Simply put, the commodities market in Chicago was established to allow farmers to get an ‘advance’ on their crops.
They did so in order to ensure that they got a base level price in case anything catastrophic happened.
But then the commodities market got expanded to include other things that weren’t quite related, such as oil.
Oil fascinates me. I know other things like Gold or other precious metals fascinate others, and that there is likely a fan base out there for pork bellies, but for me it’s oil.
Part of it is because, like other commodities, I use it everyday and because I lived in oil-centric communities during my childhood and college years. Plus, my Dad was an offshore helicopter pilot in the Gulf. And my first job out of college involved flying to offshore oil rigs (which was alot of fun!).
But also because it has global implications like very few other hedged commodities.
So I was fascinated when the price of oil started going up about 4 years ago. What was driving it? Was it speculation? Was it demand? Was it both? I concluded that it was both. It was a bit of emerging markets’ growth and it was a bit of the speculators exchanging Futures and Swaps.
Futures and Swaps:
It’s a good thing to know how the price of oil is affected, because who doesn’t react when they pull up to the gas station and are either 1) relieved the price of gas has gone down or 2) the price of gas has gone up?
While I’m not as interested in the effects of distribution on the retail price of gas, and thus not going to explore that, I am interested in the source of the pricing and that’s where Futures and Swaps come into play.
Futures:
All kinds of commodities are traded in Futures contracts, just like our farmer at the beginning of the post. Futures are essentially contracts for future delivery of a commodity, and can either be physically delivered (think an airline buying oil futures) or the contract is settled prior to the spot month (aka delivery month). Futures have been around for a very long time, but in the US since the mid 1800s.
Swaps:
Swaps are contracts that are exchanged outside of a regulated exchange (e.g. CBOT the Chicago Board of Trade). The contracts are bought/sold directly between buyer/seller and are altogether unregulated. They are settled before the spot (delivery) months and are, by their nature, speculative. Very Speculative. And this is where alot of the pricing volatility has come from not only for the oil market but for what you pay at the pump.
I am a fan of free markets, yet Swaps give me pause. (Bonus Question: Can you think of other types of Swaps that have gotten beyond nutty in the past? Credit Default Swaps, exactly). I don’t know that I trust the speculators to do what’s right for the overall movement of a specific commodity class.
I lean towards regulating any type of off-exchange, over-the-counter type of buy/sells, because of the impact they can have overall on our economy.
And that, in essence, is one of the tenets of Dodd-Frank: Regulate the speculators who are exchanging Swap contracts off-exchange.
How would it do this?
By limiting the number of contracts any given firm has for any given spot (delivery) month.
It seems pretty reasonable to me, and hopefully would limit the volatility that is caused with big market movements.
(Disclosure: I am a Fee-Only Financial Planner. I have no positions in Oil.)