Speculation, Swaps and the Price of Oil

Lots of people, myself included, arguing that speculation -- at least in the sense in which we understand that sort of thing -- in commodities markets is playing only a minor role in the run-up in oil prices. That, of course, won't stop this week's House Agriculture Committee meeting on whether the Commodities Futures Trading Commission [CFTC] is doing its job.

A more interesting discussion is the role of swaps, those off-exchange trades among large institutional investors, a class of commodities investing that has ballooned from less than $6-billion to $260-billion over the last decade. The allegation is that swaps are largely invisible, and they are larger commodities bets, so they have the capacity to move markets in a more savage way than larger markets of smaller traders can.

Swaps aside, so far there has been little light on this subject, but lots of heat. A new paper, however, tries to help out. It seems to show that for short-term contract supply dictates prices, but for longer-term futures contracts, like outside of a year, that price trumps supply. While that's Interesting stuff, and it should be a reading assignment for both sides of this debate, from Paul Krugman to politicians, the real news comes in the second-last sentence of the abstract: The authors argue that hoarding is going on in oil markets, which is something that many have alleged but no-one has shown to-date.

Speculation, Futures Prices, and the U.S. Real Price of Crude Oil

Abstract
In this study, we examine the relationship between the U.S. real price of oil and factors that affect its movement over time: futures prices, the value of the dollar, exploration, demand, and supply. All of these variables are treated as jointly endogenous and a reduced form vector error correction model, testing for cointegration amongst the variables, is estimated. We find that for model specifications with short-term futures contracts, supply does indeed dominate price movements in the crude oil market. However, for specifications including longer-term contracts that are inherently more speculative, the real price of oil appears to be determined predominantly by the futures price. Moreover, there is empirical evidence of hoarding in the crude oil market: both oil stocks/inventories and futures prices are found to be positively cointegrated/correlated with each other. From a policy perspective, the results of this analysis indicate that if regulators really wanted to limit speculation in the oil market, it should keep the shorter-term futures contracts and eliminate the more speculative six months futures contracts.

Full paper here, and WSJ discussion of House meetings on CFTC here.

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As an aside, there is a Here Comes $200 Oil! article on the front page of Monday's WSJ. Among other things, it contains this interesting comment:

...financial players continue to bid up oil on the futures market, said Larry Goldstein, an economist at the Energy Policy Research Foundation. "The problem is that the natural hedgers, the producers themselves, are shying away, while the buyers get bolder," Mr. Goldstein said.

Comments

[fxtrader07]

good article, thanks.
here you see the fed's additional borrowing facility which were actually meant to help troubled banks and brokers and to prevent a systemic melt-down are flowing probably directly into oil swaps thorugh the likes of goldman sucks and others. want to curb these excesses? closely regulate and control goldman and jpm. In fact, it is my strong conviction that the society and the u.s. economy will be way better off without goldman and jpm chase which are using every loophole and possibility to extract profits on the back of main street

[Nemoudeis]

Well, now I'm confused. The Wall Street Journal says that the producers aren't hedging their positions, while just a few days ago the Financial Times reported that the oil companies were buying put options, with "strong interest" in such options for six months to two years out.

Am I confusing two different activities here, or are the reporters for one of these papers completely full of it? Are they looking at different data (London vs. New York)? Is there some other "oil producing" group besides the oil companies that the WSJ regards as more valid in the futures market? And what about those puts ... is the FT placing too much emphasis on them, or is the WSJ discounting them in favor of some more esoteric hedging strategy that I'm just too unsophisticated to understand?

I know most of these questions sound more like snark that actual inquiries; but I really want to know ... is there some critical factor that I'm just not getting, or has somebody been fed a line?

[Dan Walker]

fxtrader07: I hate to tell you, but the Federal Reserve Bank is a private corporation and JP Morgan is its largest shareholder. Whose interest do you think Ben has at heart?

And to Mr. Kedrosky, the author of this fine piece, go look at the volumes. There has been scant volume in the forward months for the last year. The specs who are holding oil for ransom aren't interested in long-dated contracts. They are rolling from the front month to the next the week before the contracts expire. And your comment on hoarding is spot on. But that all may soon end.

[Brian Pursley]

Congress blaming speculators for high oil prices is some sort of sick Kafkaesque joke on the American people. Congress and Congress alone is to blame for high oil prices.

[jjason]

Paul,

You should read:

www.star-telegram.com/...

and

http;//commerce.senate.gov/pu...

Also, To Brian Pursley,

I do not know where you live...perhaps in some out of the way country where they don't know how to read. Your comments have proved that you know very little about the two authors that I have posted who do know what former US Senator Phil Gramm did to cheat the US public.

Brian...you are the Kafkaesque joke.

And Paul, the Commodity Futures Trading Commission has not done their job properly for many, many years.

The CFTC is part of the problem.

[maximax]

Dan Walker, this old conspiracy theory that the Fed does what their shareholders want is... well, an old conspiracy theory. Rubbish. JP Morgan et al have no say in what the Fed does.

I just read the linked article. Oh man, academia at its worst. The paper reads like a student essay. Those dudes downloaded some data from Haver and slapped some pretty standard econometrics techniques on it. The citations say a lot about the standing of the authors in this field... newspaper articles and a few seminal econometrics articles that one always has to quote when the methods are applied. The authors seem to have no clue of the oil market. They do not demonstrate any knowledge of the data (most of it would have been freely available at the EIA), statements like "OPEC having only 40% of world production" and the finding that the presence of cointegration between longer term oil futures and oil stocks is evidence for hoarding smack of ignorance. They do not even seem to be aware of the role of middle distillates in the current market, they would at least have to acknowledge it, even if they exclude it in their analysis. But their model is too simple to capture the oil market, as far as I am concerned I will not put any value into this paper's findings.

[billp37]

What would an attack on Iran do the price and availability of oil?

www.prosefights.org/th...

Let's try for peaceful settlement of these unfortunate matters.

[fireball]

maximax, i wpuld say the fed tells its shareholders what to do. today it is quite evident why jefferson and many others stood against hamilton. jackson has been trashed by history books because he would not allow a national bank. hamilton for some reason thought his lackey burre could kill the old general in a duel. if you think the federal reserve in any way serves the people of this country i have some financials to sell to you. just kidding i luckily dumped most of that mess before their bad business caught up with them. i wish i could say i saw it coming but i was just lucky. just look at what has happened to our currency since the fed was established. when i was a child a dollar was worth something. a coke was a nickel. so conspiracy or not it is not working.

[Henry Buttal]

I have to agree with maximax on the paper, especially as it concerns there assumptions about hoarding.

Even if the calculations are correct, and their coefficients are valid, there is no cross-check with the reality in their quant work. Mathmatical correlation is not causation.