What Happens to Petrodollars?

In my previous post I explained how currency exchange works. One of the related comment that is often made is that US would suffer an economic disaster if oil exporting countries start demanding payments in Euro. Some say that was the reason for attack on Iraq. In this post, I'll prove why such an action will not affect US economy. Although, a simple question is, given that most oil exporting countries are US enemies, then why they haven't already done so. Until 2008, even Iran which does not have any diplomatic relations with US was selling its oil in USD. Iran now receives its crude oil payments in Euro and has established an Iranian oil bourse where only products that are derived from oil are traded. At this point no trading is done for crude oil in Iranian bourse so all crude is still traded in dollars.

In my previous post on currency exchange I explained how USD at the end of the day is only used in US. Let's look at what happens to the money that Saudi Arabia receives for selling its oil in Dollar. So what do you think Saudi Arabia does with that money? I think most of you would answer that most of it is deposited in banks or invested. But where would that money be invested? Saudi government can buy US treasury bonds with that money if it wants to invest in US. Another option to invest in US would be to invest in US companies by either direct investment or buying stocks. Either way, the money comes to US and its demand or supply is determined by current market conditions. Another option for Saudi Arabia would be to invest it in some other country. In this case lets assume its some country in Europe. Now Saudi Arabia needs Euro for its investment purpose. In this case Saudi Arabia would first trade its dollars for Euro in foreign exchange market where the exchange rate will be determined by market forces as explained in my previous post. Then, it will use the Euro to invest in Europe. Similar scenario will occur for investment in Japan, Korea, Switzerland or any other country. USD will be traded in foreign exchange market for the currency of the country where money is to be invested. Now some people will say that, we think saudis or other oil producers just keep the money and they don't invest. that bring me to my next point which is why all these oil exporting countries which are US enemies, have been trading oil in USD till today.

Why Iran was trading oil in USD up until 2008? Why Iraq up until 2002 was receiving its oil money in dollars. Why didn't Iraq right after the end of first Gulf war in 1991, started demanding its payments in a different currency, let's say German Mark or Swiss Franc? And if Iran and Iraq were/are afraid of US response then why to this day Russia receives its payments for oil in US dollars? Is it also afraid of US sanctions? I am guessing you'd say no, Russia is not afraid of  US. And truth is that answer is much simple. It's just about good business. As much as Iraq or Iran or Libya (during Gaddafi's rule) hate US, they know what is good for business. If they don't get their payments in USD then what is the alternate? Swiss Franc? Where are they going to invest this money? Switzerland albeit a very well managed country, is not an Economy which can absorb the cash that comes from selling oil. Japan which is a distant third (it used to be second largest economy) is not as big as US and its Economy doesn't need most of the money that comes from selling which means, oil producing countries don't need their money in Yen.

So, oil is traded in USD not because US has some monopoly but because of the size of the US economy, it is just good business to trade oil in USD. Due to the economic sanctions against Iran, it can afford to do business in Euro or Yen but for Russia or Saudi Arabia or even Venezuela it is just not good business. At the end of the day, they need to invest or spend the money earned from oil. Last but not least, US economy is still the largest and strongest Economy. And as for the risks associated with economies, we know what happened to Japanese Economy in 90's and what is euro going through currently. By the way, Euro's demise was already predicted by many Economists years ago. This is what Paul Krugman said in 1998

"Here’s how the story has been told: a year or two or three after the introduction of the Euro, a recession develops in part – but only part – of Europe. This creates a conflict of interest between countries with weak economies and populist governments – read Italy, or Spain, or anyway someone from Europe’s slovenly south – and those with strong economies and a steely-eyed commitment to disciplined economic policy – read Germany. The weak economies want low interest rates, and wouldn’t mind a bit of inflation; but Germany is dead set on maintaining price stability at all cost. Nor can Europe deal with “asymmetric shocks” the way the United States does, by transferring workers from depressed areas to prosperous ones: Europeans are reluctant to move even within their countries, let alone across the many language barriers. The result is a ferocious political argument, and perhaps a financial crisis, as markets start to discount the bonds of weaker European governments."

One currency that I did not touch is Chinese Yuan. Simple reason for that is, that China is the biggest US lender. China itself would be the last country who would want oil to be traded in Yuan. I'll write about Chinese Yuan and what US means when it says that China undervalues its currency and that it hurts US exports (It's actually a good thing for US that China undervalues its currency because it helps US consumer. However it hurts those whose owns businesses that compete with Chinese exports to US).

How Currency Exchange Works

This is one of my favorite topics. Many people have misconceptions about how currency exchange works. So here I'll try to explain how it works and try to make it easy to understand. Later in a second post to follow this one, I'll try to explain about what US government means when they say China is deliberately undervaluing its currency. What are the advantages to China and how it hurts US or other trading partners. However this is a very complicated subject, so some basic understanding of Economics principles is required. I will use "Economics: A Survey" as a reference and some real data that I will use is from this book. If I use an example or text from this book, it will be italicized.

To make currency exchange simple, I'll use an example of currency exchange between two countries. Let's say US and Japan. The reason I chose Japan is because both US and Japan are strong economies and both have a lower inflation rate. It will make things simple to understand. Although in recent years Japan has experienced a deflationary cycle but I think its still a good example. Inflation rates for different countries. Let's jump in.

Money is just a commodity like all other commodities that are traded. So the price of one currency in terms of another currency in foreign exchange market is determined by its supply and demand. There are three major components of supply of USD in foreign exchange market.

1. Individuals and companies seeking to buy foreign merchandise (US imports).
2. US citizens and institutions buying foreign financial assets, for example US investment banks buying German bunds or US companies setting up factories or acquiring companies in a foreign country.
3. Foreign owners of US based factors of production seeking to convert their dollar factor into foreign currency.


Similarly demand for dollar has three major components

1. Individual and companies based in foreign countries seeking to buy US merchandise (US exports).
2. Citizens of foreign countries and foreign institutions buying US assets, for example US treasury bonds or foreigners investment in US companies (either through stock market or foreign direct investment)
3. US owners of foreign based factors of production seeking to convert their foreign currency into USD. For example if Apple decides to bring its $85B cash to US it would need to convert money held in foreign currency into USD.

Basically the above mentioned factors decide the price of USD in foreign exchange market. Let's first analyze the affect of inflation on the value of currency in foreign exchange market. Assume two country economy with Japan and US. At 2% inflation rate in the US, all US goods will increase by two percent. So a $100 item would cost $102. Japanese demand for US goods will decrease due to higher prices ($2 more). This means Japanese demand for USD will decrease. Similarly assuming no price changes (inflation) in Japan it will now be cheaper for US citizens to buy Japanese goods. This happens because prior to inflation when US citizens were buying US goods they were giving up $100 worth of Japanese goods. But now they will be giving up $102 worth of Japanese goods (remember no inflation/price changes in Japan). So it makes Japanese goods cheaper. As US citizens seek to buy more Japanese goods, this will increase the supply of USD in foreign exchange market. This will depreciate the value of USD in foreign exchange market. Following tables shows how important the effect of inflation is in the foreign exchange market [source: Economics: A Survey]. Inflation alone accounts for most of the changes in the value of the currency.

Now, let's look at the affect of government borrowing on currency value. Let's say that US government decided to cut taxes but not its budget. Now it has to finance this budget by borrowing more. This will increase interest rates. Higher interest rates will attract foreign investors to invest in US. US citizens who were going to invest in foreign countries are now going to invest in US as they are also attracted by higher return. As foreigners try to invest in US, they will increase the demand for USD and US citizens investing more in US rather than a foreign country will reduce the supply of dollars. Both of these actions will result in dollar getting appreciated in foreign exchange market.

Now here is the fun part. An appreciation in USD means that relative price of US goods has increased for foreigners. Let's say if a Japanese was paying 100 Yen to buy a $1 in US goods, then he might now have to pay 105 Yens to buy $1 in US goods. This will result in a decrease in US exports. Also for US buyers imports will become cheaper.

What this means is that, starting with a balanced budget and trade balance, when government decides to increase borrowing to fund its budget deficit, it increases interest rates, which result in inflow of capital into the country, reduces the outflow of capital, but at the same time increases imports and reduces exports thereby increasing the trade deficit.

I can write pages and pages about this, but in a nut shell, the price of a currency in terms of another currency is determined by three main factors described above. To see whether a currency has appreciated against or depreciated one should look against a basket of currencies to see the real change. For example, to see if USD has really depreciated in foreign exchange market, one should compare USD against not only Yen, but also against Euro, Pound Sterling, Australian Dollar, Canadian Dollar and currencies from similar stronger economies.

In the next post I'll explain what happens to USD that are used for oil trading in international markets and what will happen if countries decide to use a different currency for trading oil. I'll also write about how Chinese government controls the value of Yuan and US government's charge that it manipulates its currency to help its exports (I have already explained above how depreciated currency helps exports).

The Monkey Economy

Every fan of Economics must watch this video. Fascinating.

November's Job Report

Market last week soared based on some positive development in Europe and partly due to the unemployment numbers from November. Unemployment sharply dropped to 8.6%. If you read the unemployment report, you'll find that Non farm payroll increased by 120,000 in November. Out of this 120,000,  50,000 were employed by retail sector. Following is from the BLS, unemployment report.

"Employment in retail trade rose by 50,000 in November, with much of the increase occurring in clothing and clothing accessories stores (+27,000) and in electronics and appliance stores (+5,000). Since reaching an employment trough in December 2009, retailers have added an average of 14,000 jobs per month."


You don't need to be a Nobel winning Economist to realize that most people employed in November are due to the holiday season. I'd like to see the January employment situation before I get excited about the unemployment drop.

Why I won't buy facebook at $100B Valuation

According to news reports facebook will be filing an application with SEC for an IPO early next year which might value the company around $100 billion dollars. Before this number came out, I was anxiously waiting for a facebook IPO. I also tried to buy facebook shares through a secondary market but transactions  costs and volumes required to buy in such markets are prohibitively high, preventing people like me from trading in such markets.

That being said, the real issue I have now is facebook's valuation of $100B. Before we determine valuation of facebook, lets look at the current value of other technology giants, their growth opportunities and risks.

I am going to use Market capitalization for these companies at current share price as approximate firm's value. Enterprise value in each case is little less. Firm's value if calculated in each case should come around its Market Cap with the exception of Amazon in my opinion which I believe is valued much higher by the market.

To start with, let's look at Apple. It's the second most valuable company in the world and is valued at $346B at the time of this writing. Market for whatever reason is not anticipating high growth in Apple, which is reflected in its little over 13 P/E ratio. But in my personal opinion, Apple still has a bright future and it is going to grow in foreseeable future at the same rate as it has done in the last decade. I don't need to go into details about Apple's stream of revenue but we know that it offers a diverse set of products and continues to create new markets (for example from IPod to IPhone to IPads. Now prediction is they will revolutionize TV industry). Given my level of expertise, I cannot predict where Apple would be in next ten years but in my humble opinion market is undervaluing Apple at $346B. The biggest risk in investing in Apple at this point is the fact that Steve job's is gone and company needs to prove that it can be just as successful without its visionary founder.

Another similar tech giant is Google. Google is currently valued at $188B. Based on its P/E ratio of 19, we can say that market is expecting Google to grow faster than Apple. Given the diversity of its Products and Services, Google is in a solid position and in my personal opinion its market valuation, reasonably reflects its fair market value. Again Google's revenue stream mainly consists of online advertising revenue, but Google has successfully diversified revenue sources by acquiring youtube, double click and by launching a successful Smartphone operating system Android.

Third tech giant that I would consider is Amazon. Amazon is currently valued at $85.7B while trading at a P/E ratio of over 99. That is huge. Market apparently is expecting a lot of growth in Amazon. In my personal opinion nothing can justify a P/E ratio of 99 unless a company had a particular quarter where it took a huge one time charge, for either acquisition or for any other reason. This however is not true for amazon. In fact, before this quarter's results, Amazon was trading at a P/E ratio of over 120 which in my opinion, in no way, justifies the underlying value of the company. If reader's followed Netflix, they should know by experience, what happens to their investment in companies that are valued so ridiculously high. As for Amazon's revenue stream, we know that its the largest online retailer. Amazon also owns Zappos. Besides it's Kindle book reader, Amazon has recently also entered the tablet market with its new Kindle fire. As Amazon itself calls a technology company rather than a retail company, Amazon has also entered into cloud computing space to increase and diversify its source of revenue stream.

After discussing these three giants, let's look at facebook. Majority of its revenue at this point comes from online ads and some from virtual currency sold on facebook. As for risk to facebook's business, I think people have adapted to facebook and there is a network effect which will make it very difficult for any competitor to come in and beat facebook in social networking. Google has tried it multiple times with Google Plus being its latest attempt, but so far it has failed. I have already written about it and in my opinion Google plus will fail until some privacy policies are drastically changed. That being said, if there is another revolutionary idea that will change how people use internet (it has happened before with facebook being one such revolution), then facebook in its current state stands to lose most. This risk factor and the fact that its revenue stream is not as diversified as other technology giants I discussed above, I think facebook's valuation at $100B is too high, specially when compared to valuation of other tech giants. Unless you are a speculator who is trying to make a stag profit, I think you should stay away from buying facebook at such a high value.

Zappos - 365 Day Price Match Policy

One thing common among great companies is that they don't compete on prices. Competing on prices will mean that there is a high chance that someone will match it and worse beat it. So no, Zappos which I believe is a great company does not offer price match with its competitors. However, if the price of the item you purchased from Zappos went down during one year on Zappos website, they will match it, or rather I should say that it is in their best interest to match that price if a customer requests. I purchased a suitcase last month from Zappos for $207. Just yesterday, I was browsing the website and noticed that the suitcase I paid $207 for is now selling at $142. That's a $65 difference in less than a month. I contacted their live chat agent and she told me that their price match policy is only for 10 days but she'll do it once for me as a courtesy. I appreciated but reminded her that by virtue of Zappos 365 day return policy which included free shipping both ways, they are effectively offering a 365 day price match policy too. She disagreed and I had to explain her that if she refuses to price match in future, I'll simply order the same thing again, won't even open it when it arrives and then send it back with my previous orders receipt as if I was returning the original product that I might already be using. This will get me my price match and will cost Zappos extra money in shipping. Unless Zappos can find a way to tag every single item, they cannot differentiate between two similar pair of shoes or bags or anything. This will require an RFID tag which can be very costly (about 10 cents per item) and will also fly against their practice of exceptional customer service. So, in my opinion, Isabella, you are better off matching that price every time a customer requests as long as it is within 365 days, otherwise you'll end up with an unhappy customer who will figure out a way to get the price match and Zappos will end up losing price match amount plus two way shipping charges.

Stock market is doing great...well may be

This was on Google news today.

In Case of US Default

As congress fails to agree on a plan to increase government's borrowing limit, chances of US government defaulting are increasing everyday. Everyone is saying that it is going to be catastrophic. Paul Krugman said if it happens then it is going to be "1937 squared". Although market's are down but they have not collapsed and that's because market still believes the probability of default is low. So market is currently multiplying the probability of default to the impact of default and calculating new prices. Now this probability increases everyday bringing market's down slowly. When and if US government defaults, we'll see the impact because then this probability will be 100 percent.

Like most people who love Economics I have been thinking about the potential impact. So let's start from scratch. When US government defaults, its credit rating will go down. This means any future borrowing will be expensive. There are institutions who are required to hold only AAA rated bonds for their investments. They will have to sell US treasury bonds to buy other AAA rated securities. This will derive the the prices of AAA securities up and reduce their current yield. This means that institution who are required to hold AAA securities will make less money. How are they going to respond? That's a difficult question but just hope that some genius does not come out with something like "mortgage back securities" and hope that rating agencies don't assign it AAA ratings. That being said, if US government defaults, vendors will not be able to get the money. It will also reduce its spending which in turn means that several companies who rely on US government as a major customer will be at risk. Stock prices for such companies will go down due to expected lower earnings and it will create a ripple effect tanking the stock market and economy. Investors will buy gold since US dollar is no more a safe haven and we'll see a rise in already overly priced gold.

What's next for Zappos

Zappos is one of my favorite companies. In 2009 I purchased a pair of shoes from Zappos. The reason I chose Zappos at the time was the variety that they had. Before my purchase, I went to Macy's, Von Maur and was not able to find anything that I liked. When I searched online, I found Zappos and I was amazed at the collection. I noticed that their prices are same as what you'd pay at a brick and mortar store except that their collection is huge. Shipping is free on both sides and so I decided to try them. After spending a lot of time going through the selection, I ordered a pair of shoes. I used free standard shipping option. A day later I had my shoes delivered with a thank you note that said that they bumped my shipment to free overnight. I was amazed. I loved my shoes and became a zappos fan.

Last month I read Tony Hsieh's (pronounced Shay) "Delivering Happiness". First half of the book is very exciting where Tony has described the challenges Zappos faced as a young company and how they survived. I love risk takers and so I loved Tony's story about Zappos. Its a great example of passion combined with the fact that big achievements requires taking substantial risks.

Today on facebook, Zappos asked, what business should they enter next. For those who don't know, Zappos is already selling Shoes, clothing, bags (best selection again anywhere to be found in my opinion), sporting goods, eyewear, jewelry, watches and fashion accessories. Now million dollar question is what should be next? Remember, they don't sell cheap stuff. What differentiates Zappos is their customer service. If you are a Starbucks customer and haven't purchased anything from Zappos yet, then I must tell you that Zappos is the only company that matches a  customer service experience that you get at Starbucks in my opinion.

I am not going to buy books from them because I can get virtually any book I want to read from amazon and they are cheap. By the way, in case you don't know amazon owns zappos. Similarly I don't think I'll buy electronics from them as there are too many alternatives. That's why I believe (and may be I am wrong) that their housewares business is probably not very profitable. I think so because "Bed, Bath and Beyond" is a good alternative. Remember one of the reasons I am willing to pay them extra is because of their collection and I think in these areas there are many companies that are offering a huge variety and at a price lower than Zappos.

In my opinion the next big thing for them could be "Home Decor". I went to Europe last year for a vacation with my wife and kid. One of the cities we visited was the beautiful Italian city, Venice (Venezia). Besides the fact that its a beautiful city and you should go there if you ever go to Europe, one thing that me and my wife agreed was when we have our own house, we'll go back to Venice, just for shopping. You simply won't find the kind of glasswork they have anywhere else. Glasswork is not the only thing you'll find in Venice (and I am assuming its true for all of Italy). They have hand crafted wooden objects for home decor and again something difficult (definitely not impossible) to find in US.

In my opinion Zappos can bring these to American consumers. They don't have to be only from Europe. Zappos can get things that are only available in Far East, South Asia and other places in the world and supply them in US market. One thing that should be unique is a huge variety and little competition. I think we still don't have a big online store or even a brick and Mortar store that sells a huge variety of Home Decor. There are several smaller ones but it is difficult to find everything under one roof and that's where in my opinion an opportunity exists for Zappos. Search cost for consumers is high because of an absence of major player in this market and Zappos can provide value by reducing their search cost by providing a huge variety under one roof.

One of the biggest challenges in extending business in 'Home Decor' sector is the fragility of most Home Decor objects. One possible solution is to open a brick and mortar store but they don't  have any experience or expertise in running a brick and mortar store.

It's a difficult question to answer and I have to leave or I'll miss my train so I'll let Zappos figure out how to overcome this challenge.

Why Should I Use Google +

Just received an invite for Google +. Privacy policy is no better than facebook. To join I must accept that google will integrate all my pictures from Picasa. Or I can't join. Why should I use Google +? To effectively use Google + I would need to adapt myself to a new user interface. I will also have to wait for most of my friends to switch unlike Gmail which I could have used regardless of my friends using Gmail or not.

The only positive about google + when compared to facebook is that you can delete your account as opposed to "inactivate" on facebook. People are currently rushing to see Google + out of curiosity and the fact that they feel privileged as you can only join Google + by invitation. I think its going to be interesting to watch how the product will going to turn out. Let's wait and see. In my lowly opinion, its going to fail unless privacy policies are better than facebook. Even then people will be skeptical of google as it currently retains user's google searches for 7 years. But in my opinion, a better privacy policy is the only way to compete against facebook.

Google's Strategy for Google+

So Google announced Google + two days ago as a facebook competitor. One reason of facebook success is the network effect that it creates. For example, initially when  I joined facebook, I had only 10 friends for first 1 month. But in last two years, as more people started to join facebook, I have little over 100 friends. If I want to switch to a different social network, then not only I have to switch to Google +, but I would also want most of my friends (at least around 50) to switch to Google +. To break this network effect and encourage more users to use Google +, Google is using a known strategy of scarcity. You and I cannot create a new account on Google + because we don't have an invite. It's making a lot of people curious. People are curious to see what's so special about it. Specially when one of the friends on their facebook account posts a positive review of google +. So google is first creating curiosity among the end users of Google + and once the product has received enough publicity, Google will probably use the same strategy as it used with Gmail. Current Google+ users will be allowed to invite x number of their friends. They in turn can invite another x number and so on.

I think it is a great strategy and based on the product's features, facebook  can now have a formidable competitor with deep pockets and a  talented engineering team. But unlike Gmail, success of Google + will depend on substantial number of people switching to create the network effect.

One thing that I would do (I know Google won't) to lure users to new Google + is have a better privacy policy. For example, I would advertise that if you delete your account, your data is gone (unless required by law). Similarly, if Google can differentiate itself on other privacy policy terms from facebook then definitely people will have a good reason to switch. I know data is very precious and Google would decide to keep it. But in my opinion if they hit facebook on its Achilles heel, that is, privacy, then Google + will have a better chance of success.

From economics perspective, isn't it great to see competition at work? I don't know about you but I love these "Greedy Capitalist Pigs". In their quest of making more money (they call it being successful) they give this world newer and better products and services at lower prices. Be it Google + or facebook, or iOS or Android or Windows Phone 7, us consumers are better off.

Creating 10,000 Engineers (Obama's new program)

Today, President Obama announced a program to train 10K engineers yearly.

http://beta.news.yahoo.com/obama-announces-push-train-10k-engineers-yearly-180015366.html

Through this program private companies will offer more internships (intel has promised to double the number of internships) and help universities pay for their education. It is not clear how much the program is going to cost government. But one thing we can be sure of, is that there is definitely going to be some cost to the tax payer. Otherwise it is not a government program.

Problem with such programs is that although more money will be spent, we definitely wont see more engineers. Just because government is going to spend more money on Engineering, doesn't mean that it will produce more engineers as government claims. In fact what will happen is that those who are currently in Engineering programs or students who already plan to enroll in engineering programs will benefit from this program, which may or may not be a bad thing but it certainly is not what is intended.

I have not seen a good engineer who was forced to become an engineer. I don't think you can give students an incentive to graduate just so you can have more engineers.

The only good thing about the program is companies doubling the number of internships for engineering students. That's a really good thing but it is the private sector. I would like to know why number of internships is increasing under this program. Is government funding those internships? If yes, by how much? If not, then I believe looking at the demand for engineers private sector would have doubled the number of internships anyway or it will not abide by this program and government cannot take them to court because contract law requires consideration and if there is no consideration then you cannot force a party to comply by it.

Another reason why I am wary of this program is because if companies need more engineers,  and they are not available in US then companies can use H1 program to import engineers. I think an increase in H1 visa numbers is going to be cheaper, in fact government will make more money on tax and our children will do what they want to do and what they can do best. Some will become engineers, some will become Doctors, some Economists and Physicists etc. Yes some will end up working at McDonald's. But I don't think this program will change that anyway. But increasing the numbers of H1 can be politically expensive as Republicans will use it against the President during the reelection campaign so I  can understand why President won't go with this option.

All being said, any money spent on this program is not going to provide the intended benefits.

How Speculation Works

Last month an article was published on www.foreignpolicy.com (http://www.foreignpolicy.com/articles/2011/04/27/how_goldman_sachs_created_the_food_crisis?page=full) , written by Frederick Kaufman explaining how speculators on Wall St are responsible for current rise in food prices. I pointed some flaws in that article but wasn’t able to explain my point due to lack of time and space allowed on facebook comments section (A friend of mine shared that article on his page). Although a simple question that can refute the idea that Wall St is responsible for current rise in food prices is “Although speculation has been going on for decades (CBOT was established in 1848) then why current rise in food prices coincides with expected inflation due to zero bound interest rate and a devalued dollar?”

Just to make it clear, Mr Fredrick is not against speculation. He contends that the fact that Wall St is profiting from futures markets is what makes our food more expensive. He argues that if only companies taking real deliveries were trading in futures market then prices will be lower than what we see currently when there are several speculators speculating in futures market with no intention to get deliveries. I’ll explain in this note that although they are making profits, it is not increasing the cost of food for us. I will prove that prices of food would be the same regardless of Wall St making these profits or not. We’ll see that if Wall St doesn’t make this profit then the very companies taking these deliveries will drive these prices to the current level. Also Wall St has been profiting from these markets for a very long time as opposed to 1999 as Mr Fredrick mentioned in his article. So, let’s see how speculation works.

To begin with let’s start with a world where there is no speculation. I’ll use corn as an example, which is widely traded in different commodity exchanges, in the US. You can replace corn with virtually any commodity traded in commodity exchanges and you'll have the same result and that includes oil which is not harvested and instead drilled. Let’s say there was a harvest on May 1st and on that day we have following demand for corn

People like you and me who want to eat corn,
Hog bars who want to feed their hogs
Companies like Kellog for their corn flakes and lot of other cereals
Other companies who take corn deliveries for their products (for example manufacturers of high fructose corn syrup)
Archer Daniel Midland who wants to convert corn into ethanol
Alcohol producers like Miller who distill corn and make drinking alcohol

All these people want to buy corn today. Let's suppose that nobody thought of future and all of this corn is sold today for $1 per bushel of corn. In the absence of futures market all this corn will be sold in spot market for a price based on demand and supply on that day (May 1st in our case).

Now assume some future date, let’s say August 5th where corn will be required but not available until next harvesting season. Since it’s future, the market for August 5th 2011 does not exist, except in our minds. On August 5th, just like May 1st there will be some demand for corn. It would be again by people like you and me and companies who use corn in their products as mentioned above. If you think that companies would have bought for the whole year then you should add storage cost to your calculations, because as we’ll see below, Wall St benefits in futures markets through storage costs only. That is the only opportunity to make money.

Now assume that someone accidentally dropped a bushel of corn on May 1st during the delivery. How much could you sell that bushel for now on August 5th when there is no corn?

Without putting a number, we know it’s going to be very high. Assume either Kellog or Miller or ADM will bid up the price to $10. That’s a reasonable assumption given there is only one bushel against such a high demand.

Now go back to May 1st and think like a businessman (a "Greedy Capitalist Pig", a “Memon”, what ever you want to call it). What can you do on May 1st to profit on August 5th 2011.

You can store some of that corn and not sell it and then sell it in August when there is no harvest but demand is still there. In this case you can decide to not sell for $1 today on May 1st and instead store it and then sell it in August for $10 and make an extra $9 profit (I'll come to the storage cost in a minute and yes it will be considered).

What you just did is called Speculation and people who do this are called speculators. They don't buy corn to consume it, instead they buy it to make a buck because this speculator thinks that he can make a profit by selling it in future when there will be some demand but no supply. Now remember that this guy is taking a risk when doing this speculation. In the real world the demand on the day of the delivery may not be what he is estimating it is. There is certain cost when getting into speculation. For example

• When I buy this corn today and intend to store and sell it in August, then I'll be incurring storage cost.

• There are transaction costs that I have to incur as a speculator. I have to spend time to find sellers today and then go out and find buyers in August.

• While I store the corn and not sell it right away, I forgo the interest my dollar could earn. By storing corn, my dollar is tied up in this corn and I am unable to make interest on that dollar.

• I may spend money insuring the corn against natural disasters like tornadoes or floods so I have insurance cost.

To keep the numbers simple assume all this cost to be zero so it can help us understand the system and then we can add all these costs.

Now assume that the whole world is stupid to not think of future (remember hearing as a kid that we'll run out of oil...) and now we have seen that if the whole world is stupid enough to not think about future, we can profit of their stupidity. All we have to do is store some of that corn and sell it in future when there is no corn. So we buy that corn today for $1, store it (assume zero storage cost for simplicity) and sell it for $10, 4 or months later.

Your actions will have an impact on prices today. Since you and several other speculators start buying corns not in order to consume but to store and make profit by selling it later, you are a new type of buyer beside all those consumers in our example above and you'll increase today's demand thereby driving prices up in spot market today.

So basically potential for profit drew new type of buyers, driving up the prices in our spot market, let's say $3 per bushel. Some of the consumers who were able to buy corn earlier at $1 will not be able to afford this corn anymore at $3 and will be out of the market.

So, speculators enter the market to make a potential buck, driving up prices in spot market and reducing our ability to consume corn today. But guess what else happens??

Now all these speculators supplying corn in August, we don't run out of corn in August because all these speculators are willing to supply that corn to us in August. Guess what will happen to prices of corn in August now. It is NOT going to be $10 a bushel anymore because there are several million bushels available now as opposed to that one bushel that someone accidentally dropped. All this happened because there was a potential to make a buck and some "greedy capitalist" or "memon" decided to profit from this situation.

So where does this speculation stop. Before you read further, think where the process will stop. At what point do speculators say, anymore speculation and we lose. Take a minute and think.

The process stops when spot market price + storage cost equals expected price in futures market. Now it doesn't matter if speculators exchange goods or not. It doesn't matter if buyers in futures market include Archer Daniel Midland, Miller, or anyone who is not even interested in the product. Whether you take deliveries or not, storage cost is going to be the same for everyone. If you are ever lucky enough to see a difference between "spot market price + storage cost" and "futures market price" (and trust me you won't) but if you do, then sell your car, your house, your first born and do this. Buy from spot market and sell it in futures market. Because there is no risk of loss. By the way, there are people who do this and they are called Arbitragers.

So future price will always equal current price + storage costs + other transaction costs and whether it's Kellog or a Greedy Capitalist Pig on Wall St, they all have to incur this cost. So whether one takes delivery or not, price is going to be the same. And therefore presence of these speculators makes absolutely no difference except this profit is going to someone other than these companies.

Let me give you another example that should be revealing. Let's say you live on a desert island. A boat arrives on this island delivers a month of food supply that you store in some cave. You consume at a rate roughly that will allow you to be able to have food until the end of the month. What happens if you heard on a weather radio that there is a hurricane coming which will close your supply boat which wont be able to deliver your food on time (Let's a 2 week delay). How would you react to this? I'll guess you'll start eating less. Speculators perform a similar service. They get you and me to slow down the rate of consumption today, so we can have food for tomorrow. They do that by driving current prices up. So you go to the grocery to find higher than expected prices and go "must me those damn speculators". They are doing exactly what you would do on a desert island.

So, if speculators don’t drive current prices up, then the companies taking deliveries will have to incur storage costs and we’ll end up with precisely same prices. Except this time Mr Fredrick will lament “big corporations” than Wall St.
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If you find reading this interesting so far then feel free to read some more interesting details below, otherwise I believe I have proved my point.
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Notice few interesting things that have happened due to this speculation

We don't run out of corn in August.
We have reallocated the corn from today when its relatively plentiful, to future when its relatively scarce.
We have moved the corn from a time period where it has less value to a time period where it has more value and in doing that speculators have actually increased the value of stock of corn. We have maximized the value of stock of corn. Corn was not as much valuable. But speculators have increased its value (from $1 to $3 in our case).

So speculators in their motive of making profit have performed some interesting functions (described above). They have also given farmers an incentive to grow more corn. If farmers were getting $3 a bushel as opposed to $1 a bushel, they'll produce more corn next year which will drive prices below $3 given same demand.

Speculation plays fairly an important role in a capitalist system.  It serves so many  purpose that a special market, called futures market has been created for this purpose. Now what is the motivation to create this market? Let's see what happens in our case of corn. A bushel of corn weighs about 42 lbs. A speculator first has to buy a bushel of corn, find a place to store it and then haul it to that storage location. He will have to store, dry it periodically so it doesn't deteriorate and then take it out of the storage and find a buyer and deliver it. It's a pain in the butt. That's what it is. Now that is only if you want to speculate on one bushel. But if you want to speculate on any sizable quantities of corn, then you'll need a fleet of trucks and drivers and these transaction costs are going to be very high.

Futures market is just the right market to reduce all these transaction costs. It makes it easier for people to speculate.

We have a spot market where corn is sold and corn exists. Then we have a futures market where corn doesn't exists except in our brain. But corn is not being sold in these futures markets. What is being sold here is a piece of paper called a futures contract. In a futures contract for corn there will be a future specified promise of delivery and grade of corn. For example a contract for 1 bushel of corn to be delivered on August 5th 2011 for $5. This price that we agreed today is called August corn futures price and you'll pay it when I deliver that corn on August 5th. Now, I have just sold a futures contract and you have just bought a futures contract. Now the question is why would we engage in such a transaction?? The reason is that I believe that price of corn on August 5th is going to be less than $5 (I am taking a position called "short") and you believe that the price of corn is going to be greater than $5 (you are taking a position called "long"). Let's assume that price of corn in the spot market on August 5th is $6 (you were right and I was wrong), then all I have to do is buy corn at $6 right there from the spot market and deliver it to you. Chances are you don't care about the corn either. Both of us will mutually agree that I pay you the difference which is $1 and clear the contract. No deliveries, nothing. We just cleared our contract as Mr Fredrick said and one guy on Wall St also made a buck. Although it caused the prices to increase in spot market on May 1st, it did reduce the price on August 5th. In reality this future and this spot is everyday and if anything, this speculation serves an important purpose and prevents prices from a seesaw effect. That's why futures trading is a pure gamble. Although we can estimate but no one knows the real spot price in future. For example, people who were trading oil futures before Middle East crises, probably did not expected a low supply due to current Libyan crises. So those who sold contracts before middle east crises, probably end up losing a lot of money. So Wall St is losing money too.  Notice how prices are affected by real supply and demand shocks rather than you and I betting in futures market. Similarly current food prices are a result of expected inflation and a devalued dollar. If you have not checked recently, then check the price of gold. It's over $1500 an ounce and all because of expected low value of dollar rather than bunch of traders on a trading floor.

In reality a contract for corn would require a minimum of 5000 bushels. Anybody can buy and sell these and you don't have to own corn to sell a futures contract. All you have to do is deliver it on the promised day.  There are clearing houses and markets make sure everyone complies. One such market is CBOT (Chicago Board of Trade).