Table 1 breaks down open interest in crude oil futures and options on futures as of July 19, Notes: Figures are based on large, "reportable" positions of over contracts, which must be reported daily to the CFTC. Smaller positions are combined in the "Non-Reportable" category, which includes all types of market participants. The data in Table 1 prompt several observations about the market:. The figures show the amount by which long traders increased their long positions net buys and the amount by which short positions were increased net sells.
Thus, for each week and for class of trader, the data show whether on average long positions buys exceeded short position increases sells , or the reverse.
Figure 2 presents 1 the net figure of buys and sells for managed money trading, which includes trades of hedge funds, commodity pool operators, and others; and 2 changes in the price of oil during the same period. Each point in the graph represents a single week's change in these two figures: the net average sales or purchases by money managers and the price change over the same week.
The horizontal and vertical axes divide Figure 2 into quadrants. Data points located in the upper right indicate weeks when money managers were net buyers and the price of oil rose. Points in the lower left indicate weeks when the price dropped and money mangers were net sellers.
The other two quadrants indicate weeks when prices rose and money managers sold or when prices fell and they were net buyers: in other words, when their transactions and the price moved in opposite directions. Figure 2 suggests that there is a correlation between money manger transactions and price movements. The more prices fell, the more they tended to sell.
Very few data points fell into the upper left quadrant, that is, money managers were rarely net buyers when prices were falling. Indeed, the results of regression analysis, given in Appendix A , show that a strong and statistically significant correlation does exist between money manger transactions and price movements. Please see Appendix A for details of the regression. Here, there appears to be no correlation, or trend-line. Neither is there any apparent correlation between the trades of 1 swap dealers or 2 other speculators and price movements, as shown in Figure 4 and Figure 5.
Figure 2 suggests that crude oil futures are not a textbook case of an efficient market, where prices incorporating all known information about the commodity move in a random walk. The group of speculators classified as money managers appears able either to anticipate price movements or to cause those price movements through their trades. This observation raises some interesting questions. Why should money managers be better forecasters of oil price movements than other speculators or commercial hedgers?
Given that their long and short positions constitute a small share of the total market, why should money manager trades have a unique price impact? Most fundamentally, are money managers' trades determining prices or are they simply more adept than others in following trends or identifying information and news that will drive prices up or down?
Assuming that money managers have a unique impact on price, what is the mechanism by which their transactions—relatively small in terms of the total market—move prices? A possibility is that they affect intraday trading, which the available open interest data fail to capture. Short-term traders might observe and seek to copy the strategies of certain money managers who are regarded as especially capable of identifying new information that might be expected to move prices, or who simply have achieved superior returns in the past.
If significant numbers of short-term speculators copy money manager trades, the impact of those trades on prices would be magnified. In effect, under this scenario, money managers may have market power beyond what the size of their positions would suggest.
Such "herding behavior" among speculators, if it exists, would support arguments that the oil price at times includes a "speculative premium" above and beyond the price justified by the fundamentals. On the other hand, it may be that money managers do trade on fundamental information and that they are especially skilled at identifying news that is going to move prices. If money managers are consistent in their ability to identify new and relevant information that will affect prices and trade on that information before others do , one result would be the observed correlation.
A potential objection to this explanation is that it implies that some financial speculators are better analysts of the oil market than actual producers and end-users of oil, who also trade in the futures market.
Money managers might also profit by following price trends. Rather than cause price changes, they may buy when they see prices are rising and sell when prices begin to fall. But why would money managers' trading patterns, and not those of other market participants, be correlated with price changes in this way? Other market participants may have longer investment time horizons or be less sensitive to price changes. Hedgers, for example, are generally less affected by price changes, because whatever they may lose on their futures positions, they make back in the spot market because, for example, the physical commodity they produce will have gone up in price.
Similarly, swap dealer positions may reflect long-term commodity index investments by pension funds and other institutional investors who are seeking to allocate part of their portfolio to an asset class that is not correlated to other assets they hold, such as stocks and bonds.
Because the object of such investment is portfolio diversification, such investors are less likely to buy or sell in reaction to short-term price movements. Hedge funds, by contrast, are known for taking aggressive positions in search of high yields and for seeking to extract the maximum return from any price trend. A CFTC study referred to speculators "who take positions based on price expectations over a period of days, weeks, or months" as "trend followers.
If money manager trades can be said to cause price movements that is, if we assume that such trades cause price changes, rather than follow them , are they responsible for long-term price changes such as the run-up of prices in the first half of ? The data released by the CFTC do not support that conclusion. When weekly position changes are plotted against changes in price in the following week instead of the same week, as in Figures 2 though 5 , the correlation essentially disappears.
In other words, managed money trades may cause prices to rise or fall in the week they are made, but they do not appear to trigger longer price trends. The same is true over other time horizons. For example, Figure 6 shows changes in money manager positions and price changes four weeks later. The data suggest that there is no correlation between whether hedge funds and other money managers buy or sell this week and what happens to prices over the next month.
Figure 6. If derivatives speculators have mispriced oil during recent years, there are two ways this could have happened. The first is through deliberate manipulation of the price by a group of market participants. Knowing action to create artificial prices is a violation of the Commodity Exchange Act, and the regulators and exchanges have market surveillance programs to detect attempted manipulation.
The second possibility is much harder to evaluate: do derivatives markets in their normal operation have the potential to distort prices? Section 4a a of the Commodity Exchange Act describes "excessive speculation" as "an undue and unnecessary burden on interstate commerce," but there is no statutory or regulatory definition of the term.
There is an extensive literature on the relationship between speculation and commodity prices, but the question is not settled—the data are subject to conflicting interpretations. The Commodity Exchange Act CEA , the statute which governs the regulation of commodities and futures markets, makes it a felony to manipulate or attempt to manipulate the price of a commodity, including one for future delivery.
Section of the Dodd-Frank Act P. On April 21, , President Obama announced that the Attorney General was assembling a team to root out any fraud and manipulation in the oil markets that might be contributing to higher U. In May , the CFTC filed an enforcement action against three energy trading firms and two individuals, charging them with a series of manipulations between January and April a period when prices were rising rapidly.
They did so by buying large quantities of physical oil, causing market participants to revise downwards their estimates of the amount of oil available to settle maturing futures contracts.
This perception of limited available supply drove up the price, allegedly earning the defendants profits from a long position in futures. Then, having taken profits from the long position, the traders liquidated their physical oil holdings very rapidly, depressing the price and allowing them to profit from a short position in futures.
Their futures positions were calendar spreads—a long contract for one month and a short contract for another month. The CFTC complaint does not state how much or even whether the alleged scheme affected the price of oil itself—since the defendants were trading spreads, the absolute price level was less important to them than the difference between the various month contracts.
Thus, although manipulations do occur in futures markets, this case even if all allegations are proven appears to involve short-term price dislocations that do not explain the price run-up in , as it continued after the alleged manipulation ended. There are two opposing theoretical views on speculation. The first is that it tends to stabilize prices and make the price-setting mechanism more efficient; the second is that at times speculation causes price trends that cannot be explained by fundamental economic factors.
People who argue that speculation is generally destabilizing seldom realize that this is largely equivalent to saying that speculators lose money, since speculation can be destabilizing in general only if speculators on the average sell when the [commodity] is low in price and buy when it is high. To make money, speculators must be able to buy low and sell high. By so doing, they smooth out the peaks and troughs of commodity prices. If they are unable to do this successfully, if their price forecasts are more often wrong than not, they will be driven out of the market by their losses.
This benevolent view of speculation is generally supported by empirical research into the effects of futures trading on cash market prices.
Although the issue cannot be regarded as settled, numerous studies have found that the existence of a futures market either has no effect on or tends to reduce price volatility in the underlying commodity.
For example, a recent Federal Reserve study compared price movements over the period in industrial metals for which there is a futures market and metals for which no futures contract exists. Instead, commodity spot price changes are driven by world economy activity and financial investors are merely responding to these price changes.
The Task Force's preliminary assessment is that current oil prices and the increase in oil prices between January and June are largely due to fundamental supply and demand factors.
During this same period, activity on the crude oil futures market—as measured by the number of contracts outstanding, trading activity, and the number of traders—has increased significantly. While these increases broadly coincided with the run-up in crude oil prices, the Task Force's preliminary analysis to date does not support the proposition that speculative activity has systematically driven changes in oil prices.
More specifically, the report found that "changes in futures market participation by speculators have not systematically preceded price changes. On the contrary, most speculative traders typically alter their positions following price changes, suggesting that they are responding to new information—just as one would expect in an efficiently operating market. From an opposing theoretical perspective, speculation is seen as a potential source of price instability.
Describing the behavior of investors, J. Keynes distinguishes between enterprise, the activity of forecasting the long-term yield of assets, and speculation, the activity of forecasting the psychology of the market. As speculators, he wrote, " A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield.
More fundamentally, Keynes wrote that "when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. If speculators bring new fundamental information to the market, their trading should not only be profitable but should make the price discovery mechanism more efficient. When prices appear to diverge from economic reality, when a price bubble forms, many conclude that speculators are distorting the price-setting mechanism.
There are several explanations for how price bubbles expand—irrational exuberance, positive feedback, 32 herding, and so on—but the process by which bubbles start and end remains little understood.
How is it possible to know at any given moment whether speculation is playing a stabilizing role or whether markets are behaving irrationally? Which model of speculation best describes reality? The Commodity Exchange Act states that speculation may distort prices when it becomes excessive.
The term "excessive speculation" does not provide a precise tool for distinguishing between beneficial and harmful speculation—"excess" is in the eye of the beholder—but it does provide a framework for analyzing the impact of speculation on the oil market. Section 4a a of the Commodity Exchange Act declares that "[e]xcessive speculation in any commodity The point at which speculation becomes excessive is left to the regulator to determine: there is no statutory definition or benchmark.
To many observers, phrases like "sudden or unreasonable fluctuations" and "unwarranted changes in the price" aptly describe the oil markets of and When oil prices are high and volatile, and there have been no dramatic supply shocks, many blame financial speculation.
The case against oil speculators, or rather the case that oil speculation has become excessive, rests principally on two arguments. First, there is said to be too much speculative trading. While it is generally acknowledged that hedgers benefit from the presence of speculators willing to take on the risks that hedgers wish to avoid, the argument is made that financial traders have overwhelmed the market.
Rather than simply provide liquidity to hedgers, speculators now account for the majority of contracts. As Table 1 shows, commercial hedging positions account for less than half of all crude oil contracts outstanding. The tail, in this view, is wagging the dog.
This view is supported by studies from the staff of the Permanent Subcommittee on Investigations PSI of the Senate Committee on Homeland Security and Government Affairs, which found that excessive speculation has had "undue" influence on wheat price movements 35 and in the natural gas market. Amaranth's trading demonstrates that excessive speculation can distort futures prices not only in the next month or two, but for many months into the future. Currently, the major focus of the CFTC and the exchanges is to prevent excessive speculation from disrupting orderly trading of a contract near the expiration of that contract.
The CFTC and the exchanges need to be vigilant to ensure that traders' speculative positions in futures contracts several seasons, or even several years, in advance are not distorting prices. Also, a report by the minority staff of the House Committee on Oversight and Government Reform argues that "addressing excessive speculation offers the single most significant opportunity to reduce the price of gas for American consumers.
When financial institutions and investors as a group move funds into commodity markets, prices move. Even though increased financial speculation does not rise to the level of illegal manipulation, critics argue that the economic impact is the same.
In theory, higher volumes of speculative trading should not necessarily lead to more price volatility, if financial speculators base their trading decisions on the same factors as those of other market participants.
But do they? The second part of the case that excessive speculation is destabilizing is that speculators do not trade on the fundamentals. The argument is that because financial speculators never produce or take delivery of physical oil, they bring to the market strategies and expectations that, in Keynes' phrase, "do not really make much difference to the prospective yield" of the asset. As a result, prices are subject to violent swings even though there has been no significant change in underlying supply and demand.
When oil prices are high, it is common to speak of a "speculative premium," meaning that the market price is higher than what the fundamentals of supply and demand justify, and that the excess is caused by uninformed speculation. I would give you just one benchmark. Now, nothing had changed in the global supply the next day, so what was the market reacting to?
It was reacting to some level of insecurity about what the future supply was going to be. So that is people pricing into the global market what they believed their cost is going to be sometime in the future, building in their concerns and their worries about other possible supply disruptions and the ability of the market to respond to that. In other words, possible future supply and demand events are properly factored into today's price, even though those events may never occur.
Present-day supply and demand conditions are fundamentals, but so are expectations about the future. In general, free markets are expected to distinguish between relevant fundamental information and extraneous "noise" that causes prices to drift away from fundamental values.
The argument that speculation is distorting the oil market is based on one or both of two presumed mechanisms: 1 excessive speculation by financial traders is economically if not legally equivalent to price manipulation, and 2 speculators introduce unwarranted volatility by trading on information unrelated to fundamentals.
The next section of this report briefly analyzes the fundamentals of the oil market and suggests that sharp swings in the price of oil do not necessarily mean that prices are not based on fundamentals. A number of factors have contributed to higher prices for oil and other energy commodities. Rapid global economic growth led to rising demand for oil, and supply could not keep up at previous prevailing oil prices.
In theory, this contributes to prices rising until some consumers no longer buy oil and producers provide more supply, putting the market in balance again. But oil supply and demand is inelastic to price changes, especially in the near-term, which means it may take a larger percentage change in prices to incentivize relatively small changes in supply or demand.
Global economic growth increased demand for oil. Economic growth is the leading driver of oil demand. See Figure 7. These countries were going through the energy-intensive process of industrialization, which required greater use of energy sources such as oil and coal.
Oil supply growth, on the other hand, faced a number of hurdles. Oil resources in key oil exporting countries like Mexico, the United Kingdom, and Norway had been depleted and were in decline.
Other key sources of oil supply experienced supply disruptions that reduced production. Examples included strikes in Venezuela in , periodic militant attacks in Nigeria particularly since , and hurricanes in the Gulf of Mexico sometimes shutting down offshore U. Further, some countries with abundant oil resources maintained or raised new barriers to private investment in oil exploration and production, such as increasing the national oil company's control of the energy sector, raising industry taxes, or effectively nationalizing shares in some oil producing assets.
This Site. Google Scholar. Carol Dahl Carol Dahl. Published: May 19 Abstract This paper considers the role of hedging and speculation on future oil prices. Copyright , Society of Petroleum Engineers.
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In the early days, finding oil during a drill was considered somewhat of a nuisance as the intended treasures were normally water or salt. It wasn't until that the first commercial oil well was drilled in the Absheron Peninsula, Azerbaijan. The U. Drilling in the United States began in the early s, but they were drilling for brine so any oil discovery was accidental. This site produced more than , barrels of oil in one day, more than all the other oil-producing wells in the United States combined.
Many would argue that the modern oil era was born that day in , as oil was soon to replace coal as the world's primary fuel source. The use of oil in fuels continues to be the primary factor in making it a high-demand commodity around the globe, but how are prices determined?
The two primary factors that impact the price of oil are:. The concept of supply and demand is fairly straightforward. As demand increases or supply decreases the price should go up. As demand decreases or supply increases the price should go down. Sounds simple? Not quite. The price of oil as we know it is actually set in the oil futures market. Under a futures contract, both the buyer and the seller are obligated to fulfill their side of the transaction on the specified date.
In the spring of , oil prices collapsed amid the economic slowdown. OPEC and its allies agreed to historic production cuts to stabilize prices, but they dropped to year lows. The following are two types of futures traders:. An example of a hedger would be an airline buying oil futures to guard against potential rising prices. An example of a speculator would be someone who is just guessing the price direction and has no intention of actually buying the product.
The other key factor in determining oil prices is sentiment. The mere belief that oil demand will increase dramatically at some point in the future can result in a dramatic increase in oil prices in the present, as speculators and hedgers alike snap up oil futures contracts. Of course, the opposite is also true. The mere belief that oil demand will decrease at some point in the future can result in a dramatic decrease in prices in the present as oil futures contracts are sold possibly sold short as well , which means that prices can hinge on little more than market psychology.
Basic supply and demand theory states that the more a product is produced, the more cheaply it should sell, all things being equal. It's a symbiotic dance. The reason more of a good was produced in the first place is because it became more economically efficient or no less economically efficient to do so. If someone were to invent a well stimulation technique that could double an oil field 's output for only a small incremental cost , then with demand staying static, prices should fall.
Actually, there have been periods of time when supply has increased. Oil production in North America was at an all-time zenith in , with fields in North Dakota and Alberta as fruitful as ever. This is where theory pushes up against practice. Production was high, but distribution and refinement were not able to keep up with it. The United States has built an average of one refinery per decade construction has slowed to a trickle since the s. There's actually a net loss : the United States has two fewer refineries than it did in Since the beginning of oil's rise as a high-demand commodity in the early s, major peaks in the commodities index have occurred in , , and Oil peaked with the commodities index in both and Note: there was no real peak in oil in because it had been moving in a sideways trend since and continued to do so through Then there's the problem of cartels.
Although the organization's charter doesn't explicitly state this, OPEC was founded in the s to—put it crudely—fix oil and gas prices. By restricting production, OPEC could force prices to rise, and thereby theoretically enjoy greater profits than if its member countries had each sold on the world market at the going rate.
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