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How Oil Futures Impact Prices

written by: Steve McFarlane•edited by: Jason C. Chavis•updated: 8/21/2010

Traditional economics says that natural pricing and demand and supply is what sets prices; Add to that equation futures trading. Here is how oil futures raise prices.

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    Trading oil futures is a strategy that institutions and individuals use to profit from or protect their interest from volatility in oil prices. While many of the trades in the oil futures market are taken by parties who are involved in getting petroleum based products to consumers, there are speculative traders who have a strong hand in influencing the prices as well.

    There is a realization, and to some extent a fear, that the world will soon reach peak oil, that is, the point at which supply will be unable to meet demand as new and existing reserves dwindle. As oil breached and traded above the $140 per barrel mark in 2008, there was some speculation that the world had indeed reached peak oil, but the precipitous drop to $40 per barrel at the height of the market crash suggest that there was some creative financial gymnastics that was responsible for the lofty prices, at least in part. This is how oil futures raise prices.

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    Who or What Sets the Prices at Gas Pumps?

    In a way prices are determine by the natural price principle. In essence, the price of any product includes all the costs that are incurredHow oil futures raise prices at the pump-heating oil-pic  in making the product ready for the market; anything that the market pays above that price is profit to the seller. On the other hand, conventional economics tell us that the forces of supply and demand is what really determines prices, and that the market will not pay more than what it believes is a fair price for a commodity without reducing its demand for the product.

    If these price determination principles are true, then the true market price is determined by what average motorists are willing to pay for a gallon of gasoline… but is seems as if speculative traders have significant influence over the supply and demand equation.

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    How Oil Futures Trading Affects Prices

    To understand how speculating in oil futures drives up the cost of oil, we will use a simple example. Let us say that an island nation Why are oil prices so high and Volatile at times-crude oil-heating oil- receives a shipment of oil once every three months, and that that supply is enough to satisfy the demands of the local market. What would happen if an organization had enough money and clout to purchase and hold half of the supplies? Naturally, it would create an artificial shortage in the market and consumers would be forced to pay more as the remaining reserves are rationed. This is the effect that oil futures-trading has on the market.

    It is not a big issue when a few small traders start to buy futures contracts, but when traders or institutions purchase large contracts the price has no where to go but up until there are real signs that consumers are unwilling to accept the new prices, or other market events force futures traders to abandon their long positions.

    In part, it is the failure of other markets that has cause a flood of money to enter the oil futures markets. When traders and financial institutions started diversify the portfolios by pulling money from real estate and stocks they looked to next hot market, if that happens to be oil, prices will naturally rally on the back of the artificial demand.

    The government did take steps to regulate the future market from excessive speculation by setting up the Commodity Futures Trading Commission (CFTC) in 1974. Unfortunately, the CFTC was limited to overseeing trades on the New York Mercantile Exchange (NYMEX). Companies and consortiums found their way around this regulatory framework by establishing other exchanges and systems such as the Enron loophole and the Intercontinental Exchange (ICE).

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    While the market forces of supply and demand weigh heavily in determining market prices for oil and oil related products, speculative trading has its say too. Oil futures and oil ETF traders drive up the price of the commodity when the influx of money creates artificial demand. While the authorities have tried to regulate these speculators, they continue to find creative ways to side step any governmental oversight.

    Image credits:

    How oil futures raise prices at the pump - heating oil-pic”

    Why are oil prices so high and Volatile at times-crude oil-heating oil-pic” richardmasoner