Home > Energy Market Articles, Record oil prices, Speculation and fundamental in oil prices > The other side of the story on speculation in the oil markets

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:

  1. limits on speculative positions
  2. increased margin requirement on trading
  3. increased transparency in the reporting of the weekly CFTC traders’ report
  4. regulation of the exotic commodity products by exchanges
  5. 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.

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  1. April 17, 2011 at 5:41 pm

    CFTC and dood-frank’s reports seek to place limits on trading positions…. these steps while important would only serve to “cure the symptoms”….other key root cause must also be tackled to be effective. key market segments of the oil markets are physicals, Futures, OTC-derivatives and forwards… all are important for proper market definitions. How each of their prices are being discovered and reported each day should provide some key directions for solutions to be found. Their inter-relationships and bounds must be re-examined. It is healthy for non-physicals like futures and derivatives to be leveraged in trading volumes over physical oil. However, derivatives must be bounded in that their values are derived from physical and futures’ markets. If we allow derivatives to be predominantly driving the physical values without any OB markers, then we are likely to be heading for more disasters.
    Sadly this has been the case over the past few years. Commerical interests of financial institutions, reporting agencies, & rating agencies(sometimes in cohoot) are driving into this direction. The docile Opec members and oil majors are just helpless “empty-vessels”, doing little to see others “rob their markets”. Most of them are just cheering as players who have never seen or touch a barrel of oil, are running havoc in the oil price arenas across the world. The psyche of the new-breeds ….”beat the system for profits” is the name of the game. The ethos of creating value of providing real goods and services are just too much hard work!
    If We allow the ropes of price discoveries & their methodologies to be “hijacked” and do little to counter them, then we deserve to be robbed….officially sanctioned robbery!

  2. Eric Tham
    March 1, 2012 at 2:10 pm

    On point (i) in the blog article above, Senator Frank of the Dodd-Frank Act has repeated his call for position limits to be placed on the energy exchanges.
    http://www.platts.com/RSSFeedDetailedNews/RSSFeed/Oil/6003738 a year later the article has been written. Whilst CFTC has voted in favour of the position limits, the motion has been sued by the Securities Industry and Financial Markets Association and the International Swaps and Derivatives Association and awaiting a final decision by the District of Columbia court.
    It remains to be seen if the motion is ever passed, and even if does how long it will take.

  1. September 15, 2011 at 7:32 am
  2. January 1, 2012 at 9:01 am

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