The Role of Financial Speculation in Driving the Price of Crude Oil
By Guy Isherwood
OVER THE PAST 10 years, financial firms have significantly increased the size of their positions in the oil futures market. At the same time, oil prices have increased dramatically. The conjunction of these developments has led many observers to argue that financial speculation caused the run-up in oil prices. Yet several arguments cast doubt on the validity of this claim. There is no question that financial activity in
the futures market can significantly destabilise oil prices, a Belgium-based academic told the US Commodity Futures Trading Commission (CFTC) as part of a recent debate the agency held as it weighs new rules. “In 2007 and 2008, destabilising financial activity caused oil prices to respectively over and undershoot their fundamental values by significant amounts,” Ine Van Robays, an academic at the Department of Financial Economics at Ghent University in Belgium, told the CFTC. She added, however, that financial activity in the futures market only typically produces a short-term impact. “This implies that financial trading matters, although its effect on spot oil prices is only short-lived.” The overwhelming message from the CFTC
meetings was that financial flows can – and often do – dominate commodity price formation ... “Not all the time, but enough of the time to make a real difference,” said David Frenk, Executive Director of market watchdog Better Markets. Frenk said that financial speculation is excessive and is causing higher, more volatile prices than would otherwise be the case. “Given the enormous importance of commodities to the lives and livelihoods of people across the earth, facts should be more important in the debate and purely financial price increases of commodities should be stopped,” he said. University of California Professor James Hamilton
told the CFTC that, “
...the real story driving the price of oil has been stagnating world supply in the face of a big increase in world incomes,” not financial speculation.
Fundamentals Open interest and the volume of oil futures
contracts have multiplied over the past 10 years. These developments have been interpreted by some observers as prima facie evidence for the importance of financial speculation in the oil futures market. However, this simple yardstick is misconceived
10 September 2011
according to Ron Alquist and Olivier Gervais in a recent discussion paper: The Role of Financial Speculation in Driving the Price of Crude Oil, from the Bank of Canada.1 Although the stock of open futures contracts is
many times larger than the flow of oil consumption in the US, comparing these two statistics is misleading they contend. Stocks are not measured with respect to a specific unit of time but flows are; so the two are not directly comparable. Second, empirical analysis shows that changes in financial firms’ positions do not predict oil price changes, but that oil price changes predict changes in positions. Third, the evidence indicates that financial firms’ positions did not cause the market to expect persistent price increases during 2007/08.
Attributing wide fluctuations to financial factors is plausible
Other explanations for the increase in oil prices
include macroeconomic fundamentals, such as interest rates and increased demand from emerging Asia. “Of these two explanations, the one that seems most consistent with the facts explains oil price fluctuations in terms of large and persistent demand shocks related to growth in global real activity in the presence of supply constraints,” says the report. Attributing wide fluctuations to financial
factors is plausible because investors have come to view commodities as a distinct asset class. This portfolio shift has led to large financial flows into the commodity futures market. Estimates indicate that, by June 2008, the total value of commodity index-related trading funds held by institutional investors was worth approximately US$200 bn, up from about US$13 bn at the end of 2003. By June 2008, investment in NYMEX crude (US$51 bn) made up about one-third of the total value of commodity index investment in US markets according to the CFTC. To many observers, the conjunction of these two trends suggests a causal connection between financial speculation and the increase in oil prices. Alquist and Gervais cite three important
arguments: (i) The growth in the number of open futures positions increased oil prices;
(ii) The open positions of financial firms caused the increase; and,
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