What is going on in the oil market? Spot crude prices surged recently to over $38/bbl for WTI and longer-term futures prices are close to $28/bbl all the way out to December 2010. Although such high spot prices are unusual they are not unprecedented, especially given the low level of industry stocks at present and growing concerns about the reliability of future supplies. However, since the crude oil futures markets were created in the early 1980s longer-term prices have never been so high.
Many blame speculators for high oil prices. Long positions held by non-commercial traders (companies that have no offsetting position in the physical oil market)in the NYMEX WTI futures market are indeed at record levels. Some are therefore arguing that oil prices are distorted by growing numbers of speculators, who are entering the oil market because it offers better returns than other markets such as equities. OPEC, for example, says that high oil price levels remain predominantly a consequence of long positions of market speculators in the futures markets. Can all this be true? At first sight, the evidence seems supportive.There is no doubt that speculators have greatly increased the size of their positions in the crude oil futures market, both in absolute terms and as a share of the total number of long positions.
The fact there is such an obvious correlation between changes in crude oil prices and the long positions held by non-commercial traders further reinforces the view that speculators are responsible for pushing oil prices up to their current high levels. However, is this really enough to explain why oil prices are so high?Earlier work by the CGES on this subject argues that it is necessary to consider the role of hedgers as well as speculators in the oil futures market, since prices are set by the interaction between willing buyers and willing sellers,and neither side can trade without the other. As Figure 3 shows,there is also a strong correlation between changes in crude oil prices and the short positions held by commercial traders yet nobody would want to claim that oil prices are being inflated by a surge in short selling by oil companies!.
Furthermore, although there is clearly a close contemporaneous correlation between changes in oil prices and changes in the open interest positions of both speculators and hedgers, this does not mean that one necessarily causes the other as many commentators try to argue in the case of speculators. Establishing a causal relationship requires more elaborate statistical analysis that can test whether changes in WTI prices follow changes in the open-interest positions of hedgers or speculators or lead such changes. Once again, earlier work by the CGES on this question, covering a four-and-a-half-year period from 1995 to mid-1999, showed that there is no evidence to support the idea that changes in the open-interest positions of speculators (or hedgers) drive changes in oil prices. In fact, the reverse appears to be true changes in oil prices lead to changes in the open-interest positions suggesting that hedgers and speculators are trend followers,adjusting their open- interest positions over periods of a week or more in response to shifts in the oil price.
The results of this updated investigation of the behaviour of speculators and hedgers in the crude oil futures market are broadly consistent with earlier work by the CGES. Although speculators currently hold a much larger share of all open interest positions than they did in the earlier CGES study (covering the period 1995 to mid-1999), there is no evidence from the behaviour of prices and open interest that speculators are now in a position to influence prices. Speculators remain a volatile group of market participants, whose behaviour is highly responsive to prices and price expectations. If oil prices rise over a sustained period of time as, indeed, they have done over the past two years this creates expectations of further price rises. In these circumstances it is perfectly reasonable for a growing number of speculators to want to enter the market to buy futures contracts. However, this does not mean that they are responsible for driving prices up. It is clear from the results of the updated causality tests for the more recent 2000-2004 period that speculators are still price followers rather than price setters.
Yet, speculators obviously fulfil an important role in the crude oil futures market. If there were no speculators liquidity would be greatly reduced and hedgers would find it much more difficult to buy and sell futures contracts, especially when prices and price expectations are changing rapidly. In a rising market, speculators are prepared to buy futures contracts at a time when many hedgers may be reluctant to do so. However, speculators will only continue to buy as long as they expect prices to go on rising. Hedgers too will buy if they expect prices to continue to rise since they have offsetting positions in the physical oil market that they need to protect. The difference is that hedgers who buy oil futures are short of physical oil and would only hedge if they believe prices are on a sustained upward trend which will not be reversed within a time period that could benefit their underlying business. For example, an airline may not want to lock in the current high price of oil but may be forced to do so if it is selling tickets forward to customers and is worried that the cost of jet fuel will continue to rise in the meantime. Overall, it must be true that the level of prices in the futures market is set by the combined expectations of both hedgers and speculators.
If hedgers do not share the same price expectations as speculators, then there will be fewer hedgers willing to buy and sell futures contracts. However, hedgers are always active participants in the crude oil futures market. Although the share of commercial longs has fallen in response to the rising price trend, many hedgers continue to buy futures contracts at ever higher prices, indicating that there has been a major upward shift in price expectations over the past two years. Without this shift in expectations most long hedgers such as airlines and power generators would not be prepared to buy futures contracts at higher and higher prices, leaving speculators to hold most of the long positions in the crude futures market which they obviously do not.
Over the past two years, the price expectations of both hedgers and speculators have been moving upwards, indicating a fundamental re-appraisal of the outlook for oil prices in both the short and the longer term. The persistently steep backwardation in the crude oil futures market is easy to explain: it is consistent with the very low stock levels observed in recent years. However, the dramatic increase in long-term oil price futures from $20/bbl two years ago to $28/bbl today indicates a fundamental re-appraisal of the prospects for oil moreover, one that is shared by buyers and sellers alike. Without this change in long-run expectations oil markets would still be in steep backwardation, but longer-term oil futures prices would not be so high. Speculators alone cannot be blamed for a major shift in expectations that is clearly shared throughout the industry.