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July 6, 2008

Speculation, Swaps and the Price of Crude 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.

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