One of the more important questions in the petroleum business is the degree to which speculators influence oil prices.
If speculators can significantly move oil spot prices, there might be “overshooting” on the downside, in the current oil price environment. That is, the spot price of oil might drop more than fundamentals warrant, given that spot prices have dropped significantly in recent weeks and the Saudi’s may not reduce production, as they have in the past.
This issue can be rephrased more colorfully in terms of whether the 2008 oil price spike, shown below, was a “bubble,” driven in part by speculators, or whether, as some economists argue, things can be explained in terms of surging Chinese demand and supply constraints.
James Hamilton’s Causes and Consequences of the Oil Shock of 2007–08, Spring 2009, documents a failure of oil production to increase between 2005-2007, and the exponential growth in Chinese petroleum demand through 2007.
Hamilton, nevertheless, admits “the speed and magnitude of the price collapse leads one to give serious consideration to the alternative hypothesis that this episode represents a speculative price bubble that popped.”
Enter hedge fund manager Michael Masters stage left.
In testimony before the US Senate, Masters blames the 2007-08 oil price spike on speculators, and specifically on commodity index trading funds which held a quarter trillion dollars worth of futures contracts in 2008.
Hamilton characterizes Masters’ position as follows,
A typical strategy is to take a long position in a near-term futures contract, sell it a few weeks before expiry, and use the proceeds to take a long position in a subsequent near-term futures contract. When commodity prices are rising, the sell price should be higher than the buy, and the investor can profit without ever physically taking delivery. As more investment funds sought to take positions in commodity futures contracts for this purpose, so that the number of buys of next contracts always exceeded the number of sells of expiring ones, the effect, Masters argues, was to drive up the futures price, and with it the spot price. This “financialization” of commodities, according to Masters, introduced a speculative bubble in the price of oil.
Where’s the Beef?
If speculators were instrumental in driving up oil prices in 2008, however, where is the inventory build one would expect to accompany such activity? As noted above, oil production 2005-2007 was relatively static.
There are several possible answers.
One is simply that activity in the futures markets involve “paper barrels of oil” and that pricing of real supplies follows signals being generated by the futures markets. This is essentially Masters’ position.
A second, more sophisticated response is that the term structure of the oil futures markets changed, running up to 2008. The sweet spot changed from short term to long term futures, encouraging “ground storage,” rather than immediate extraction and stockpiling of inventories in storage tanks. Short term pricing followed the lead being indicated by longer term oil futures. The MIT researcher Parsons makes this case in a fascinating paper Black Gold & Fool’s Gold: Speculation in the Oil Futures Market.
..successful innovations in the financial industry made it possible for paper oil to be a financial asset in a very complete way. Once that was accomplished, a speculative bubble became possible. Oil is no different from equities or housing in this regard.
A third, more conventional answer is that, in fact, it is possible to show a direct causal link from activity in the oil futures markets to oil inventories, despite the appearances of flat production leading up to 2008.
Where This Leads
The uproar on this issue is related to efforts to increase regulation on the nasty speculators, who are distorting oil and other commodity prices away from values determined by fundamental forces.
While that might be a fine objective, I am more interested in the predictive standpoint.
Well, there is enough here to justify collecting a wide scope of data on production, prices, storage, reserves, and futures markets, and developing predictive models. It’s not clear the result would be most successful short term, or for the longer term. But I suspect forward-looking perspective is possible through predictive analytics in this area.
Top graphic from Evil Speculator.