Paul Krugman, New York Times columnist and supposedly an expert, heaps scorn on the idea that trading in futures contracts might affect the price of a commodity, specifically, crude oil.

Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil — the actual price people pay to have a barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference.

Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. And that’s true no matter how many Joe Shmoes there are, that is, no matter how big the positions are.

Paul, that is nonsense and if you don’t understand the futures markets you have no business writing about them. Some futures contracts are bets. An obvious example is the S&P 500 futures contract, which is a bet on the value of the eponymous index on a future date. However, the crude oil contract is not. It is a contract for the delivery of 1000 barrels of light crude oil to Cushing, Texas. Every contract is between a buyer and a seller of crude oil.

Any effect on the spot market has to be indirect: someone who actually has oil to sell decides to sell a futures contract to Joe Shmoe, and holds oil off the market so he can honor that contract when it comes due; this is worth doing if the futures price is sufficiently above the current price to more than make up for the storage and interest costs.

As I’ve tried to point out, there just isn’t any evidence from the inventory data that this is happening.

Paul, this is also nonsense. The reason it is called a futures contract is because it is about the future. Futures contracts originated as early as the 17th. century in Japan for the delivery of rice. A farmer making the financial commitment today to plant his rice crop wants to be assured that he will be able to sell his harvested crop, and at a price where he will make a profit. So he sells a futures contract to lock in a sale of his future harvest. He doesn’t have the rice until he has harvested his crop. If his crop fails, he will have to buy rice from some other farmer to settle the contract (or pay someone else to take over his commitment). It is common for lenders financing mines to insist that the mining company sell the output of the mine in the futures market. Oil producers can sell their future output for the same reasons and in the same way. None of these futures sellers hold inventory against the contract, they are simply pre-selling their output. It is not rocket science to figure out that, for example, when a futures contract is deliverable, and the seller doesn’t have enough production because of, say, a strike in Nigeria, that seller will have to go to the spot market to buy crude to meet his commitments and thereby affect the spot price. Or maybe the seller was the aforementioned Joe Shmoe, who never had any crude to deliver in the first place? That’s the difference between a cash settled futures contract, which Joe could settle from his bank account, and the physically settled contract, where Joe has to go buy some crude oil. As the Nymex.com site says:

Crude oil is the world’s most actively traded commodity, and the NYMEX Division light, sweet crude oil futures contract is the world’s most liquid forum for crude oil trading, as well as the world’s largest-volume futures contract trading on a physical commodity. Because of its excellent liquidity and price transparency, the contract is used as a principal international pricing benchmark.

Now it is true that there are crude oil contracts that are cash settled, that are just bets. And it is also true that a seller of crude futures can offset his commitment at any time by buying a matching contract. But it is naive to think that the futures market does not affect the spot price.