The other side of the story on speculation in the oil markets
When oil prices spiked to $147 in July 2008, debate centred on if speculation or fundamentals contributed to its rise. An initial report by the CFTC attributed fundamentals as the main reason for the rise. This was later reversed in late 2009 to speculation having a part to play.
A paper by the author attributed both fundamentals and speculation to be important in the rise of the oil prices. A study using stochastic parametric regression indicates the sensitivity of the oil prices to fundamentals and speculation had varied with time. This is likened to fundamentals acting as a steering wheel that determines the oil price direction while speculation is the gearbox. Depending on the gear level, the oil prices can move quickly up or down. Indeed the oil price fell to $40s in half a year after reaching a peak in July 2008. No one however seemed to mind that too much.
The Obama administration in 2008 mandated to curb speculation in the oil markets. Some of the measures include:
- limits on speculative positions
- increased margin requirement on trading
- increased transparency in the reporting of the weekly CFTC traders’ report
- regulation of the exotic commodity products by exchanges
- more cooperation among exchanges worldwide to curtail oil trading
Interestingly, except for point ii and iii, none of these measures has been passed two years after its initial release. It was only in January last month that as oil prices started to climb that politicians have renewed calls for laws to be implemented to curtail speculation.
The limits on speculative positions on non bona fide investors are hard to determine. Restricting these limits too stringently dries up the liquidity for bona fide hedgers and causes the oil markets to malfunction. Further, in this inter-connected world, traders could have easily taken their positions to other exchanges which have lesser restrictions and would welcome the revenue from increased oil trading.
Regulation on the exotic oil derivatives on exchanges is difficult. There are no standard contracts for the more popular products including target redemption funds, window barriers, extendible options etc. These are customized to customer needs with different targets, window periods and specific contract characteristics which make them difficult for delivery in an exchange. Perhaps the simpler Asian swap contracts can be listed on the exchanges, but these contracts are already marked off the monthly futures contracts listed on the exchanges.
Increased margin requirement is also unlikely to have much effect on curbing investor interest in oil trading. The additional millions just don’t deter cash-rich banks and hedge funds in an environment flush with liquidity.
Perhaps the increased transparency in the CFTC reporting has done some good segregating the banks and index traders in the oil markets. At present, this is however more useful in shedding light on speculative and hedging interests than actually curbing trading interest in the markets. It must already be realized that the CFTC has all along their proprietary set of inside data in deriving their conclusions.
Why investors’ participation (speculation) is necessary?
In spite of the criticism on investor participation in oil markets, it has actually done some good. Firstly it creates liquidity in the markets allowing the prices to adjust quickly to the fundamentals and also allows oil producers to hedge their production. When the spare capacity in the oil markets decreased to about 1-2 million barrels in 2008, investor interest drove the prices up as any further supply disruption will severely disturb the demand supply balance. This caused the consumers to take heed (fortunately) and gasoline demand in US decreased by 1 million/ barrels a day even in the peak summer driving season. One could only imagine if consumption continued to stay high depleting further the oil reserves in the short and medium term. Instead consumers are encouraged to use oil optimally and as a scarce resource.
Perhaps one may argue high oil prices hurt the economy. Whilst this is true, high oil prices have actually accelerated investment into deep sea technologies and other improved oil drilling methods, increased exploratory activities and investment into alternative forms of energies. In 2007/08, there was a rush into investment in bio-fuels supported in part by government subsidies. A similar spike in oil prices now will further accelerate development into renewable fuels, many of which will not have been feasible in a low oil price environment.
In conclusion, the free markets still triumph. Investor participation in the markets is a necessary gear box that allows the markets to react to the times.