How can financial speculation affect oil prices?

  The Obama Administration just announced that they may limit the ability of financial companies to engage in speculative trading in oil futures.  The reason is the recent run-up in oil prices.  I don’thave a problem with the idea.  After all, I am a conservative of a sort, in the sense that I like to limit the animal spirits of those crazy market types on principle. 

But still, I don’t understand the point.  The reason why I don’t understand the point is that I don't understand how futures trading can drive up the spot price.  That doesn't mean that it can’t; that just means I don’t understand how it might in the absence of a rise in actual oil inventories. 

What’s a futures contract?  Simply put, it’s an agreement to sell a given quantity of oil at a given price at a given date in the future.  So let’s say you and I strike up a contract that says that I will sell a barrel of oil to you at $100 in a year.  How do I make good on that contract?  One way is to run out into the market, buy a barrel of oil, and sit on it.  That will drive up the price of oil, got it, very clear.  When a year rolls around, I sell you that barrel for $100. 

A second way is to wait around until the contract is due, buy oil at whatever the market price happens to be, and then sell it to you for $100.  I do not understand how doing so could possibly drive up the price of oil.  I can vaguely sort of see how it might increase volatility:  trading on the futures market presumably reveals information (if only information about the neuroses of futures traders) and that information will be used by traders on the spot market.  When they use that new information, prices will move.  More information revelation, more price volatility. 

But seriously, people aren't worried about short-term volatility.  They'’e worried about big run ups and sudden falls.  I don't see how you can blame the speculators for those, absent big swings in inventories. 

In fact, inventory changes in the oil market tend to run against price swings.  During the recent price plunge, unsold oil piled up in stockpiles and supertankers all over the planet.  Those stockpilers were going long on oil, but in the context of falling prices.  Now that the price has risen, those stockpiles are shrinking ... and some analysts (not entirely coherently) blame the price rise on the inventory fall.

Am I missing something, or is this whole speculation story nonsensical?

Comments

[David Allen]

"After all, I am a conservative of a sort, in the sense that I like to limit the animal spirits of those crazy market types on principle."

Does this mean that Republicans are liberals?

"...is this whole speculation story nonsensical?"

Two possible points:

1. It wouldn't push the price up under normal circumstances, but it might help to inflate a developing bubble.

2. If I understand correctly, the favored trade is long commodities and short dollars. This has an extra path to pushing up prices, as well as a patented bubble-generating feedback loop.

[Bernard Guerrero]

"A second way is to wait around until the contract is due, buy oil at whatever the market price happens to be, and then sell it to you for $100. I do not understand how doing so could possibly drive up the price of oil. I can vaguely sort of see how it might increase volatility..."

I think you're close to the answer right there. If the market is made up of a bunch of heterogeneous agents with generally bad information about fundamentals, speculative futures buying by one segment might drive the spot market up via other segments attempting to hedge against a future rise in prices.

Hypothetical:
Agent A figures demand will be higher in a year because of "green shoots" or what have you. He buys a contract for delivery a year from now and thereby helps bid up the futures price.

Agent B (an end user or somebody who already sold futures contacts and is on the hook for delivery) sees the price of futures being bid up and, being risk averse, buys on the spot market and stores in expectation of a price increase.

(You might object that he'd be better off hedging by buying a futures contract himself. Possibly they've been bid up beyond his storage costs. Maybe he doesn't like being exposed to counter-party risk, the times being what they are.)

[Noel Maurer]

That makes sense, Bernard, but isn't the rise in the spot price still effected by the second guy deciding to hold oil in inventory? The change in the future price might have motivated his decision, of course, but the spot price rise should be accompanied by a rise in inventories.

[Bernard Guerrero]

I recall during the initial run-up that there was talk of "shadow" inventory. i.e. the Iranians storing crude offshore in tankers. I don't honestly know enough about the specifics of the market to know if it's possible or easy to move crude off inventory.

In any case, though, aren't commercial stocks up from last year? I believe on the order of 18% y-o-y. You'd normally interpret that as having downward pressure on the spot price, but maybe it's being driven by fear/hedging. Actual consumption might be down even as stocks are being built. Of course, that can't last forever. Either the speculators and end-users they're driving are right and demand picks up with the economy, or eventually the spot price collapses.

[Bernard Guerrero]

Alternative?

I see several papers that appear to be arguing for risk premia applied to the spot price based on volatility.

[Noel Maurer]

This is useful. Thank you!

[Tom Karthaus]

I would think about in slightly different way:

Remember, the oil producers can play in the futures market as well. Obviously, right? The so what is - what if the futures price starts to have an affect on the oil producers decision making criteria? I think this changes the cause/effect relationship that has been relied upon in the above analysis slightly.

Here's an example:

1) The oil producers see a futures price significantly higher than the current stock price. We'll assume the oil producers have sufficient storage capacity to build up some inventory and that the higher futures price more than offsets the carrying costs.

2) Given these assumptions, the oil producer chooses to sell futures contracts and build inventory rather than sell at the spot. Would you rather sell at $90 in three months or $60 today if it only costs you $3 per month to hold the inventory? These numbers are for example purposes only.

3) This could do several things - first, inventories would rise; second, there would be a corresponding shortage of oil being sold into the spot market, which would drive spot prices higher; third, oil consumers would see spot prices and futures prices rising and buy oil on the spot as well as futures to lock in prices, thus creating even more demand for both spot and futures; fourth, this starts to spiral out of control as the futures price begins to lead the spot price. And thus, the tail is now wagging the dog.

4) This could be one cause of the odd outcome that has been mentioned in which inventories and spot prices rise simultaneously.

5) Without financial players manipulating the futures price (whether due to fear, greed, market expectations, etc. doesn't really matter), it is unlikely the differential between futures and spot price would increase to the point where oil producers would rather hold than sell. Said a different way, financial players introduce more factors into the futures/spot market relationship than just traditional carrying costs.

This is one way I can see it playing out. I would be really interested to hear your thoughts, especially if I have missed something in my analysis.

Also, It has been a while since I sat in your BGIE class. I hope you are doing well.

[Noel Maurer]

Hi, Tom! Good to hear from you again. Did you go back to Blackstone?

This is interesting. It's bit like Bernard's story at the beginning. Changes in the spot price still need to be intermediated by changes in inventory, but you're suggesting that the decision to hold inventory could be prompted by a speculator-induced rise in the future price.

The interesting part occurs in step 3. Rising prices now causes rising futures prices, causing rising prices now. Ergo, a bubble.

So let's think about the recent rise-and-fall of oil prices. The big run-up starts in January 2007. OECD stocks of crude continue their slow upward (but volatile) trend until August. So some evidence of a feedback bubble there.

In August, crude inventories collapse. AFAIK, oil exports didn't drop much at that time, so it's not clear that there was an uptick in producer speculation either. So can futures speculation explain the continuing run-up from August 2007 to July 2008, without any corresponding changes in inventory?

It makes sense to me that futures speculation could have prompted the earlier run-up. But it doesn't seem to explain the bubble that took oil from $70 to $140 a barrel. We might not be able to see OPEC inventories, but we can see their exports, and they didn't break trend during that period.

So something happened during that period. If it was speculation, it would have to be speculation unmediated by a past or concurrent rise in inventories. Your story clarifies a lot of oil market behavior since prices started their secular rise in 1999, but I'm still confused as to whether it had anything to do with that spectacular bubble in late '07.