Russ Roberts over at Cafe Hayek recently received an email purportedly from United Airlines pushing to have speculators (the bad ones, not the good ones) punished for driving up the price of oil in the futures markets.

If it is from United Airlines as supposed, it shows some basic ignorance on behalf of an organization in communication to its customers. Maybe inept is a better word. I’ll concentrate on a single point in the letter sent to the good Dr. Roberts:

A barrel of oil may trade 20-plus times before it is delivered and used; the price goes up with each trade and consumers pick up the final tab.

The problem with this one statement shows a general lack of comprehension of how a futures market works. Let me explain how futures work another way:

Let’s pretend I love cocaine and like to do it a lot but I have this paranoia that the police are going to put a short-term dent in the supply which will cause my drug dealer to raise prices. I don’t want prices to be raised. I want my 8-ball for no more than $275. I go down and talk to The Snow Man and say, “hey, let’s make a deal. I’ll give you $25 now if you’ll sell me an 8-ball for $250 next month.”

Now Snow Man may be thinking - hell yeah, I’ll get $25 now and I don’t have to give anyone anything. I just have to deliver an 8-ball next month?  Snow Man agrees.

Note that no drugs are exchanged. I hand him $25. That $25 gives me the right to buy drugs at $250 in the FUTURE. Cool hunh? but I bet you’re confused at this point. So let’s see what happens under two scenarios:

Price of cocaine goes up:

If the price of cocaine goes up to $300 for an 8ball between now and next month I still get to purchase the cocaine at $250. I gave the dealer $25 for the OPTION to buy the coke so I have a total cost of $275. I can now feed my addiction at the same price I always have and the price of cocaine NOW is irrelevant.

Price of cocaine goes down:

If the price of cocaine goes down to $200 for an 8ball, then I lose $25 but I can just pay the market rate of $200. Sure, I’m paying more for the cocaine than what the dealer is selling it for ($200 plus I already paid $25). It sucks that I have to pay more but at the same time, I come out o.k. I can just say f#@$k it and forget about buying the cocaine at all.

Remember, when I’m buying an option (also called a ‘call’), I’m buying the right to buy something in the future at a given price.

Now you can also sell an option (called a ‘put’) where you can sell at a given price in the future. It’s just the opposite of a ‘call’. If Snow Man wants to make sure he can sell his coke for $275 next month but expects there to be a bunch more dealers and a lot of cocaine out on the street, he might just go out and set up an agreement to sell some of his coke next month for $275.

If the street price of coke goes up, he begins to lose money. He’ll lose any money he gives out to buyers who agreed to buy his product at $275.

If the street price of coke goes down, he makes money because he can sell the coke at $275 to those people who bought his ‘put’.

In any event, note that when you have a ‘call’ or ‘put’ you pay a small price to protect against large price swings. It narrows the band of risk. This is what people mean when they say they need to ‘hedge’ their bets. You can reduce the impact of price fluctuations on a business that deals in anything that is generally a commodity.

Much of what is happening in the Oil industry is a situation where many people have started have fears about the price of oil in the future. So they buy options to bet on which way the price of oil is going to go. The profits from taking the options can then be used to bring the price down to a given point that is close to the present market rate. If a company bets wrong, they lose some money - but they do not lose all of their money. There is no actual oil be exchanged. Just a lot of options to buy and sell. In reality, some trades do actually take place. But in the world of commodities, it is often better to take the profits to off-set the cost of goods rather than having to worry where you will be putting 10000 barrels of oil - and that is why the futures and options markets are financial markets!

Imagine your drug dealers down at the corner actually trading drugs every time they wanted to buy and sell an option at a given price! You won’t because it doesn’t need to happen, they can just use the money made from trading the options on the underlying cocaine.