There is no question the the world runs on oil, and the price of oil can influence economies around the world. While most people are familiar with the laws of supply and demand, it can be less clear how oil futures raise prices.
Oil futures are simply a contract between a seller and a buyer, where a buyer agrees to purchase a specified amount of a commodity such as oil and a preset price. Oil futures offer a way for investors to bet on whether oil will increase in price at a later date.
In 2006, the price of oil began to rise, despite the fact that US petroleum reserves were at an eight year high. As demand rose, supply kept pace although prices continued to climb. This was the beginning of an artificial market for oil, and this artificial market has been blamed for the price of oil jumping more than $100 per barrel between 2004 and 2008.
How Oil Futures Raise Prices: The Basics Of Oil Speculation
It is important to understand the basics of oil speculation in order to understand how oil futures raise prices. As the price of oil has risen, people have searched for answers to why. While supply issues and geopolitical issues have been cited as possible explanations, those theories haven’t always panned out, leaving the experts to assert that oil speculation has been to blame for the rising costs.
Adam Smith, an 18th century political economist stated that everything that can be bought or sold has what is referred to as a natural price. This natural price is the total of the values of everything that is required to create a product or service.
Distribution, labor, and raw materials all contribute to a products natural price, and any amount received over that natural price is considered profit. Using derivatives, an investor can place a bet on the future price of a commodity. A derivative’s value is based on the value of a commodity – for example, a wager on whether a barrel of oil will decrease or increase in price.
How Oil Futures Raise Prices: Investment Firms And Other Major Players
A speculator has no hand in the sale of the commodity they are wagering on as they are neither the seller nor the buyer. A speculator betting on a single futures contract will have no effect on the market. A speculator with a sizable amount of capital to put to work however, can purchase a stake that is sizable enough to sway the market, and is considered the major factor in how oil futures raise prices.
As speculators purchase on rumor rather than fact, a speculator purchasing a large amount of futures at a price that is higher than the market value of oil currently can lead to the hoarding of the commodity by producers in the hopes that the commodity can be sold for a higher price in the future.
As the supply of oil is reduced by these actions on the part of the producer, this leads to a realized increase in the price of the commodity both in the present as well as the future. An investment firm as well as oil producers stand to make a huge profit, as an estimated 60% of oil’s per barrel price is the result of speculation on the part of investment firms and other major players.
Investing in oil futures carries significant risk, as these instruments exhibit extreme volatility, and are subject to outside influences such as natural disasters and geopolitical events. As a retail investor, it is advised that you consult with a financial professional, such as the investment specialists at online broker ETrade prior to committing any capital.
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