Futures markets in oil create more, not less, volatility

Another piece of news in today’s Financial Times designed to restore our faith in the efficiency of financial markets.  It turns out that last Tuesday’s big spike in oil was caused by one man, Steve Perkins, a  “rogue trader” purchasing a huge number of Brent Oil futures contracts in the middle of the night.  When other traders staring at their screens saw the rising prices, they jumped in, bidding oil up to the highest price of the year.  In one hour, Perkins all by himself traded as much  oil as Saudi Arabia produces in a day.

When introductory finance textbooks explain the function of futures markets, they use the homely analogy of a farmer, fearing a drop in wheat prices and a bread maker fearing a rise.  To lock in their tight margins, the farmer and the bread maker get together, agree on a price for future delivery. That way each can proceed to harvest and bake, without worrying that conditions out of their control will make all their hard work unprofitable.  What could be wiser, what could be more efficient, what could be farther from the truth of modern futures markets.

It is speculators, not producers that dominate the futures exchanges.  Almost none of the buyers of pork belly futures expect to take delivery.  The huge majority of contracts are unwound before they are due.  The original purpose of futures markets was to limit risk. Today these electronic casinos increase risk, increase volatility in commodities markets to little benefit to the rest of us.

There is a solution, not that complicated, although the City will scream if it is imposed. If exchanges worldwide impose a Tobin tax, force speculators to pay the government a small percentage of the value of each transaction, it would make much of the speculation unprofitable without affecting our farmer and our baker’s risk management strategy.  Economists have discussed the Tobin tax for decades. Good luck getting it passed.

In the middle of the night, last Tuesday oil prices worldwide shot up 3 per cent. One man sitting at a keyboard had spectacular impact on the value of the world’s most important commodities. Since then prices have fallen 10 per cent, even though the real world supply and demand of oil is about the same as it was a week ago. The notion that deep financial markets make our economy more efficient becomes harder and harder to swallow. It is time to stop letting the financial tail wag the real economy dog.