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An Anti-Speculative Frenzy

by Blake Clayton
April 12, 2012

I was worried that my defense of speculation in the oil market, published this week on ForeignAffairs.com, was late to the game, but my timing turned out to be right on. Just yesterday, an op-ed appeared in the New York Times by Joseph P. Kennedy arguing that “pure” speculators should be “banned from the world’s commodity exchanges.”

I am wholly sympathetic to Mr. Kennedy’s motivation—to make sure that the wealthy do not profit at the expense of those of more modest means, who are genuinely hurt by high and volatile prices for staples like heating oil, rice, and other goods. But the recipe for a better-functioning oil market that he cooks up is not the answer.

I’d like to address a few of the major points that Mr. Kennedy makes in his piece. Let’s start with his conclusion:

“Federal legislation should bar pure oil speculators entirely from commodity exchanges in the United States. And the United States should use its clout to get European and Asian markets to follow its lead, chasing oil speculators from the world’s commodity markets.”

Commodities markets need at least some what he calls “pure” speculators (meaning those who act as brokers or investors rather than actual producers or consumers of oil) in order to function. This isn’t just my opinion. Commissioner Bart Chilton of the CFTC—hardly a shill for Wall Street—hammered home in a speech last month that “Speculators are necessary liquidity providers to [commodities] markets.” In other words, “pure” speculation is an essential part of the oil market.

Why is that the case? As I tried to explain in my ForeignAffairs.com piece, oil producers and consumers use financial markets to hedge their risk. But they need someone willing to assume that risk. In industry jargon, they need a counterparty to trade with. At times, oil producers and consumers are able to trade among themselves, but not always. That’s where “pure” speculators come in.

For example, Chevron might contract in advance with Southwest Airlines to sell it 1,000 barrels of jet fuel for delivery in New York in 2015. But what if Southwest needs to buy a certain quantity or type of oil for future delivery and no oil producer can commit to providing it for them? That’s when a speculator, acting as a broker, can be useful. He takes the other side of the trade with Southwest for the time being. Then, when an actual oil producer decides it can deliver Southwest what it needs, the speculator sells the contract to the producer. The deal is done. If companies choose to contract with one another directly, rather than through a speculator acting as an intermediary, they are free to do so. But were such intermediaries banned from the market, as Mr. Kennedy calls for, companies that would like to minimize their risk by pre-buying or pre-selling oil would often be stymied.

The amount of damage an oil producer or consumer could suffer by losing out on the ability to hedge is huge. Back to the example of Southwest Airlines—as oil prices trended upward between 1998 and 2008, the company saved more than $3.5 billion thanks to hedging in the oil market, while many of its peers that didn’t hedge suffered. Pure speculators enabled it to rack up that magnitude of savings.

The op-ed also makes the following claim:

“Because of speculation, today’s oil prices of about $100 a barrel have become disconnected from the costs of extraction, which average $11 a barrel worldwide.”

This paragraph reflects a misunderstanding about how oil prices are determined in the marketplace. The market price of oil has to do with marginal production costs, not average costs. That means that the most expensive barrel produced to meet global demand is also the one that more or less establishes a floor for prices. Right now, many experts reckon the marginal cost of production is the cost of producing oil shale and oil sands. Barclays Capital reckons that extracting oil from Canadian oil sands requires an oil price of at least $85 to be economically viable. Once you correct for that error, you realize that $100 oil is not far-fetched, especially in light of ongoing geopolitical disruptions.

It continues:

“Pure speculators account for as much as 40 percent of that high price, according to testimony that Rex Tillerson, the chief executive of ExxonMobil, gave to Congress last year.”

This claim—that Wall Street speculators account for as much as 40 percent of oil prices—is Mr. Tillerson’s estimate, but I have not seen any publicly available study to support that figure. (If I’m mistaken, I’d love to see the report–please send it to me.) Discerning analysts should bear in mind the circumstances under which Mr. Tillerson provided that estimate. Under pressure from Congress last year, oil company executives were called to Capitol Hill to explain why oil prices were so high. They were right to defend themselves. Oil companies receive far more blame in the popular media when gas prices are high than likely they deserve. Still, I have not seen any data validating the 40 percent figure he cites.

Mr. Kennedy argues that the 40 percent estimate “is bolstered by a report from the Federal Reserve Bank of St. Louis.” That’s far from the case. The report he’s referring to is being cited frequently as evidence that speculators are running wild in the oil market, causing prices to move in whatever direction they’d like. But that’s not the study’s primary finding at all. It concludes that “On balance, the evidence does not support the claim that a sudden explosion in commodity trading tectonically shifted historical precedent” (emphasis mine). The bottom line is that “the increase in oil prices over the last decade is due mainly to the strength of global demand” and that “fundamentals continue to account for the long-run trend in oil prices.” The study suffers from some severe methodological limitations due to a lack of data, which calls into serious question its conclusions about how pure speculators affect prices (it says they were up to 15 percent of the 2004 to 2008 price run-up), but there it is. More on that study in another post.

Oil prices can certainly diverge somewhat from supply-and-demand fundamentals for periods of time. That problem is exacerbated by the opaque and contradictory data about what’s happening in the global oil market, which gets in the way of the market’s efforts to determine fair value for the good. My colleague Daniel Ahn has written an excellent CFR piece describing this phenomenon and its implications for regulation. Oil speculators can and do fall prey to irrational exuberance from time to time. Ultimately, though, you’d still be far more accurate to blame supply and demand than you would Wall Street for pain at the pump right now.

I applaud Mr. Kennedy’s desire for sound, proactive regulation of commodities markets. Traders operating within them should continue to be subject to reasonable rules and restraints to prevent abuse, fraud, and manipulation. Where speculators are guilty of illegal practices, they should answer to the law. The CFTC is wise to weigh policy options to improve these important markets. Unfortunately, Mr. Kennedy’s prescription for fixing them is not the right one.

Post a Comment 10 Comments

  • Posted by David B. Benson

    Not only is there some irrational exuberance but also excess arbitrage trading may well occur. Dampen this by a well designed transaction tax (which might depend in part on how rapidly the strike prices are changing).

  • Posted by Dave

    I agree that Mr. Kennedy overstepped when he called for banning speculation in commodities. Indeed, traditional speculators, who from 1936 to 2004 usually comprised 20-30% of the markets.

    The problem is that since the deregulation of commodity markets in the 1990s, “pure” speculators have run amok. This is especially the case with pension funds, endowments and other institutional investors who make their investments based not on the supply and demand conditions of different commodity markets, but on how to “balance out” their portfolios. They just plop down hundreds of billions of dollars on a long term bet that prices will rise in the long term.

    These “speculators” have thrown off the functioning of commodity markets as documented in close to 100 studies by prestigious academics, market analysts, governmental and non-governmental institutions (http://www2.weed-online.org/uploads/evidence_on_impact_of_commodity_speculation.pdf).

    In the US, over 450 organizations including large business associations of companies that use commodity markets, consumer, faith-based and farmer organizations and other NGOs have advocated for returning to strict speculation limits in commodity markets (http://stopgamblingonhunger.com/endorsements/).

    These markets functioned well for many decades with very strong limits on speculation. It is time we return some sanity to commodity markets and limit (not ban) speculation.

    We should ban commodity indexes, ETFs and ETNs, but not speculation altogether.

  • Posted by Steve Maley

    As a producer of oil and gas, I sure wish the speculative masterminds that control the price of crude oil would turn their attention to natural gas.

    Natural gas is currently trading at 10-year lows, and probably half its replacement value. The current crude oil price is nearly 50 times the wellhead value of 1 mcf of gas, probably an all-time historic high.

  • Posted by A. W. Rice

    Replies to Dave –
    Dave: “They just plop down hundreds of billions of dollars on a long term bet that prices will rise in the long term.”
    Reply: If the Fed were maintaining price stability for commodities, they would lose their bet. But the Fed is not doing that. It has a publicly stated aim of at least 2% annual price inflation (the latest CPI increase indicated over 3%). Pension funds, endowments, and all retired people on fixed income want to preserve the buying power of their savings. Paper money won’t do that – it’s being printed in quantity by central bankers. So they put some of their funds in commodities and commodity futures to maintain buying power. Can you blame them?

    Dave: “We should ban commodity indexes, ETFs and ETNs, but not speculation altogether.”
    Reply: Commodity indexes, ETFs and ETNs give the small investor access to participation in commodity prices. Retired people with savings are grateful for this access. Witness the popularity of GLD and SLV. Do you want to take this away?

  • Posted by Martin horzempa

    I agree with Dave. The deregulation that has occurred in the commodities markets needs to be rolled back. Given the inaction by the CFTC and the resistance by Wall Street, I think that the President should act by Executive Order to ensure that the Dodd-Frank Act provisions concerning speculation are enforced. He should execute the Rbob Gambit. Details at http://www.rbobgambit.org . Unwinding all the long trades that are currently being held by ETFs, commodity funds, university endowment funds, hedge funds, sovereign wealth funds, and retirement funds will return to the American public hundreds of millions of dollars that is currently being expropriated every year.

  • Posted by David B. Benson

    Dave — What is wrong with commodity indexes? It seems to me to be useful information.

  • Posted by Chris Cook

    I think the problem here is that within the portmanteau phrase ‘speculator’ there are being lumped two entirely different beasts.

    As I see it the classic ‘speculator’ is an investor who puts his capital at risk in search of a transaction profit through buying and selling, but not necessarily in that order.

    As Blake Clayton rightly says, this assumption of risk by such ‘speculators’ is a necessary element to enable end user consumers or producers to ‘hedge’ price risk.

    Unfortunately another class of investor – the inflation hedger – has flooded into the markets, particularly once the Fed combined QE with zero interest rates.

    These ‘passive’ investors – as Mike Masters dubbed them in 2009 – are structurally ‘long only’, and aim to take on the risk of owning commodities while off loading the risk of holding dollars. This is of course the precise opposite of producers who are hedging future production by selling it forward and being structurally ‘short’.

    Banks have been swarming into this market by selling ETFs and ETNs to exactly such ‘inflation hedgers’.

    This had the effect of enabling producers (ask yourself who gains from high prices?) to support prices at high levels for the last few years, apart from the brief collapse of the first correlated commodity price bubble in 2008, before the price was reflated.

    The beauty for banks is that it is the customers who take the market risk (and far more than they realise) while the banks benefit from serving the funds, providing liquidity with high frequency trading and ‘asymmetric’ information. So banks make spectacular returns on minimal capital at risk, which is why they sell these funds so vigorously.

    I agree with Mike Masters that the material presence of passive investors in any market destroys the price discovery of that market.

    In my view we will shortly see prices collapse, at least in the completely manipulated global market in crude oil where far from being the culprits, the true speculators will be among the major victims.

  • Posted by Dave

    A good explanation of the dangers of commodity indexes is here: http://stopgamblingonhunger.com/wp-content/uploads/2010/01/Dangers-of-Passive-Investment1.pdf
    and the link I gave above.

    The main points:
    - they are price insensitive in that they enter and exit commodity markets not based on supply/demand conditions, but when they want to balance out their portfolios

    - they are long-only, so end up soaking up liquidity, not providing it

    - their constant rolling of hundreds of billions of dollars throws off the market and has created a network of bottom feeders taking advantage of this roll

    - all of these things interfere with the priced discovery mechanism of commodity markets.

  • Posted by Dave

    A.W. – I understand why investors want to have a little money in commodities, the problem is that since that idea has become en vogue, around 2004, commodity markets have lost their functionality – I work with a coalition of business end users trying to get speculation limits and other regulations back in commodity markets.

    When I say commodity indexes and ETFs should be banned, I should be more specific and say those that use food, energy or industrial metals futures should be banned. People don’t go hungry when gold or silver gets expensive, but they do when wheat or oil do.

    While these types of investments may help investors (note that due to extended contango, returns for indexes are a shadow of what people expect), those returns are not worth losing the functionality of probably the most important markets out there – those for our food and energy.

  • Posted by David B. Benson

    Dave — Thank you.

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