With falling oil prices, short-sellers may win big

by Brian Fisher Johnson
Thursday, January 5, 2012

Blogging on EARTH

We all heard it this summer: national politicians blasting speculators for driving up oil prices. Journalists and academics may never sort out the actual significance of speculators in this regard. But those same speculators have likely lost big time the last several weeks, says James Hamilton, an economist at the University of San Diego.

Speculators trade contracts to buy oil at some future date, at rates of 1,000 barrels per contract. They trade these contracts at the New York Mercantile Exchange (NYMEX) — a commodities market separate from the New York Stock Exchange on Wall Street.

But how does all of this work? Here’s how Hamilton says such a deal between oil speculators in the last few months might have played out:

• Say that Speculator A signed a contract with Speculator B in June, promising to buy oil in December from B for $123 a barrel (multiplied by 1,000 barrels equals a contract worth $123,000).
• Then, in July, Speculator A may have sold this contract to Speculator C for $145 a barrel (equal to $145,000). Speculator A made $145,000 but only paid $123,000 — so he made $22,000 in profit.

Good for Speculator A.

But why was Speculator C willing to pay so much for the contract? Because “oil prices generally went up a lot between June and July, and people were expecting them to stay high,” Hamilton says. In other words, Speculator C thought oil prices would continue to rise, allowing him to make profits of his own.

However, oil prices have lost much of their value since July. So Speculator C is out of luck, Hamilton says. “If Speculator C tried to sell that contract now, it would only be worth $67 a barrel [or a $67,000 contract] … So, Speculator C is out $78,000.”

Laugh now if you hate speculators — or at least think you do. But “short-sellers” may get the last laugh.

Given the way the market turned out, Speculator B, way back at the beginning of this example, could stand to make the most money out of the three. That’s because Speculator B, if you recall, sold the original contract with A for $123 a barrel ($123,000). If he bought another contract now for the same price C sold his ($67,000), he’d be up $56,000!

That would make Speculator B a short-seller. (Like Speculator A, in fact.) They — assuming this was the plan all along — speculated that oil prices would go down. They essentially bet against the oil market, and won!

Short-selling is just part of playing in the oil contracts markets, Hamilton says. Still, the U.S. Securities and Exchange Commission didn’t appreciate this kind of betting against their markets during the financial crisis, and the SEC, along with other countries' financial regulators, temporarily banned short-selling of financial institution stocks this summer at the New York Stock Exchange. In the same way speculators were accused of driving oil prices up at NYMEX, Wall Street short-sellers might be accused of pulling Wall Street stocks down.

But don’t point fingers at short-sellers now. What? As if you wouldn’t do it if you knew you might make $56,000?

To gain more insight into economic principles in today’s markets, visit Hamilton’s blog.