Financial speculators are widely blamed for artificially inflating prices in physical commodity markets and regulators have come under pressure to draft new rules that will limit speculative trading. The US Dodd-Frank Wall Street Reform and Consumer Protection Act requires the Commodity Futures Trading Commission (CFTC) to set new limits on speculative trading positions for both futures exchanges and OTC (over-the-counter) markets. Yet little effort is being made to understand the role of speculators in commodity markets.
Speculators are important for the futures and options markets, acting as counterparties for hedgers and providing essential extra liquidity to facilitate transactions. Although the speculative share of the NYMEX WTI market has expanded rapidly over the past decade, much of the growth was in spread trading, which does not affect the net positions of speculative traders. Spread trading represents 70pc of the combined open interest positions of futures and options and the CGES' calculations using Holbrook Working’s speculative T-index do not indicate that excessive speculation took place. The growth of spread trading has improved price discovery in NYMEX's WTI market by extending open interest and liquidity out along the forward curve.
The CFTC’s disaggregated Commitments of Traders (COT) report provides new insights into the behaviour of speculators, who are now broken down into three categories — swap dealers, managed money and 'other reporting' traders. Simple correlations between the net open interest positions of hedgers and the three speculative trader categories suggest a two-stage market in which managed money operators and 'other reporting' traders provide the main counterparties for hedgers, with swap dealers and managed money operators also trading extensively with each other.
Regulators seeking to impose speculative position limits for derivatives markets need to recognise the importance of speculative trading both in satisfying hedging needs and improving market liquidity and price discovery. Although spreads are not expected to be included in overall (all-month) position limits, they may be taken into account when setting position limits for a single contract month. If this ends being the case, speculative traders may find that single-month position limits inhibit their scope for spread trading, reducing liquidity further out along the forward curve for longer-dated contracts and impairing price discovery in the crude oil market.