Target Oil Market Transparency, Not Speculation

High prices for crude oil and gasoline have returned a familiar scapegoat to the American political arena: speculators in the oil market. As oil prices touched $105 a barrel in April, President Obama unveiled a $52 million initiative designed to intensify regulatory efforts to prevent “an irresponsible few… [from] illegally manipulating or rigging the energy markets for their own gain.” Joseph P. Kennedy II, a former Democratic congressman and founder of the non-profit Citizens Energy, went even further in a New York Times op-ed. For oil and gasoline prices to return to affordable levels, Kennedy argued, “federal legislation should bar pure oil speculators entirely from commodity exchanges in the United States.”

Kennedy went on to charge speculators with driving up the price of oil purely for profit and detaching oil market prices from the cost of oil extraction. These accusations, as with Obama’s calls to “crack down” on speculators, undoubtedly reflect the sense of frustration among policymakers and ordinary Americans alike as oil prices—which have (despite a recent drop) remained around or above $100 per barrel for most of the last six months—continue to threaten the nascent economic recovery.

But is Kennedy’s call for a complete ban on oil speculation the answer? Unfortunately, his argument is grounded far more in opinion than fact. Ensuring effective market regulation, especially in the volatile markets for oil and other commodities, is a critical policy objective, and there is indeed much that could be done to strengthen current regulatory reform efforts. But a radical move like banning speculation entirely would do very little to address the root causes of high oil prices, and could very well exacerbate them.

Speculators and the Paper Market

For Congressman Kennedy, a primary factor behind today’s high oil prices is the impact of what he calls “pure” speculators: investors in oil futures contracts that do not take physical delivery of oil. But speculation should not be conflated with market manipulation. Though Kennedy may deride them as “middlemen” who “add little value and lots of cost,” these market participants actually play a critical role in maintaining oil price stability.

When a trader buys an oil futures contract, that trader is purchasing a contract to take delivery of oil at some future date. Oil producers and consumers use futures (and associated oil-based derivatives contracts) both to lock in prices for oil and protect themselves against sudden price swings. However, the buying needs of consumers (the quantity or quality of oil required and the price) seldom match the selling preferences of producers (the amount that producers are willing to sell and their asking price). As both sides seek to minimize their risk of losses in an unpredictable and volatile market, financial speculators generally assume this risk instead, brokering deals in the futures market between producers and consumers. Investment banks and commodity trading houses that buy and sell futures contracts may not actually take delivery of oil (though several do charter tankers and own storage facilities), but function to match buyers to sellers by providing needed liquidity in the marketplace. Banning them completely from the trading of oil futures would severely impair both this process of price discovery and the ability of producers and consumers to hedge against price volatility.

Kennedy rightly points out that the trading of “paper” barrels of oil greatly exceeds the trading of physical barrels, but the extent and frequency of non-physical trading does not necessarily point to price rises. As economist James Hamilton of the University of California at San Diego explains in his own response to Kennedy, the vast majority of these trades have a seller for every buyer and thus an offsetting mechanism exists to prevent the buyers from simply driving prices up.

Moreover, the sheer size of the oil futures market and its inherent volatility impose further constraints on would-be market manipulators. Oil futures trading is global, and the cast of non-physical oil traders extends far beyond a handful of investment banks, making the adoption of a common trading strategy by a concentrated group of buyers extraordinarily challenging, if not impossible. Then there remains the question of market risk. In an essay on defending oil market speculation, Blake Clayton of the Council on Foreign Relations notes that the futures market “imposes its own form of discipline rather well”: an oil company or trading firm that hoards oil in anticipation of higher future prices would be assuming an enormous risk if its speculative position turned out to be wrong.

Anticipating Future Fundamentals

Clayton and Hamilton point to the natural gas market to further illustrate that an increase in speculative activity need not result in higher prices for a commodity. According to Clayton, “financial firms have been even more active in this market,” with speculators holding 60 percent of natural gas futures traded on the New York Mercantile Exchange (NYMEX) in February 2012; he compares that figure to the 47 percent of NYMEX’s benchmark oil futures that were held by speculators during the same month. Then consider this chart comparing trends in oil and natural gas futures since 2002: far from showing significant increases, natural gas prices have plummeted to their lowest levels in over a decade.

Why the difference in price behavior? Because financial speculation is anticipatory, as traders gauge what the future market conditions for a commodity will be. Record-low natural gas prices reflect expectations that the current glut in supply—the result of advancements in drilling technology that have enabled the development of America’s vast shale gas reserves—will continue.

Oil prices also largely reflect the fundamentals of supply and demand, but these fundamentals have generally pointed to higher prices. Slowing demand from Europe and North America has been offset by growing demand from emerging economies such as China and India. Satisfying this demand has meant turning to more expensive sources of crude, such as deepwater offshore wells and Canada’s oil sands. In this context, Congressman Kennedy’s charge—that speculators have caused oil prices to become “disconnected from the costs of extraction, which average $11 a barrel worldwide”—is a red herring, since it is the marginal cost (the cost of bringing an additional barrel to market) rather than the average cost of extraction that determines the market price of oil. And energy analysts have found that the higher marginal cost of oil production from the newer, more expensive sources has helped keep oil prices above $90 a barrel.

Finally, global supplies of oil have been subject to numerous disruptions or the threat of disruptions. Last year the Arab Spring and the conflict in Libya pushed oil prices above the $100 mark for months, while the return of prices to these levels earlier this year reflected worries that tension with Iran might escalate and lead to a blockade of the Strait of Hormuz, a vital artery for Middle East oil exports. In a market environment defined by macroeconomic and geopolitical uncertainty and potentially tight supplies, traders have reason to anticipate that future oil prices will remain high.

Getting Regulation Right

From a regulatory perspective, banning or significantly restricting financial speculation from oil futures and derivatives markets would raise vexing legal questions and probably be counterproductive. Regulators would need to legally define “speculation,” not at all an easy task when the term could include almost any trade of commodity-linked securities. Equally difficult would be distinguishing necessary speculation (i.e., the brokering of deals between commodity producers and users) from excessive speculation. Excluding all but the physical producers and users from the oil market would remove the market’s primary hedging mechanism, leaving these two groups dangerously exposed to market risks. Another measure of restricting speculation, floated by President Obama, would be to increase margin requirements, or the amount of cash traders must put up as collateral. But this too could backfire, warned the International Energy Agency, by squeezing smaller traders out of the market and concentrating trading among a handful of large firms with the resources to meet the margin requirements; with fewer traders would come reduced liquidity and “more volatile, rather than more stable, oil markets.”

Yet speculators cannot be ignored. In a previous piece on commodities market regulation, I noted the spectacular growth of investment in commodities markets over the last decade and cited an economic paper that regarded these huge cash inflows as a potential source of increased market volatility. That argument remains contentious, but as these markets become ever larger, more fluid and systemically important, ensuring that regulators provide proper oversight will be critical.

So what steps, if any, can regulators take to curb oil price volatility?

Daniel Ahn, an energy fellow at the Council on Foreign Relations, has some suggestions. Oil markets, he correctly points out, are plagued by imperfect or unreliable data on supply and demand, with few countries outside a handful of industrialized economies providing consistent, reliable statistical releases. To mitigate the possibility of price swings based on imperfect information, Ahn calls for U.S. policymakers to use existing international energy data-sharing institutions, such as the Joint Organizations Data Initiative, to promote greater “physical transparency” in the oil market. Given the sensitive nature of this data to many countries, especially oil producers, achieving this goal will likely take years of negotiations and considerable diplomatic capital.

Ahn also calls for greater “financial transparency,” arguing that market regulators should require trading firms to regularly report trade data, which the regulators would then publicly release (while protecting the firms’ anonymity). In this way, regulators might be better able to monitor excessive risk-taking in the marketplace, while public releases of trade data would “reduce price volatility by anchoring prices to the terms of previous transactions.” Such transparency could be especially beneficial for the enormous and opaque derivatives market, where trades are executed not on centralized exchanges (as futures are) but “over-the-counter,” or bilaterally between producers, end users and speculators. In such a setting, broader access to information about market activity may act as a confidence-builder for market participants. Improved financial transparency could reduce the costs of trade execution and hedging, which would in turn attract new traders to the market and boost liquidity, while safeguarding against market manipulation by a few large and better-informed traders. American regulators are currently taking significant steps towards improving financial transparency under the 2010 Dodd-Frank Act, including instituting reporting requirements and public data releases.

Given the strategic importance of oil markets to the global economy and human welfare, popular demands to curtail price volatility are entirely understandable. But a complete ban on speculation in the futures market is not the solution, since the damage that such a ban would have on the market’s price-discovery and hedging mechanisms could only result in unpredictable market movements and potentially even higher prices. Moving towards greater physical and financial market transparency, however, could do much to remove significant barriers to diffusing information, a critical element to reducing uncertainty and price volatility in the marketplace.  It would also help market actors and policymakers to better gauge the global energy picture in their long-term investments and decisions. Such clarity will become vital to devising energy management strategies that adapt to a future of high oil prices, pushed up by the growing energy needs of developing countries and more expensive oil supplies. Transparency may not have the same populist ring to it as a ban on speculation, but it would go much further to move the world onto a path towards stable economic development and greater energy efficiency.