There’s nothing to beat a dearth of substantiating data coupled with a highly emotive issue to fuel a lively debate. And the current debate about the role of speculators in the oil market seems no exception. Is speculation in oil futures driving the current price spike? Or are current prices an inevitable consequence of oil demand moving ahead of supply?
A July 10 survey by Public Opinion Strategies and the Mellman Group, carried out for the Air Transport Association of America, found that 80 percent of people polled believed that oil speculators are manipulating oil prices and that 70 percent of the respondents believed that oil speculators are making unfair profits by driving up the price of oil. In the published survey results, oil speculators came out on top of the blame list for high gasoline prices. Oil demand in the United States came sixth in the list, and the list did not feature rising oil demand in countries such as China and India. Nor did the blame list feature oil supply constraints as a price driver.
Political actionPoliticians have made much of a “blame the speculators” movement. Multiple bills designed to curb oil speculation have jostled for attention in the corridors of Washington, D.C.
And there’s been no shortage of advice for the politicians.
“The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil to be delivered in the future in the same manner that additional demand for the immediate delivery of a physical barrel of oil drives up the price on the spot market,” said the U.S. Senate Permanent Subcommittee on Investigations in a June 2006 report.
In June 2008 legendary hedge fund manager George Soros, testifying before the U.S. Senate Commerce Committee, described the escalating oil price as a bubble that would burst when the U.S. economy goes into recession. The bubble results from institutional investment organizations such as pension funds fueling prices that are already rising as a result of high oil demand, tight oil supplies and a weak dollar, he said.
Proponents of the speculative bubble theory say that, encouraged by low margin limits, institutional investors have been riding the back of the climbing oil prices by pouring money into oil futures contracts. And just as in the recent Internet and house price bubbles, the rush to put money into these contracts has created a self-fulfilling increase in contract prices.
Not so, said Professor Craig Pirrong, expert on market manipulation and director of the Global Energy Management Institute, Bauer College of Business at the University of Houston, in testimony before the U.S. House Committee on Agriculture on July 7.
“Speculation is not the cause of high prices for energy products; the arguments advanced in support of this view are logically defective and at odds with an understanding of how the markets work,” Pirrong said. “Most importantly, there is no evidence to support claims that speculation — or manipulation for that matter — is responsible for high energy prices.”
Almost without exception, trading by financial institutions has made no contribution to the demand or supply of physical oil and, as a consequence, trading by these institutions does not distort the physical market in oil. In addition, a speculative distortion in prices would result in the accumulation of excess oil inventories. No such oil inventory accumulation has been observed, Pirrong said.
So who is right?
Price bubble?A graph of the steeply rising oil price over the past year certainly resembles the price graphs of the upswing sides of historical asset price bubbles. And there are data indicating the operation of large numbers of speculators in oil futures, with oil futures prices tracking oil prices on the spot market.
On the other hand, the futures market provides an essential means for companies who sell or use oil to hedge the risk of future price changes. For example, by locking in a future price, an airline can gain some level of certainty around its future fuel costs. And futures trading tends to smooth out price fluctuations by anticipating impending price increases and decreases — essentially the futures encapsulate the cost of future uncertainty.
But there are two types of futures trader — hedgers and speculators. Hedgers consist of businesses that own oil to sell or that actually use oil. These businesses buy and sell futures to hedge risk. Speculators on the other hand buy and sell futures contracts to try to make money out of future price changes. Speculators “lubricate” the futures market by providing high levels of liquidity for futures trading.
The recent invective around oil prices has been directed at the speculator component of the market, with bills in Congress that aim to tighten speculator position limits and margin requirements (i.e. increase the limits on how much trading a speculator can do and how much money the trader can borrow to speculate).
CFTC: no action neededBut testimony by Jeffrey Harris, chief economist of the Commodity Futures Trading Commission, to the U.S. Senate Committee on Energy and Natural Resources on April 3 questioned the need to take any action against oil speculators. CFTC is an independent government agency that regulates commodity futures and options markets in the United States.
Harris said that although the volume of futures trading has expanded dramatically during the period of oil price increases of the past few years, the relative proportions of hedger and speculator trading has remained almost constant during that time. Moreover, speculators tend to switch between betting on price increases and betting on price decreases from one month to the next, he said. And during the price run up of the past year or so CFTC studies have consistently shown that hedgers react first to new market information, with speculators then reacting in response to what the hedgers have done, Harris said.
“Looking at the trends in the marketplace, combined with studies on herding behavior and the impact of speculators in the markets, there is little evidence that changes in speculative positions are driving up crude prices,” Harris said. “Given the relative stability of the makeup of participants and their positions in the markets and the absence of evidence that speculation has caused oil price changes, it appears that fundamentals provide the best explanation for crude oil markets.”
Supply and demandThat’s a view put forwards in BP’s 2008 Statistical Review of World Energy, published in June. That report concluded that escalating oil demand in developing countries such as India and China, coupled with worldwide supply constraints, lies behind the current oil prices. On the other hand, some economists have questioned whether the current exceptionally high prices truly reflect the relationship between oil prices and the levels of demand and supply — perhaps excessive speculator trading accounts for at least some component of the price?
And the Air Transportation Association of America, with its strong interest in fuel prices and in the importance of the oil futures market, certainly blames the speculators in a big way — ATA has launched a “stop oil speculation now” campaign.
However, before anyone starts tinkering with the futures market, they might want to pay attention to the law of unintended consequences.
“While certain targeted controls on speculation are appropriate, speculators … provide the market liquidity to allow hedgers to manage various commercial risks,” Harris said. “Unnecessary limitations on the amount of speculation that an individual or entity may engage in could limit the amount of liquidity in the marketplace, the ability of hedgers to manage the risks and the information flow into the marketplace, which could in turn negatively affect the price discovery process and the hedging function of the marketplace.”
Or, to put it another way, if it ain’t broke don’t fix it.