Don't let your market bias affect your trading judgment.

- Phil Flynn

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October 23, 2007

Get daily research letters from Phil Flynn of Alaron Energies

Phil is one of the world's leading energy market analysts, providing individual investors, professional traders and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline and energy markets. Phil's market commentary, fundamental and technical analysis, and long-term forecasts are sought by industry executives, investors and media worldwide. Now you can get this highly sought after analysis with your daily research newsletter from Phil Flynn. Learn more about this complimentary offer and sign-up today.

If a dog is mans best friend, loyal always willing the please than I would have to believe that a healthy vibrant economy’s best friend is the market speculator. That’s right the speculator. The much maligned most misunderstood cog in the great over all economic wheel that keeps the whole economy running smoothly  keeping things going in this great incredible up and down role that allows  the human psyche to play out its worst fears and its sometimes greedy longings. At times speculators run the market way too high and some times way too low but without them it’s likely that the economy couldn’t function at any reasonable sustainable pace. If someone isn’t ready to lay their capital down and take a risk than the whole capitalist system comes tumbling down. By creating a market place that can define that risk it allows the market place and real users of the product or buyers of the stock to plan, innovate and build. The economy functions much better with a marketplace that is liquid with speculators and hedgers (users of the product) so the growth in the economy can grow unfettered. Futures markets provide the playing field and sometimes the battleground that ultimately defines a fair price for the buyer and the seller.

A perfect example of the value of the futures markets and the future market speculators has been of course the US stock market.

One of main reasons the US stock market has been able to perform better than any time throughout our history has been in part because of the introduction of stock market and index futures. Stock market indices have incredible participation by market speculators yet their value to all investors in stocks has been undeniable. Forgetting the fact that the worlds stock markets have had better more constant returns since the launch of the Chicago Mercantile Exchange groups S&P 500 in the 1980’s, people tend  to forget that people tried to blame the S&P 500 and excessive speculation for the stock-market crash in 1987.

Of course later studies proved that not only did the S&P 500 and speculators not only did not cause the crash put by having the futures as an outlet they probably stopped things from being a lot worse. In fact, if memory serves me right, the day after the 87 Crash the S&P 500 opened on time while the OEX and the stock market suffered delays.

My point is that as stock prices rose and stock prices fell the market speculator got the majority of the blame and took most of the heat. Of course whenever an actively traded market makes a move either up or down speculators are easy targets. People have some type of false assumption that if the speculator did not exist then somehow prices would be less volatile. The truth is that in most cases they would be more volatile.

The underappreciated role of the market speculator is really a danger to the health of the market by those who would seek to change the way the markets could trade.

The market that is taking the brunt of the speculative criticism is the world’s oil markets. The bashing of speculators in the oil market is by uninformed and biased watchers of the energy prices and energy markets is the new sport for those that still are in denial about the real fundamentals facing the market.. Most of those who bash the speculators are oil market bears that can’t face fact that they are wrong the market and really fail to grasp the complexities of the world oil market. Instead they choose to bash the free markets, capitalism and even go as far as trying to take away the free markets in oil in a pathetic attempt to prove that somehow their flawed analysis of the world oil market fundamentals were some how correct.

People ask if oil supply is so tight why we not have gas lines. Well it’s because the futures markets give transparent price discovery and raises prices to adjust demand so we don’t have shortages. It is very possible that we could have had gas lines if we didn’t have free markets and we were to believe those that thought $2.00 a gallon gas at the pump was just too high based off the fundamentals. And that market would not exist if it were not for the speculators and their risk capital to create the situation.

The Department of Energy addressed the question that has been asked every time oil has made a large move also whether it was about fundamental or speculation that has driven the price of oil. The DOE Energy Information Agency says that once again questions about speculators and its impact on prices have arisen in face of rapidly rising oil prices.

“The first of which is the degree to which speculation has driven the upward trend. At least as important is the question of turning points -- how much higher will oil prices rise and how far may they fall if oil markets soften, in, at least, the near-term, following recent end of year patterns. EIA’s current analysis suggests that supply and demand fundamentals, including readily quantifiable factors such as the level of inventories and spare upstream capacity, and less quantifiable ones such as the effect of heightened geopolitical risks on desired inventory holdings under conditions of tight spare capacity, can provide an explanation of the recent increase in oil prices. In recent years, as oil market participants perceived the large reduction in the surplus capacity cushion that can be used to sustain previously prevailing prices in the event of a disruption, they have been increasingly inclined to build and maintain a higher level of precautionary stocks during periods of heightened geopolitical risks. Unlike the level of inventories or the amount of surplus capacity, geopolitical risk cannot be readily quantified, but fear of potential disruptions and actions taken to prepare for them are inherently fundamental forces in determining the demand for inventories in today’s oil marketplace. Tight supply conditions, against a backdrop of growing global demand, have tightened global inventories over the past 12 months, making markets even more anxious.”

The Report goes on to say that “EIA has developed models that demonstrate the ability of fundamental market factors to account for historical variation in crude oil prices during both low- and high-price periods since 1992. Our results, however, do not ‘prove’ that the hypothesis that speculators have played a role in the run-up of crude oil prices is false. All we can say is that fundamental factors alone can explain recent price developments, and that general principles favor a focus on fundamentals, rather than consideration of alternative price drivers, when the explanatory power of fundamentals is high.”

Even back as far as I can remember our friends back in the OPEC cartel would blame speculators for every time prices went up. And in recent years the speculators have been blamed for pushing oil above $25, $30, $35, $40, $45, $50, $55, $60, $65, $70, $75, $80 and in every case the critics said the fundamentals do not justify the price. Yet the facts show that the speculators have been proven right time and time again.

Yet the charges still come. Some even one have to compare the recent run-up in oil to the Hunt Brothers failed attempt to corner the Silver market to the explosive world growth phenomena facing the energy complex. That argument has about as much validity as saying that the entire stock market worldwide is a fraud because of the collapses of the Enron Corporation and Tyco. Hey wait, maybe some Democrats did say that well any way.

The argument all comes down to the fallacy of fair price. A fair price is basically what someone is willing to pay for it and in today’s world that’s over $80 a barrel. Of course all those that swore I was crazy thinking that oil could hit $85 a barrel of course get lost in what is called the fallacy of fair price. They are prejudiced because they think they know what the fair price should be with out making adjustments for fluctuating currencies, increasing demand and limited resources and probably too because they have trouble reading a chart. Or maybe it’s because they see only what they want to see in a chart. Ultimately it’s because they have a false sense of what they think oil should be worth. Of course lately with the dramatic run oil has made in such a short period of time the speculator bashers are out.

Yet Saturday’s Wall Street Journal made the case why oil prices have risen dramatically in recent weeks. It said that amid the record run of oil prices lies a troubling trend: western nations, particularly in Europe, drew down their oil tanks during the summer months -- a time when they would normally build them up. “Central to the concern about tight supplies is what happened to inventories between July and September.” The IEA said that “in that time period stocks fell by 33 million barrels a day. That contrasts with an average third-quarter increase in stocks of 280,000 barrels a day over the last five years.” That has lead to a below the five year average of about 54 days of consumption. This rare drop in inventories ahead of winter and the drop in the value of the dollar is strong evidence that there is some strong fundamental meat behind the recent run-up. And what it also means is that we could see continued big moves this winter.

The price oil could drop back towards the 80’s but if their speculators are any indication more than likely we could see moves up towards the $95 a barrel area. Of course with distillate supply below year ago levels it’s likely that heating oil could soar if we get cold weather. Of course as long as speculators are involved we shoulder fear shortages as the forces in the market place will make sure we are well supplied.

Ultimately when it comes right down to it the roller of the speculator is to invest in the economy. It is to act as a writer of insurance policy against adverse price risk and in the hopes of making a profit. And what is wrong with making a profit? It is that desire that has built America and built this country. With out the desire to take a risk to make a profit it is unlikely that our country would still exist. Our economies best friend is the speculator.

Get daily research letters from Phil Flynn of Alaron Energies

Phil is one of the world's leading energy market analysts, providing individual investors, professional traders and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline and energy markets. Phil's market commentary, fundamental and technical analysis, and long-term forecasts are sought by industry executives, investors and media worldwide. Now you can get this highly sought after analysis with your daily research newsletter from Phil Flynn. Learn more about this complimentary offer and sign-up today.