Thursday, April 21, 2011
Oil Prices and Speculation
Every time crude oil and gasoline prices become uncomfortably high, as they are currently, blame is cast on speculators who are somehow manipulating this market. In fact, at a "town hall" meeting on April 19 at Northern Virginia Community College in Annandale, Va., President Obama said: "It is true that a lot of what's driving oil prices up right now is not the lack of supply. There's enough supply. There's enough oil out there for world demand. The problem is, is that oil is sold on these world markets, and speculators and people make various bets, and they say, you know what, we think that maybe there's a 20 percent chance that something might happen in the Middle East that might disrupt oil supply, so we're going to bet that oil is going to go up real high. And that spikes up prices significantly." In the Reuters article on this, it was noted that the White House is worried about the effect of rising oil prices on the economy and on the 2012 election. The article also noted that Saudi Arabia and other OPEC members have been making a similar argument about there being plenty of supply.
Whether speculation in futures and OTC derivatives markets affect the price of oil has been controversial. The simple version of the argument of proponents of this view is that the speculative money flowing into the oil derivatives markets must have this effect. Others counter that this cannot be right. First, they point out that for every futures contract bought one is sold. Second, they say that bets on future oil prices cannot affect spot prices unless something is also happening in the physical market, such as the hoarding of oil or reduced production. Just as a bet on the outcome of a sporting event cannot affect the result (unless something crooked is going on), bets in the futures markets, while they may be good (or not so good) predictors of prices in the future, do not affect physical market prices.
While CFTC Chairman Gary Gensler wants to impose position limits on oil and other physical commodity derivative markets, the CFTC has pushed back the imposition of any such rules to 2012. There apparently is some disagreement among the Commissioners. In this connection, it is worth noting that an interagency task force led by CFTC staff stated in a July 2008 report: "The Task Force's preliminary analysis also suggests that changes in the positions of swap dealers and noncommercial traders most often followed price changes. This result does not support the hypothesis that the activity of these groups is driving prices higher. The Task Force has found that the activity of market participants often described as 'speculators' has not resulted in systematic changes in price over the last five and a half years. On the contrary, most speculative traders typically alter their positions following price changes, suggesting that they are responding to new information – just as one would expect in an efficiently operating market. In particular, the positions of hedge funds appear to have moved inversely with the preceding price changes, suggesting instead that their positions might have provided a buffer against volatility-inducing shocks."
Perhaps, this is why the CFTC felt it had to say the following in its Notice of Proposed Rulemaking on Position Limits for Derivatives: "The Commission is not required to find that an undue burden on interstate commerce resulting from excessive speculation exists or is likely to occur in the future in order to impose position limits. Nor is the Commission required to make an affirmative finding that position limits are necessary to prevent sudden or unreasonable fluctuations or unwarranted changes in prices or otherwise necessary for market protection. Rather, the Commission may impose position limits prophylactically, based on its reasonable judgment that such limits are necessary for the purpose of 'diminishing, eliminating, or preventing' such burdens on interstate commerce that the Congress has found result from excessive speculation."
I have never seen this kind of statement in the Federal Register, which I used to have to read and write for from time to time. I would note that it doesn't really make sense. The CFTC is not required affirmatively to find that something is necessary but it can proceed if it reasonably believes that something is necessary "prophylactically." Perhaps, there are lawyers who understand the distinction.
With regard to the speculation debate, Paul Krugman is one of those who argue that the futures markets speculation does not drive the spot market for oil or other physical commodities. (See this article and this blog post on food prices.) His basic argument is that something must be happening with the physical commodity for there to be dramatic price changes. Speculative bets by themselves do not alter the fundamental supply and demand conditions which determine prices.
Yves Smith on her website has offered a more sophisticated argument about how oil futures market speculation can affect spot prices. Her argument is that there are many long-term contracts for the physical delivery of oil which are based on futures market prices. The argument is that if futures prices are high, producers of oil will limit supply in order not to undercut these long-term contracts. (For more on this argument, see this post on "naked capitalism" and this one. Also, this "naked capitalism" guest post.)
It seems there is a lot more for the CFTC and others to study on this issue. Unfortunately, the data on the global market for oil is not great, and conclusions by serious researchers will have to be hedged. But we can expect speculators to be blamed when oil prices rise, and for those doing the blaming to be remarkably silent about speculation when oil prices fall.