How Traders Influence Prices

Earlier in the week, I wrote a post explaining that cracking down on commodity trader speculation could cause OPEC to gain more power. Commenter Adam asked:

It doesn't seem immediately obvious to me how traders cause higher prices. What's the mechanism that allows oil traders to control and drive-up oil prices? Why would killing a large portion of the oil trading market cause the price of oil to plummet?

I wanted to explain this, in case any other readers had the same question.

The easiest, and probably most familiar, analogy would be to think about stock traders. Stocks prices rise and fall based on the amount of money people are willing to buy and sell those stocks for.

Imagine I want to buy a share of Pepsi (PEP). There are a finite number of PEP shares in the market. Everybody has their price, so there's some price that some owner of PEP is willing to sell me his share for. I ask around and find the lowest price that someone is willing to sell me the share for and buy it from her.

This is a very simplistic example, and it explains why exchanges are so great. They bring buyers and sellers together so that the transaction is very efficient. They also make it much easier to discover the prevailing prices to buy and sell shares.

Let's turn to commodities. They're a little different, because they're physical things. But some portion of the supply of those items are bought and sold by traders. So let's say I want to buy some oil as an investment. I can do that through the commodities market in a similar way to how someone would buy stocks. The process isn't quite as simple, because the market isn't exactly the same, but it's easy enough since there are numerous brokerage houses that allow even amateur investors to invest in commodities.

Now why does that affect broader oil prices and eventually the prices that you see at the gas pump? Because in economics there's a law of one price that essentially says, if a market is efficient, then a good should only have one price (at least approximately). So whatever commodities dealers are trading oil for, that's also the price that suppliers and oil refineries see. If that weren't the case, then there would be incredible arbitrage opportunities where you could buy oil for a price in one market and sell it for a higher price in another.

As a result, if commodities traders begin to develop irrational expectations about oil prices, then that price is what everyone else has to pay too. The law of one price could, theoretically, fail if suppliers suddenly refused to recognize the prices that commodities traders demanded. But that's simply now how the world works. Eventually prices stabilize to approximately one level, which everybody has to pay.

Now onto the second question -- why might curbing commodities trading lower oil prices? It depends on market conditions. If OPEC wants oil prices higher than, then it wouldn't -- curbing traders would cause the price of oil to rise as OPEC reduces supply. But the assumption is that speculators' irrational expectations drive prices higher. If you eliminate that speculation, then prices would go back down. Of course, the flip side is that if traders have artificially negative expectations, then ending their speculation would cause prices to rise. So it just depends.

Finally, the commenter also asked:

To make an analogy, would getting rid of StubHub reduce ticket prices at Cubs games?

No. Maybe.

First, the "no." In this case there are really two distinct markets: the primary market where you buy tickets from the Cubs, and the secondary market where you buy tickets from a scalper like StubHub. These markets may not always be in sync, especially when they are not efficient (and I'd argue that the primary market for sports tickets is no where near efficient). Also, for another analogy think about initial public offerings of stock, and then buying that stock after it's been on the market for a few months or years. The prices change.

So what about the law of one price? If the Cubs realize that scalpers are successfully and consistently selling tickets for more than their initial price, the team should raise its prices accordingly. At some point, scalpers would no longer be able to make a profit, because baseball fans have a limit to how much they'd be willing to pay for a ticket. StubHub (and its sellers) manages to capture that additional revenue by finding those individuals, at the Cubs' expense. But if the tickets were already offered by the Cubs for that price, then scalpers would not be able to profit and have no business.

Even on Wall Street there are times when primary and secondary markets are out of synch. At the first signs of the financial crisis they went way out of balance for asset-backed securities. Both supply and demand variances in these two markets threw things out of whack. Under normal economic circumstances, the prices in these markets should come together, however.

Then the "maybe." If StubHub (or its sellers) is willing to purchase tickets for irrationally high prices, and the Cubs realize this, then they would charge a higher price. If StubHub suddenly disappeared, then the Cubs would be forced to lower prices. But that isn't likely what's going on. If StubHub was paying more than the rest of the market would, they wouldn't be able to resell the tickets and would go out of business very quickly.

I hope that helps.