold it too, but to be honest check out FXI, the chinese market crashed in the past year but its honestly on sale for a long hold. I am a believer that each countries market is just the power of its people and in the U.S. our $16 Trillion Dow is the power of 300 milion people and China’s market $2 Trillion dollar capitalization is the power of 1.3 billion people??? I read somewhere that by 2025 its possible China could have a $125 Trillion dollar cap while the US would be around $30 Trillion with India somewhere in between. Maybe you could write a post about it.

    Also have you ever bought KMP? You should for your 20s portfolio.Its one of my favorite div stocks with a 7% yield and the distribution has grown for the last decade+. They’re in the pipeline business so high price we still move gas, low price we still move gas….NG they move that too along with other things. It has really nice tax benefits as well.

  • kevin duffey said:

    Thanks Danny,

    I agree with you that the Chinese market is a good buy for the long haul. I am definitely looking into it further as prices have come way down.

    Thank you for the comments and recommendations!

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