Oil Prices and Speculation

The Washington Post says the scale of speculative activity in commodities markets is larger than previous estimates indicated:

A Few Speculators Dominate Vast Market for Oil Trading, by David Cho, Washington Post: Regulators had long classified a private Swiss energy conglomerate called Vitol as a trader that primarily helped industrial firms that needed oil to run their businesses.

But when the Commodity Futures Trading Commission examined Vitol's books last month, it found that the firm was in fact more of a speculator... Even more surprising ... was the massive size of Vitol's portfolio -- at one point in July, the firm held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange.

The discovery revealed how an individual financial player had gained enormous sway over the oil market without the knowledge of regulators. ...

Some lawmakers have blamed these firms for the volatility of oil prices... "It is now evident that speculators in the energy futures markets play a much larger role than previously thought, and it is now even harder to accept the agency's laughable assertion that excessive speculation has not contributed to rising energy prices," said Rep. John D. Dingell (D-Mich.). ...

Using swap dealers as middlemen, investment funds have poured into the commodity markets, raising their holdings to $260 billion this year from $13 billion in 2003. During that same period, the price of crude oil rose unabated every year.

CFTC data show that at the end of July, just four swap dealers held one-third of all NYMEX oil contracts that bet prices would increase. Dealers make trades that forecast prices will either rise or fall. Energy analysts say these data are evidence of the concentration of power in the markets.

CFTC leaders have argued that speculators are not influencing commodities' prices. If any new information arises during the agency's examination of swap dealer activity, officials said they would report it to Congress.

"To date, the CFTC has found that supply and demand fundamentals offer the best explanation for the systematic rise in oil prices," CFTC spokesman R. David Gary said, reading a statement that had been crafted by agency officials. "Regardless of their classification . . . the CFTC's market surveillance group scrutinizes daily the positions of all large traders, both commercial and non-commercial, to guard against market manipulation." ...

For most of the past century, regulators put limits on financial actors to prevent them from dominating commodity exchanges, which were much smaller than the bond or stock markets. Only commercial operations, such as farms, airlines, manufacturers and the middlemen that handle their trading activities, were allowed to buy nearly unlimited quantities. The goal was to allow these businesses to minimize the effect of price swings.

The first major change to this regulatory framework occurred in 1991, when Goldman Sachs, through a subsidiary called J. Aron, argued that it should be granted the same exemption given to commercial traders because its business of buying commodities on behalf of investors was similar to the middlemen who broker commodity transactions for commercial firms.

The CFTC granted this request. More exemptions soon followed...

A second turning point came when Congress passed the Commodity Futures Modernization Act of 2000. ... Critics have called this piece of legislation the "Enron loophole," saying Enron played a role in crafting it.

In the months after the act was passed, private electronic trading platforms sprang up across the country, challenging the dominance of NYMEX. ...

In the coming months, swap dealers expect to have yet another venue for oil speculation. The CFTC has stated it would not stand in the way of trading in U.S. oil contracts overseas in Dubai. ...

Many people have said that recent price movements make it clear a speculative bubble in the commodity markets has popped. I can't add my voice to that exact wording.

The term "bubble" has become watered down with popular usage in the press and elsewhere, but technically a speculative bubble is the result of price movements that are divorced from the underlying fundamentals (as with housing). Yet the stories I hear for oil price and other commodity movements mostly involve fundamental factors.

Let me say this another way. I've also heard that it can't be supply and demand that's pushing prices around. But even if there's a speculative bubble or market manipulation, it's still movements in demand and supply that are pushing up prices around. Demand skyrockets (or plunges in a crash), or perhaps supply is artificially constrained, it's just that the demand shifts are driven by non-fundamental factors. Supply and demand are still at work, it's simply a question of what is driving the shifts in the supply and demand curves, fundamentals or something else.

It's possible for the underlying fundamentals to shift quickly. The possibility of, say, a war can change very fast altering the outlook for future supplies and when it does  prices will change along with the change in the outlook, as they should. But that is not a bubble popping, that is a fundamental driving the price around. Big swings in fundamental factors that cause big swings in expected future supply or demand (and hence affect supply and demand today) can cause big swings in the price, and it can happen relatively fast.

I have yet to be convinced that the big swings in prices we have seen are due to prices departing from the underlying fundamental factors and then returning, i.e. that the price swing is from a speculative bubble in the technical sense (or maybe we are simply debating what we can count as a fundamental fundamental factor, but a technical bubble is still something different).

I don't deny, and never have, that speculation is at work in moving prices around, I've drawn diagrams in the past showing how a change in expected future conditions can change today's price. But I agree with the article, I just don't see the evidence of outright, intentional manipulation of the price. Holding large shares, or seeing large volumes alone are not enough to make that case, and it's hard for me to believe that manipulation alone can explain the size of the swings in price that have occurred in commodity markets. I also don't see the case for a more traditional speculative bubble (i.e. a price change driven by a departure from fundamentals rather than manipulation), but as I've said all along, this is hard to prove one way or the other and there could be some of this at work.

So maybe there was some manipulation attempts, I don't know, but if the evidence was strong we would have heard about it. And maybe there has been some departure from fundamentals, again it's hard to know with any certainty, but I still believe the majority of the price movements can, in fact, be explained by fundamentals as defined above.

I could be wrong, maybe there has been manipulation, or perhaps we've seen a more traditional speculative bubble, again in the technical sense, but so far I haven't seen enough evidence to be convinced that this is a better explanation for the preponderance of price movements than shifts in supply and demand driven by underlying fundamentals. But that doesn't mean we shouldn't keep investigating to see if the claim of no manipulation holds up against additional scrutiny, or if there is evidence for a more traditional type of speculative bubble.

Comments

[reason]

Would somebody controlling 11% of the market for brown shoes be considered in a position to manipulate that market?

[reason]

This is just saying there are some big players, and we already knew that. But making bets on the direction of price movements (as Krugman pointed out) doesn't change the price movements themselves. To do that you need to hoard.

[hari]

Mark is desperately trying to avoid identifying speculation as the principal factor for oil price explosion. Rationalization of one sort or another will not hide the fact how the Oil Futures Market works when CFTC made it possible for hi fi investmnt houses to enter the market without risk of regulatory control. The failure of the market was fundamentally a failure of CFTC oversite of how and under what conditions futures market was being monopolized with leverage from investment houses and rolled over with expiry of options.

The fact that a handful of speculators with leverage could not only control but also direct the futures market was indicated by those of us who know something about commodity markets and how they function.

Unless oil market is regulated under an international commodity agreement between producers and consumers, I'm afraid we shall revisit this speculative bubble more often than not - as transpareency and scarcity of supply/demand functions become critical for allocation of unit price(s).

[hari]

SEC took action against so-called *naked options* to avoid the banking institutions equity from being manipulated by highly leveraged speculators. Something similar is required to regulate the operations of the oil futures market - since it functions as allocator of spot price(s) for dealers - and avoid revisiting another speculative bubble....

says...

The same arguments by the "speculators can't control these markets" crowd were used when the investmant houses. Enron, and friends were controlling the California energy markets. the natural gas market, etc.

There is not one functioning market left; bonds, equities, FX, real estate, or commodities. We are in the denial phase.

[reason]

You are misunderstanding, I'm not saying speculators can't control these markets. I'm saying that if they do (for any substantial length of time) we'll see tell tale signs that they are. And we haven't seen these signs. That doesn't mean to say that was not a speculative component in some of the rises earlier this year, but many of those speculators have already been badly burned, as you would expect in a market governed mostly by fundamentals.

[ddt]

the futures market is never governed by fundamentals in the short term. It is entirely speculative, you know, being a future contract and all. If you are buying or selling a futures contract you are speculating on the future price. The price you are guessing is based both on long term fundamentals through being linked to the spot market and on what you think the speculative consensus (futures contract prices) will be in the future. As Mark noted, it's difficult to say where the speculation ends and fundamentals begin. If traders speculate that there might be a war in Iran, and the price goes up, and then there is no war and prices move down again, was that move based on fundamentals or speculation?

Anyways, my main point here is that there is always speculative behavior in futures markets, and that fundamentals will eventually correct the mis-pricing through the spot market in the long term (I think Mark actually demonstrated this in one of the models). The thing is that there used to be rigorous controls and disclosure rules that mitigated the risk of futures prices rapidly diverging from fundamentals via speculation.

At any rate, I think we can all agree that a re-regulation of the futures markets is in order. I don't care about going after speculators or manipulators, or imposing windfall profits taxes, just repairing the markets.

[ken melvin]

Yeah, but what caused the speculation?

[odograph]

I think I've argued here that speculation was in the mix, and never that it was the only driver, "divorced" from all else.

That seems an odd word and standard actually. I don't think housing prices here in southern California were "divorced" from the fundamentals. Speculation seemed very much to leverage off the fundamentals (booming incomes, less open land).

Is this piece above about understanding or making a defense by setting a high bar for "speculation?"

[groucho]

Mark, well said.

AS usual, when you follow the money, GS pops into the picture.

Fundamentals....Speculation....Manipulation?

If you had the financial horsepower to push and pull the markets, would YOU do it?

Is there a FREE market on planet earth?

says...

Mark, Bridge or Poker?

I'm guessing you have a Bridge mentality (play your hand straight)

The real world is Texas Hold'em, though and markets are ALWAYS gamed, bluffed, played, etc.....

Look what the PPT did to Frddie and Fannie last year. Now they have to give up ownership....they were played.

[bakho]

In order for speculators (or cartels) to game the oil market, they need for the gap between supply and demand to be relatively small. If the gap is too large, the portion of the market controlled by speculators is too small to affect price. As the gap closes, speculators control a significantly greater piece of the gap and have significantly greater control over prices.

We see this with the actions of OPEC in the late 70s. OPEC could basically name their price for oil. The US response was to cut oil demand. By 1983 oil demand was cut by over 20% and new production was brought on line. OPEC desperately cut production to close the gap between supply and demand. By 1985, the gap between supply and demand had widened to the point that OPEC was no longer able to affect the price of oil.

The argument over how much speculation there is in oil markets is mostly semantics. The key to lower oil prices is expanding the gap between demand and supply. Drill drill drill is unlikely to produce a large impact on the gap and is much more expensive than decreasing demand by increasing efficiency.

[Cassandra]

TO further understand this debate, it might useful to decompose activity, for prices are determined on the margins.

Commodity Index Funds ARE the equivalent of hoarding, with their static long positions rolled month-in and month-out. This , in itself is not irrational where inflationary expectations are rising, but it represents a local optimization problem, for surely everyone cannot buy-forward and hold (hoard) without massive dislocations. Say for example all this "demand" is met by rolling forward sales from producers executing bona fide hedge trades. That's fine. What percent of the open interest might this represent? Without any actual knowledge, twenty-five percent of open interest sounds plausible (though the actual is somewhat irrelevant to my eventual point).

Then there are other long hedgers (utilities, refiners, airlines, land transport co's, bulk chemical co's ) who - whether its executed directly or indirectly vs. dealers who manage hedges - will wish to purchase forward - again perhaps met by producer hedges. Might these make up another twenty-five percent of open interest?

Assume for the moment they do. And plausibly assume that all this activity are "core" reasonably stable and consistent positions, rolled and executed month-in and month-out deemed reasonably necessary for core business risk-management. Now Vitol's 11% of open interest is looking more like 22% of marginal activity. And this is extraordinarily large in itself.

Now consider that there are all manner of feedback trading strategies that seek to both predate large orders in the short-term and piggyback even large position movements in the medium term (CTAs trend followers etc.). Each Vitol contract thus has something akin to a multiplier effect, sucking in new longs in response to additional purchases at higher prices. This is plausibly one-to-one - probably higher, since systematic trading has become so profoundly widespread as stand-alones and as sub-strategies within large funds. Moreover there are common and popular pseudo "market-neutral" commodity strategies, also of the mimetic variety, that for example buy the top six performing contracts and short the bottom six, further amplifying directional moves. Together this footprint upon the market - where the its the marginal buyers (or sellers) that impact price - can and does cause large dislocation.

This evolving feedback loop (and it is an innovation since commodity-indexing and the increasing predilection for feedback-oriented strategies) does not necessarily imply concerted manipulation. Market structure is market structure, and astute traders will quickly figure out what marginal buying and consequential price moves it takes to trigger stops, torpedo weak-hands through inability to meet margin calls, or merely lock-in low-risk abnormal returns at expiration, or basis option contracts, and the like. For, like the legalized theft perpetuated by the flawed structure of the NYSE that existed for years, inimical as it was to the role of the equity market in efficiently allocating capital, so to should the market structure of energy markets - important as they are - be of great concern to lawmakers and economists interested allocative efficiency, and the effect of volatility upon it. Not for the demagogic purpose of lawmakers pandering for votes by engineering [potentially] unsustainably low prices that inhibits long-term adjustment to the inevitability of higher long-term liquid hydrocarbon prices, but for the purpose of market fairness, market efficiency, and chain of dependencies which these prices have in the lives of untold billions of people.

Finally, to be fair to Vitol, they are a large refiner, as well as a "trader" and speculator. Now, they are probably satisfying their demand requirements by contracting physical cargoes from producers and intermediaries, but it remains at least theoretically possible that a portion of their position is a bona fide hedge. Unlikely from the rumours of Vitol traders shooting the moon, but possible nontheless.

[halbhh]

Mark, I've done what you're doing in the blog entry -- argue after new evidence that the new evidence should be discounted, and my old view must be correct. After years of thinking about thinking, I switched to a difficult new technique of presuming I don't know, and starting over in my assessments, again and again. This sentence is a red flag: "So maybe there was some manipulation attempts, I don't know, but if the evidence was strong we would have heard about it." -- because of course, we are now hearing about it, and there is no reason to believe that we were somehow guaranteed to have embarrassing information from the CFTB previously (earlier). In other words, their opinion could be wrong for years before being internally challenged and corrected.

There has been an "either-or" mistake made a lot in this broad public debate on oil price speculation -- that since fundamentals indicated sharply rising prices, that the sharply rising prices must therefore have been entirely from fundamentals -- actual supply and demand responses by producers and consumers alone -- and not at all from a speculative price divorced for a while from supply and demand.

Either-or is usually inapplicable in a complex system. We should consider both-and routinely, and be suspicious of either-or presumptions.

[James]

Michael Greenberger has been doing some great work in this area. He knows his stuff.

This story in the Post contains the essence of the story. A few financial firms were able to influence rules changes (cherchez Phil Gramm and wife) that allowed outrageous speculative manipulation of energy prices. Enron was just an early example.

In a futures laddered market, prices are set at the margin. If you have deep enough pockets, and its a no limits game where the house limits the positions of the other players, its hard to lose while the game is going.

The silver market is an almost better example of this where four financial houses are short nakedly several times the total supply of silver in the world as we speak.

Why doesn't someone just take them on, buy contracts and demand delivery? Seems logical right. If the markets were 'free and efficient.'

If you were to bother looking into that question, you might find many answers.

Until we are willing to fix these things, these obvious abuses that crept in during the 1990's and reached full flower this decade there can be no change, no health in our economy.

And until economists start understanding this, and help to stop covering up the problems with obfuscation and too often their own ignorance of how markets work except at the comic book level, the situation will worsen.

Read the article closely. Its well done and has a lot of the clues. Read some things from Michael Greenberger. Watch any youtube videos he has put out.

Tools.

[kharris]

"I just don't see the evidence of outright, intentional manipulation of the price."

Take this as the correct view. Then, consider the possibility that sheep-like behavior led many, many large investors to engage in similar trades. Shed financial shares and grab commodities, because that's what made money in the prior period. Leverage and mimickry, together, could make a big difference.

[James]

kharris

Rather than retreating into the world of the hypothetically possible, why not read the story carefully and examine the evidence at hand?

[James]

Here is an NPR interview with Michael Greenberger that is interesting background. He was formerly a regulator with the CFTC and is now a professor of law.

http://www.npr.org/templates/player/mediaPlayer.html?action=1&t=4&islist=true&id=13&d=04-03-2008

says...

I tend to side with halbhh. The practical aspects of how commodity futures markets function are very complex. Therefore, there are very few economists who have studied them closely enough to be able to have any idea whether the evidence presented in the media is evidence of manipulation, speculation or fundamentals.

If an economist doesn't have the time to spend a couple of weeks -- if not months -- studying how these markets operate, perhaps that economist should be willing to admit that he or she is too ill-informed an individual to be able to say anything about the causes of price increases in the market. Assumptions about how markets should operate are rarely effective in describing how they do operate.

[Dr Future]

The speculation of oil prices is directly linked to the health of the American (World) economy.Prices should be driven down by worldwide reduction of unnecessary usaage and implementation of practicle new technologies.

[Mark Thoma]

I'm trying to figure out what part of "I don't deny, and never have, that speculation is at work" is hard to understand. I'm saying it wasn't manipulation or a departure from fundamentals, i.e. it wasn't a particular type of speculation. I'm not saying that speculation didn't move prices around, not at all. There are different types of speculation, as I've noted in the past, and I just don't see the evidence for a particular type. But there's plenty of evidence for other types.

Also, manipulation isn't a bubble. Saying a bubble popped is different than saying there was manipulation. Those of you who are now using the manipulation story to support the bubble claims you made in the past are the ones reaching to support a point of view.

[dissent]

I second the rec for that npr interview with Michael Greenberger. It was one of the most clarifying things I've read or heard in the last year on our economy. Obama folks, listen in!! And everyone else, do yourselves a favor.

[Ryberg]

Economists should understand that the financial markets are not like conventional economic markets. Both the supply and demand curves tend to have a pasitive slope. When financial fundamentals are working, both buyer and seller are expecting prices to increase. And the more the prices increase the more both buyers and sellers participate in the market. This is how a bubble can occur in the real economy. Both buyers and sellers get ahead of physical supply and demand. Speculators understand this phenomenon and try to take advantage of it. They are not trading based on economic fundamentals but on financial fundamentals. Manipulators look very much like speculators but they are trying to effect the economic fundamentals or the financial fundamentals by manipulating something in the other market. A focus on one market is never going to successfully explain something giong on in the other market

[kharris]

James,

Rather than assuming I haven't read and characterizing my comment as a "retreat", why not mind your manners and address others' comments are they are given? Pompous git.

says...

Here's another way of looking at the data using economic theory: We know that financial institutions (and those who work in them) have been making extraordinary profits over the last few years. This would not be possible if the markets in which they trade were competitive. Therefore we can assume that they are profiting from market power in some markets.

In an oligopolistic setting I don't think anyone's ever defined the distinction between exerting market power and manipulating the market. Therefore the only question is what are the markets in which market power/manipulation is being exerted.

says...

I just want to thank you, Mark, for providing this forum where we get to vent our opinions on these issues. Please don't take it personally that this is where some of us take the opportunity to vent our frustrations with the economics profession.

I, speaking I think for many others as well, deeply appreciate the vast amount of work you put into this site.

[odograph]

Well ... my only defense is that many of us seem to have picked up the same vibe. Consider this paragraph:

I could be wrong, maybe there has been manipulation, or perhaps we've seen a more traditional speculative bubble, again in the technical sense, but so far I haven't seen enough evidence to be convinced that this is a better explanation for the preponderance of price movements than shifts in supply and demand driven by underlying fundamentals.

Did you suggest there that since speculators did not work in isolation, they could not be responsible for a "preponderance" of price movements?

Is there a rule for that? It seems to defy common sense ... but then my background is chemistry, where catalysts have effects far beyond their concentration ...

[Winslow R.]

Fundamentally the futures market is a commodity based monetary system that lacks fractional reserves to back up bets and in addition is missing a supplier of last resort.

The lender of last resort for any particular commodity is the producer (farmer, miner, manufacturer, etc.)

When is the 'market signal' sent to producers from commodity markets based on ficticous demand so distorted that it becomes useless?

BUFFER/PRICE SETTER
Perhaps government should create/set/determine minimum buffer stockpile/production capacity in each commodity that is traded and become the lender of last resort when necessary. AKA Strategic Oil Reserve. Government would then set the price based on level of stockpile (say 90 days worth depending on production contraints) and would offer to purchase the commodity up to that level. If stockpile drops to 60 days then price increase by 10%. If stockpile goes over, then price drops 10%.

Would likely be a helpful tool to set fiscal policy. Perhaps it could even be automated.

[outsider]

outsider says...

NYMEX oil futures (light sweet crude).

Oct. 2008 close 121.08
Dec 2012 close 121.59
Dec 2015 close 121.39

The futures market indicates oil is where it's supposed to be for 7 years.

The odds of change up or down; 50/50. The pros give no bias.

On settlement date, speculators take delivery or sell. To sell positions and roll them over a year or two is normal for longer term speculators, but hoarding something like oil is probably impossible.

The Hunt brothers in Texas cornered the silver market leading up to 1980, but long term futures stayed lower, and the market reality of usage and demand eventually bankrupted them. I see no hoarding of oil in the prices.

Hot commodity markets often trade more than the "crop" consists of but (speculative) buyers and sellers liquidate before delivery date. Only those who have and those who want determine the price at that point.

Speculators are just noise.

[reason]

outsider
BRAVO!

[groucho]

"Speculators are just noise."

outsider, reminds me of the kind of denial Warren Buffet was putting on last night after the movie IOUSA.

He kept claiming that the US would "expand the pie" quicker than the increase in US public and private debt and the ability to service said debt.

He's in Obama's camp which means greater debt through expanded govt programs so he's making a political statement not an economic one.

How about you? Speculation "just noise"

My grandfather lost the family farm back in the depression just speculating on commodity prices.(mortgages couln't be repaid when crop prices went bust)

Japan's now at the mass suicide level 2 decades after their speculative noise episode. And the current unwinding of the Anglo consumption speculative bubble(what fundamentals?).........

The party's just ending and the long term effects are just getting started. Foreclosures, bankruptcies, divorces, murder and suicide are "just the noise" of another speculative adventure.

[Winslow R.]

"Speculators are just noise."

Depending upon a commodity characteristics, that noise can become a trend for quite some time.

Business cycles are just noise as well.

[Real Person from the Real World]

I'm sorry, but I must say that in this day and age, the rules have changed. What might have once been a tail, now wags the dog. For example, today, mutual funds dominate the markets, so when one of them dumps thousands of shares what happens? They used to argue, that it would not affect the market much, but take a look at the volatility now-a-days. This is the day and age of financial gaming, thanks to the Chicago School of Economics, and I have no doubt speculators are far more of a problem then anyone actually wants to admit.

[outsider]

outsider says...

Real Person,

You are correct in mutual funds etc. potentially "hoarding" and accumulating shares in perpetuity issued by a paper person with a potentially infinite lifespan ( a corporation) may influence prices long term.

Commodity futures, however, are time limited. A "long" contract means you are to accept delivery of a specified commodity at a specified grade at a specified price on a specified date. On delivery if you have gunned , say corn, to twice its realistic price by buying futures, The warehousers and farmers will say "Where do you want it?" 2x current wholesale, COD as specified. Your option is to accept a freightcar of corn, pay for it to be stored and inspected, or making tortillas with it lose money because everyone else bought corn lower. If you try to warehouse, the primary users will buy the minimum and wait you out...and/or hedge by shorting later delivery against your overhang, or you could liquidate your contracts at the going rate and take the tax loss.

Also, as delivery date approaches, the warehousers and farmers (opec, etc. for oil) take the opposite side by shorting "promising to deliver the commodity on the date at the price." You can take it or bail to the "greater fool" if possible, but someone will be stuck.

At settlement date, supply and demand decide the price of tortillas (or oil) though with no settlement date, Enrons and Googles may blow forever.

[ddt]

um, what about cash settlement?

[specs wishing they were just noise]

Jamie Galbraith just nailed the spec story in Mother Jones. "how to burn the speculators"

[Mark Thoma]

Jamie and I had a very long debate about that very article by email. That's not so clear, not at all...and Hamilton made the WaPo article look silly.

[Winslow R.]

http://www.motherjones.com/news/feature/2008/09/exit-strategy-how-to-burn-the-speculators.html

Would like to see the debate. Not sure what doesn't jive. Seems pretty sound. Even Palley's idea would have some short term effect that would either require someone else to accumulate more inventory or Saudi Arabia to pump a little less oil.

[Real Person from the Real World]

Outsider.... I agree, my metaphor may not be accurate, but I still stick to my guns that technology is gotten good enough that the right individuals/entities with deep pockets can game the system and win at others' expense.