Speculation in Oil Markets

Editor's note: The following is an excerpt from a research paper I recently completed.

Background

Oil futures markets are a relatively recent phenomenon.  The first “oil” futures contract developed was for heating oil traded on the New York Mercantile Exchange (NYMEX) beginning in 1978. The success of the contract led to the implementation of the West Texas Intermediate (WTI) crude oil futures contract in 1983 as well as a gasoline contract in late 1984.  By 1990 there were 10 active oil futures trading contracts worldwide. Prior to 1978, the “bible” for price discovery was a daily publication called “Platt’s Oilgram”.  Prices for physical oil were reported to Platt’s by the oil traders themselves.  Platt’s makes a good faith effort to verify prices by contacting parties on both sides of the transaction.  Obviously, verification takes time so Platt’s price information, although relatively quick and accurate, is not instantaneous.   

The oil futures market provides instantaneous price discovery.  Futures markets also allow industry participants to shed risk by selling product for future delivery at a guaranteed price.  This practice is known as hedging.  The futures markets allow non-commercial players (speculators) to participate in oil markets.  Speculators serve two purposes.  First they provide liquidity to the market allowing trades to be made more readily.  Second, they represent the “other side” of the transaction.  For example a crude producer may want to sell his oil into the futures market to “guarantee” a price in the future.  Obviously, for each contract there must be a seller as well as a buyer.  The futures market provides a clearing house for buyers and sellers.  A speculator may be that buyer.

Dueling Models

Has “speculation” driven prices to levels higher than the “true value of oil”?  The three part answer is as follows.

o       The Commodity Futures Trading Commission (CFTC) says no.

o       The James A. Baker III Institute for Public Policy at Rice University (JBIPP) says maybe

o       The St. Louis Fed says yes

Each of the aforementioned institutions agrees on one point – The supply/demand balance is the single largest factor in pricing of oil.

So, why is there such disagreement on the role of speculation in the oil futures market?  I think that the answer lies in the mathematical models each institution uses to determine the relationship between speculation and price fluctuations.  The CFTC uses ARCH and GARCH models (acronyms for Auto-Regressive Conditional Heteroskedasticity and Generalized Auto-Regressive Conditional Heteroskedasticity).  The JBIPP in a paper entitled “Who is in the oil futures market and how has it changed?” points out the limitations of ARCH and GARCH models and posits some alternative conclusions.  The St. Louis Federal Reserve in a paper entitled “Speculation in the Oil Market” utilizes a FAVER (factor-augmented vector autoregressive model) which determined a significant role in speculation as a driver of oil prices.  All of this is very arcane.

Common Sense

Now let’s cut through the BULL (bombastic utterances by laughable lads).  Or more appropriately let’s examine the BULL by applying a “smell test”

Fact: Non-commercial participation in the crude oil futures markets has increased dramatically

o       Between 1995 and mid 2008 (the height of the last oil spike of $147/bb), non-commercial participation increased from about 20% of the market to over 50% of the market (see figures below)

o       Since 2008 non-commercial participation has remained in the 40-45% range

Comment:  The question is whether or not a 40-50% non-commercial participation is “juicing” the price of crude oil?  Non-commercial participation in the natural gas futures market has been running at a 60% level and natural gas prices are at historic low prices.  In addition, natural gas reserves are high and increasing due to “fracking” technologies.  Conversely, spare capacity for crude oil is tight.  So, in the case of oil or natural gas, prices seem to be tethered to the realities of supply and demand.  Also, if you believe that speculation pumps prices in tight markets, its follows that speculation deflates prices in physical markets swimming in product.  My opinion is that speculation does have a modest impact on price.

Fact:  Since 2001 there has been a very high correlation between the value of the dollar and oil prices.

Comment:  In the JBIPP paper, the author posits that the falling value of the dollar is a significant cause of increasing crude oil (and other commodity) prices.  The figure below illustrates this point in a very convincing way.  There is a very high correlation between a weak dollar and high oil prices since 2001.  It is interesting that the Federal Reserve concludes that about 15% of the price of oil is a result of speculation.  In my opinion the Fed has a vested interest in deflecting blame.  I believe that the Fed’s weak dollar policy has significantly impacted the price of oil and other commodities and that the Fed’s claim of low inflation is not credible.   

Fact:  The government through the CFTC can reduce non-commercial activity in two ways

• Increase margin requirements.  This increases the cost of speculation
• Limit positions by individual players.  This limits the market share and potential influence of a single entity

Comment:  I have no objection to either of these measures so long as the limits imposed are reasonable.  Remember that non-commercial participants play an important role in the functioning of any futures market and that heavy handed over-regulation could result in negative unintended consequences.  In addition, my belief is that either of these measures will have only a very small impact on price.

Fact:  Hedging is a prudent strategy

Comment:  I am sure that commercial participants see the real possibility of a major supply disruption and see the declining value of the dollar.  In either case hedging would be a prudent strategy.  For example airlines might want to protect themselves from rising fuel costs and might buy futures contracts to “lock in” or hedge fuel costs. School districts with a fixed budget might want to hedge their bus and heating oil fuel costs by purchasing futures contracts.  The collective action of a significant number of hedgers would tend to increase the price of the contract.  I believe that it is likely that a “risk premium” and hedging activity is pushing prices higher.

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