Amidst all the political noise on speculation in oil futures markets, some serious researchers have written useful blogposts and op-eds pointing out the lack of evidence that speculation is a cause of the current high oil (and gasoline) prices. One of the leading researchers, Jim Hamilton at UCSD, has a great blog and has recently listed very useful posts by other researchers on the topic.
Those posts point out that the so-called evidence of speculation increasing oil prices is just selected data that show a positive correlation between the number of “non-commercial” traders in the oil futures markets and the price of oil. These researchers have shown flaws with the statistical analysis and noted that other markets — and the oil market at other times — have seen the opposite correlation. The most recent counter-example is the ramped up activity of natural gas traders as the price of gas has plummeted. Should we be praising those traders for bringing us cheap natural gas? In reality, these traders are following the market, not moving it.
The stubborn link between commodity futures markets and the physical product has gotten far less attention. Buying or selling a futures contract isn’t like trading stock in Apple or Google, or even Exxon. Individuals who buy and sell stock are betting on the entire net present value of all future profits of the firm. We don’t know what products the firm will be selling years from now, so there is only a weak connection between the stock price and sales or delivery of any specific goods.
A futures contract, in contrast, is for delivery of a specific amount of a specific commodity at a specific time and place, e.g., 1000 barrels of light, sweet crude oil delivered to Cushing, Oklahoma in June 2012. When June 2012 arrives, all the uncertainty ends, because real physical supply of oil meets real physical demand, and a price of oil that clears that market is set. Every holder of a futures contract to buy crude must either take delivery and pay the contract price or must unwind their position by selling the same number of futures contracts they have bought in order to attain a net zero position. But, critically, buyers have the option to take physical delivery and sellers have the option to provide physical delivery, so there is an easy arbitrage if the futures price is out of line with the physical price of oil.
Some proponents of the “first thing we do, let’s kill all the speculators” view make the simple-minded argument that “paper” trades in oil futures now swamp the physical market and the price for physical oil ends up getting determined by paper trades. This just doesn’t make sense. If oil futures were to set a price that didn’t actually equilibrate physical supply and demand for oil, then the physical price of oil would separate from the price of “paper” oil. Of course, there would then be a profitable arbitrage buying physical oil and delivering it at the higher “paper” price. Then the buyers, who were not expecting physical delivery, would just have to sell it back into the physical market at the lower price. The result would be no net change in the physical market, but paper oil buyers would lose money until the price of paper oil again lined up with the physical market.
Other critics make the more sophisticated argument that speculators can cause oil to be pulled off the market today by driving up distant futures prices and making it appear more profitable to deliver oil later. This is clearly true. It can also be a good thing. If there is a risk of war that would disrupt oil shipments in a few months, for instance, the price of oil for delivery a few months out will rise, which will make it profitable to store oil rather than deliver it today, which will, in turn, pull up the spot price. That is the market exercising the sort of precaution that we wish more households had followed in taking on mortgage debt a few years ago: saving today against the possibility of disruption in the future.
But the evidence doesn’t suggest this caused either the 2008 oil run-up or the current high prices. First, and most important, the markets have to be sending the signal that it is more valuable to produce oil later than today. They’re not. Crude markets are in “backwardation” meaning that the price of oil for future delivery is lower than the spot price. The price of Brent Crude — which is the benchmark crude these days due to a glut of oil trapped in the Midwest (more on that in another post soon) — is 5% lower for delivery a year from now and 9% lower for delivery two years from now. Delaying production of oil looks like a very bad investment.
Second, the sophisticated argument that speculators are driving up distant futures is inconsistent with what speculators are accused of doing. The “evidence” on increased speculation is driven in large part by the increased ease of participating in these markets through exchange traded funds (ETFs) that invest in oil futures contracts. But most of those ETFs are offering financial instruments that track the spot price of oil, which they do by buying front-month futures contracts, not contracts for delivery months in the future. The ETF then “rolls” those contracts every month, selling the nearest month as it expires and buying the next month.
Finally, while inventory data are imprecise, there is no evidence of build-ups on anything close to the scale necessary to boost prices by a non-trivial amount. Let’s take a common type of claim that oil prices would be $20 per barrel lower if we stopped speculators. (This is mild compared to many of the claims made, including Joseph P. Kennedy’s op-ed in the NY Times a few weeks ago.) This means that the price that would equilibrate supply and demand is $100 per barrel, about 16% lower than the actual price of $120. If that is true, how much excess supply for physical oil would there be at $120? The answer is a lot. Even taking the extreme assumption of no supply elasticity and -0.1 demand elasticity, this would cause inventories to increase worldwide by about 600 million barrels in a year, just slightly smaller than the entire U.S. strategic petroleum reserve. There’s no evidence that anyone (including China) is hiding that much oil. With a more mainstream estimate of -0.2 demand elasticity and some small supply elasticity, the numbers become even more implausible.
So why does the speculator story persist? It seems to be in no one’s interest to face the realities of the oil markets, that reliance on oil will leave a big part of our economy out of our hands. Politicians on the right want to drill our way out of this– $2.50 gasoline for everyone! — despite the fact that no credible researcher suggests more domestic drilling will have a significant impact on oil prices. The left doesn’t want to just say “oil is expensive, we need to deal with that reality” so they instead say we can solve the problem by shooting the speculators. Or they blame large U.S. oil companies for driving up oil prices, despite any evidence to support the assertion. On both sides, the domestic politics of oil prices remain stubbornly resistant to the basic facts on which economists of all political persuasions agree.