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Are Speculators to Blame for High Oil Prices? Part II

by Michael Levi
May 3, 2011

I received some thoughtful (offline) responses to my post yesterday on the impact of speculators on oil prices – or, to be more precise, the relationship between financial and physical oil markets. One group insisted that financial markets can’t push up the price of physical oil without also leading to substantial inventory buildups. (Higher prices mean more supply and less demand, and thus, everything else being equal, growing inventories.) Since in many of the cases where people blame speculators for high prices, we haven’t seen big inventory buildups, financial markets can’t be responsible. The other group insisted that huge volumes of paper oil trade mean that financial markets can overwhelm physical ones, and basically dictate prices, at least for some time. In particular, these people noted that most financial traders sell out their futures contracts before they expire, rather than taking delivery of physical oil. Thus, they argued, it is possible for financial markets and physical markets to become largely decoupled from each other.

I don’t buy either argument. Let’s start with the first point. Futures markets tend to serve a price discovery function: if people bid up near-term futures, producers will price their physical oil at that higher futures price. That should boost supply and curb demand relative to what it otherwise would have been, which in turn should lead to inventory buildups. Since we don’t see big inventory buildups, people argue, speculation can’t be having a big impact.

There are two big problems with this. First, short-term elasticities of supply and demand are very low, and possibly negative in the case of supply, which means inventory buildups can be small or nonexistent. Most producers can’t respond to higher prices by quickly pumping out more oil; indeed many believe that some OPEC producers respond to higher prices by cutting back production (keeping their revenue constant). On the demand side, motorists are pretty unresponsive to high gas prices (up until a point). Even worse, since refiners are currently minting money, they can to some extent suck up higher oil prices and be slow to pass them along to their customers. To the extent that higher oil prices don’t pass through, final demand remains unchanged. (Basically, in this case, refiners’ elasticity of demand is even smaller than motorists’.) All this means that prices can get jacked up considerably while only introducing small imbalances in the physical market, and hence small inventory buildups.

Which leads us to the second big problem: There are many other things that influence inventories. (If you don’t believe me, ask yourself whether inventories were constant before the growth of financial markets. They weren’t.) In the presence of this noise, it can become all but impossible to separate out relatively small speculation-driven inventory buildups. At a minimum, anyone who has sophisticated enough techniques to see that sort of thing is probably trading oil, not writing blog posts.

On the flipside, I also don’t buy the “financial and physical markets are decoupled” argument. There are two problems with it. First, (financial) futures prices ultimately converge with (physical) spot prices. Those physical prices need to be consistent with what’s going on in the physical market. By implication, so do the financial prices (as the relevant futures contracts get close to maturity). If they don’t, we’ll see futures prices failing to converge with spot prices – but we don’t. (All of this is true regardless of whether financial traders are buy and selling a gazillion paper barrels each day.) Second, if for some weird reason futures prices didn’t converge with spot prices, why would physical consumers care if those futures prices were high? I care about what I pay for gasoline, not what it’s trading for on the NYMEX. And if someone wants to respond by saying “but if people push up prices on the NYMEX, you’ll end up paying more”, they’ve just made my point – financial prices translate into physical ones.

To be sure, futures that don’t mature for a while can get way out of whack with fundamental values. This is interesting, and can have an impact on production and consumption decisions that have long lead times, but they don’t have a direct impact on what you pay at the pump today. What matters for the “high gas prices” discussion is physical prices and near-term futures.

One last note: Don’t read my discussion about whether speculators can influence oil prices as a discussion of whether speculation is good or bad. Alas, ninety-nine percent of commentary about speculation seems to conflate “speculators are influential” with “speculation is bad”, and “speculators aren’t influential” with “speculation is fine as it is”. But there is no reason why one’s understanding of how reality works should dictate one’s value judgment as to whether a particular activity is good or bad. Unfortunately, when we tie the two together, our value judgments tend to dictate (and thus warp) our analytical findings. That’s not good for anyone. It’s certainly not good for informed debate.

Post a Comment 2 Comments

  • Posted by R Dean Foreman

    Michael,

    I enjoy your blog and was the one who recently asked that you be invited to present to the American Petroleum Institute’s Economics & Statistics Committee, which I currently chair.

    Your point about financial prices affecting physical ones could be made even more strongly. Term contracts under which major oil compnies lift cargoes out of Saudi Arabia (and other OPEC countries) generally are indexed to benchmark crude prices, such as Brent, so there is a direct linkage between the financial markets’ outcomes and the prices refiners pay for crude. Also, many financial players have become involved in the physical and storage markets.

    Financial market outcomes obviously reflect expectations about a myriad of factors, but there is a high correlation between large short-term price movements and speculators being counterparties to industry participants, so it does seem that speculative fund flows affect price discovery.

    However, the prices cannot stick unless consumers ultimately are willing and able to pay, which as you note is quite insensitive to price in the short run. In the longer term, the cost-based fundamentals, substitution and income effects set in, and numerous liquid fuel alternatives become viable with sustained real oil prices in excess of $90 to $100/bbl. Speculation is therefore more like a vehicle for prices to get from one place to another, but ultimately it is drivers [figuratively and literally] who float the system with their demand for liquid fuels.

    In this context, the only “bad” thing about speculation is that it may enable price discovery to outpace the transparent flow of market information in markets that can be rather thin [e.g., one party cornered 1/3 of UK Brent cargoes in January]. Technically this may be an efficient reflection of current information but also exposes price-inelastic consumers to vagaries of the market, which becomes a political debate about equity and fairness. To low income households, where total energy costs can exceed ~10% of income, escalated energy costs force painful tradeoffs. This price discovery has also revealed much to OPEC members about what the market will bear, thereby dispelling outdated notations about what prices the global economy could pay. And it is with this in mind that energy policy should be designed to promote investments that lessen OPEC’s market power. All it takes is a bit more spare capacity to keep the market amply supplied.

    Thanks for your blog commentary. R Dean Foreman, Chief Economist, Talisman Energy, 2000-888 3rd St. SW, Calgary, Alberta T2P5C5

  • Posted by Arnold

    Michael,

    I want to add my two cents to this. There can be another perspective to this whole issue. And the perspective will challenge two foundational factors of most popular analysis: (1)is whether the futures market serves as a price discovery role, or a price setting role, and (2) whether price really moves opposite to demand (i.e. when price goes high, demand goes low).

    I think the question to first question is, in recently years, futures market has rather served as a price-setting role, rather than discovery. Securitization and leverage actually have a great impact on the price of crude. In other words, prices on future contracts goes up not because people expect oil price to go up, but because speculators want to “make” the price go up.

    The answer to the second question is it depends. The price-demand-supply relationship of financial markets and critical commodities works a little different from normal commodities. In the financial market, demand actually goes up when price goes up, because speculators expect profits in re-selling the financial contracts in the future when price goes even higher, and they know their “buy” action itself helps this trend. Further, crucial commodities demand will not shrink too much even when prices goes high, as the cost of going alternative may be even higher. So before the price really reaches to a critical level, the market will just suck it up.

    Given these said, the critical element to examine, in order to determine whether speculators are gauging up the price, should be taking look at the recent trading activities and large positions.

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