Are "Speculators" Controlling Oil Prices?
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. The Energy “Blame Game”
2. Commodities Gain In Popularity
3. Are Speculators Driving Prices Higher?
4. Merrill Lynch Study On Speculators In Oil Futures
5. So What Is Driving Commodity Prices Higher?
6. “Let’s Shoot The Speculators” – by Robert Samuelson
7. My Own Thoughts On The Role Of Speculators
8. Finally, Should Speculators Be Stopped?
Oil and gasoline prices have doubled in just the last 18 months. $4.00+ a gallon gasoline prices have shocked our nation and potentially threaten our economy. Blame has to be placed somewhere, supposedly, and consumers and the media are looking anywhere they can for the culprits. This must be some form of manipulation, right? But by whom?
As oil prices soared above $100 per barrel, the media and even some in Congress have sought to place the blame for soaring energy prices on the so-called “speculators” in the commodity futures markets around the world. Never mind that speculators - those who seek to profit from their commodities trading (but often don’t) - have been a critical part of the futures markets since their inception.
So are today’s soaring oil and gasoline prices simply the result of supply/demand issues, or is there something more sinister going on? This week, we will focus on the energy futures markets and what is driving prices. Long-time readers will recall that I have a long history in the commodities futures markets dating back to late 1975. I have seen markets like this before, and I have some insights regarding speculators that you may appreciate.
I will also review the latest in-depth study by Merrill Lynch on the subject of whether speculators are driving up oil prices. What follows may surprise you, or maybe not. Let’s get started.
The Energy “Blame Game”
As oil prices began to double over the last year, the initial culprits were thought to be – at least in the media – China, India and other developing nations who were/are sharply increasing their energy usage. Yet as energy prices continued to soar, the culprits then became the “Big Oil” companies who were/are earning record profits.
The blame was also focused on OPEC – why can’t they produce more? Never mind that OPEC can’t increase oil output like they could back in the 1970s and ’80s. Along with OPEC, blame was also laid at the foot of the falling US dollar (oil is priced in dollars), and to a lesser extent, the Fed for its easy money policies over the last two years.
More recently, as oil prices continued well above $100 per barrel, the blame game has increasingly turned to so-called “speculators” who trade in the commodity futures markets in crude oil and gasoline, as well as other markets. Yet speculators have been a critical part of the commodity futures markets since their very beginnings. Speculators provide the liquidity required to allow those who actually deal in the underlying commodities – producers, dealers, users, etc. – to “hedge” their prices well into the future.
Unlike stocks and bonds, the commodity futures markets are a “zero-sum game” in that for every dollar gained, a dollar is lost. Likewise, in the futures markets for every buyer, there must be a seller and vice versa. If speculators, on balance, want to buy crude oil futures, there must be a seller for each and every contract traded.
Commodities Gain In Popularity
Over the last eight years, we have seen an explosion in new interest in commodity futures and derivative instruments. For purposes of this discussion, the words “futures” and “derivatives” may be used interchangeably. According to the Bank For International Settlements (BIS), the total contract value of all outstanding derivatives traded on organized exchanges globally - in stock indexes, currencies and interest rate derivatives alone - are now more than four times greater than they were in 2000.
Likewise, BIS reports that the total contract value outstanding in OTC derivatives has increased five-fold globally in the same period of time. Equity, currency and interest rate derivatives - the so-called “financial futures” – do not include dozens of other futures and derivatives markets in such commodities as energy, metals, grains and foods, etc., which have also seen their total contract values outstanding skyrocket over the past eight years.
As this phenomenal growth has occurred, the “open interest” in most commodity derivatives increased significantly. Open interest is merely the total number of outstanding contracts on the various futures exchanges at any given time.
The obvious question is, where is all this new interest coming from and why is it happening? With global demand for commodities rising every year, the production of commodities has risen significantly in most cases over the last decade. As a result, there has been a corresponding rise in the need to hedge these physical commodities in the futures markets. Add to that the fact that more and more producers, dealers and users of commodities are hedging their transactions.
On the other side of the fence are the so-called speculators, and the number and types of players in this world have expanded dramatically over the last decade as well. In basic terms, any entity that trades in the commodity futures markets, but is not involved in the actual production, distribution or usage of commodities directly, is considered to be a speculator.
While the commodity futures markets were shunned by many so-called “institutional investors” for many years, we have seen a dramatic change in this view over the last 10-15 years, and especially in the last several years. Institutional investors have increasingly accepted commodity futures and other derivatives as a legitimate “asset class” that can provide additional portfolio diversification.
Institutional investors are organizations which pool large sums of money and invest those sums in various asset classes. They include banks, insurance companies, retirement funds, pension funds, hedge funds, Commodity Trading Advisors, managed futures funds, and even the more recent commodity-linked mutual funds and ETFs. Over the last decade, we have also seen the entrance of so-called “sovereign wealth funds,” which are state/government-owned investment funds that allocate money around the world.
Institutional investors in all of these categories have significantly increased their exposure to commodity futures and other derivative instruments over the last decade. The number of individual investors who participate in the commodity futures markets has increased over the last decade as well, but this group pales in comparison to the institutional investors.
The combination of the increasing demand for hedging of commodities, and the significant rise in the number of institutional investors, has led to an explosion in not only open interest (as discussed above), but also trading volume in most commodity futures and other derivative markets.
Are Speculators Driving Prices Higher?
Over the last couple of months as the blame game has intensified, we have seen increasingly spirited debate over whether this large increase in commodity futures and derivative products investing in recent years has caused the prices of many commodities to become disconnected from the underlying fundamentals of supply and demand.
Politicians in Washington, of course, saw this debate as an opportunity to get involved. The Senate has held hearings with the purpose of determining if institutional investors (i.e. – speculators) were/are driving energy and food prices well above what the supply and demand fundamentals justify. Lawmakers have heard opinions on both sides of the issue.
One hot spot was the rapid rise in so-called “commodity index-linked funds” – those which are designed to follow a certain commodity index or a certain market sector. Lawmakers heard arguments on both sides as to whether these popular index products are, or are not, partially to blame for soaring commodity prices.
This debate is far from over – I will come back to it later on.
Merrill Lynch Study On Speculators In Oil Futures
On June 17, Merrill Lynch released a 17-page study addressing the question of whether or not “speculators” are largely responsible for the soaring price of oil and other commodities. I’m not sure why the study was sent to me since I am not a client of Merrill Lynch, but I found the study quite interesting nonetheless. I asked Merrill Lynch for permission to reprint the study, but I was denied, so I’ll summarize it for you below.
On the question of whether the dramatic growth in the commodity futures and derivatives markets in recent years is a good or a bad thing, Merrill Lynch (ML) unequivocally believes that the significant increase in participation and open interest and trading volume is very positive. ML bases its opinion on the fact that the world economy is growing and production capacity in numerous commodities needs to be expanded significantly. As a result, ML contends that the derivatives markets need to continue to expand at a rapid rate to allow producers and users of commodities to be able to hedge their price risk.
ML presented various data to support their view that the dramatic increases we’ve seen in open interest and trading volume in commodity derivatives in recent years has not contributed significantly to the rise in prices. Likewise, ML presented data refuting claims that the rapid growth of commodity index-linked funds are dominating the markets and thus driving prices significantly higher. In fact, ML cites US Commodity Futures Trading Commission data which show that index traders’ share of total open interest has been sideways for the last two years.
ML also presented data refuting claims that commodity index-linked funds tend to distort “spot” prices when they have to roll their long futures contracts forward every few months. Some argue that because these index funds have to sell their soon-to-mature positions every few months and buy contracts further out in maturity, that they somehow cause spot prices to move higher. ML refutes this line of thinking with some interesting data. I happen to agree with ML on this one, but for different reasons.
ML also debunks the argument some are making that speculators drive commodity prices artificially higher because they supposedly take supply away from the market. This argument has never held up because speculators rarely take physical delivery of the commodities in which they trade. They are simply buying and selling futures contracts, not actual physical commodities.
So What Is Driving Commodity Prices Higher?
Merrill Lynch argues, and most analysts agree, that commodity prices – energy and food in particular – are being driven higher by a combination of factors. Obviously, supply and demand fundamentals are at or near the top of that list. Global demand for energy in the years ahead may well outpace supply unless conditions change. This is a major reason why crude oil prices have skyrocketed over the last 12-18 months.
But could conditions change? Certainly. With oil prices above $140 per barrel and gasoline above $4.00 per gallon (and much, much higher in many parts of the world), that will serve to decrease demand and increase supply over time. By how much we don’t know. Time will tell. The current soaring price of oil will also spark additional research into alternative sources of energy that may reduce our dependence crude.
Grain prices (and thus food prices) have been driven significantly higher in large part because corn, soybeans and other crops are being diverted from the food chain to the production of ethanol and bio-fuels, which is a questionable and very risky proposition in my opinion (see my June 3 E-Letter on ethanol). The current record high grain prices are almost certain to decrease demand and increase supply over time. By how much we don’t know. Here too, time will tell.
ML also points out in its report that Fed monetary policy over the last two years has, in their view, contributed to a rise in inflation, especially in the US, which has also fueled interest in commodities. ML states: “Looking back thirty years, we find that a 1% reduction in real interest rates results in a 17.5% increase in spot commodity prices 10 months later. This estimate suggests that loose monetary policy has played a much more important role than speculators in the recent commodity price rally.”
Frankly, I have never heard or seen any data that suggest a 1% reduction in real interest rates results in a 17.5% rise in commodity prices less than a year later, and the ML study did not provide any backup for the statement. That seems high to me, but I trust ML would not make such a statement were there not empirical data to support the claim.
I would add that Fed monetary policy over the last two years has contributed to the glut of global liquidity, much of it in US dollars which have gone down in value. While the ML report does not say so specifically, many believe the prolonged weakness in the US dollar and the extremely low interest rates in the US have fostered a desire among many of our trading partners to invest their dollars in areas that have the potential to offset the declining value of the greenback. Commodities and derivatives have increasingly become the sectors of choice.
ML Says Speculators Are Not The Problem
This summary of the Merrill Lynch study is greatly abbreviated, but I believe it adequately represents their main points. It is true that energy and food prices have moved sharply higher during a period when global interest in commodities investments was also soaring, and trading volume in futures and other derivatives increased significantly. However, ML concludes:
The following article by Robert Samuelson seems to support Merrill Lynch’s conclusion that speculators are not the main reason for soaring oil and commodity prices. Samuelson is a contributing editor for Newsweek and the Washington Post and has written on business and economics for over 30 years.
Tired of high gasoline prices and rising foods costs? Well, here's a solution. Let's shoot the speculators. A chorus of politicians, including John McCain and Barack Obama, blames these financial slimeballs for piling into commodities markets and pushing prices to artificial and unconscionable levels. Gosh, if only it were that simple. Speculator-bashing is another exercise in scapegoating and grandstanding. Leading politicians either don't understand what's happening or don't want to acknowledge their own complicity.
Granted, raw material prices have exploded across the board. From 2002 to 2007, oil rose 177 percent, corn 70 percent, copper 360 percent and aluminum 95 percent. But that's just the point. Did "speculators" really cause all those increases? If so, why did some prices go up more than others? And what about steel? It rose 117 percent -- and has increased further in 2008 -- even though it isn't traded on commodities futures markets.
A better explanation is basic supply and demand. Despite the U.S. slowdown, the world economy has boomed. Since 2002, annual growth has averaged 4.6 percent, the highest sustained rate since the 1960s, says economist Michael Mussa of the Peterson Institute. By their nature, raw materials (food, energy, minerals) sustain the broader economy. They're not just frills. When unexpectedly high demand strains existing production, prices rise sharply as buyers scramble for scarce supplies. That's what happened.
‘No one foresaw that China would grow at a 10 percent annual rate for over a decade. Commodity producers just didn't invest enough,’ says analyst Joel Crane of Deutsche Bank. In industry after industry, global buying has bumped up against production limits. In 1999, surplus world oil capacity totaled 5 million barrels a day (mbd) on global consumption of 76 mbd, reckons the U.S. Energy Information Administration. Now, the surplus is about 2 mbd -- and much of that is high-sulfur oil not prized by refiners -- on consumption of 86 mbd.
Or take non-ferrous metals, such as copper and aluminum. ‘You had a long period of underinvestment in these industries,’ says economist John Mothersole of Global Insight. For some metals, the collapse of the Soviet Union threw added production -- previously destined for tanks, planes and ships -- onto world markets. Prices plunged as surpluses grew. But Mothersole says ‘the accelerating growth in India and China eliminated the overhang.’China now accounts for up to 80 percent of the world's annual increased use of some metals.
Commodity price increases vary, because markets vary. Rice isn't zinc. No surprise. But ‘speculators’ played little role in these price run-ups. Who are these offensive souls? Well, they often don't fit the stereotype of sleazy high rollers: Many manage pension funds or university and foundation endowments.
Their trading might drive up prices if they were investing in stocks or real estate. But commodity investing is different. Investors generally don't buy the physical goods, whether oil or corn. Instead, they trade ‘futures contracts,’ which are bets on future prices in, say, six months. For every trader betting on higher prices, another is betting on lower prices. These trades are matched. In the stock market, all investors (buyers and sellers) can profit in a rising market, and all can lose in a falling market. In futures markets, one trader's gain is another's loss.
Futures contracts enable commercial consumers and producers of commodities to hedge. Airlines can lock in fuel prices by buying oil futures; farmers can lock in selling prices for their grain by selling grain futures. The markets work because numerous financial players – ‘speculators’ in it for the money -- can take the other side of hedgers' trades. But the frantic trading doesn't directly affect the physical supplies of raw materials. In theory, high futures prices might reduce physical supplies by inspiring hoarding. But that's not happening now. Inventories are modest. World wheat stocks, compared with consumption, are near historic lows.
Recently, the giant mining company Rio Tinto disclosed an average 85 percent price increase in iron ore for its Chinese customers. That affirmed that physical supply and demand -- not financial shenanigans -- is setting prices: Iron ore isn't traded on futures markets. The crucial question is whether these price increases will continue or ease as demand abates and investments in new capacity expand supply. Prices for some commodities (lead, nickel) have receded. Could oil be next?
Politicians promise to tighten regulation of futures markets, but futures markets aren't the main problem. Scarcities are. Government subsidies for corn-based ethanol have increased food prices by diverting more grain into biofuels. A third of this year's U.S. corn crop could go to ethanol. Restrictions on oil drilling in the United States have reduced global production and put upward pressure on prices. If politicians wish to point fingers of blame, they should start with themselves. END QUOTE
My Own Thoughts On The Role Of Speculators
The commodity futures and options markets exist primarily to provide a mechanism whereby producers, dealers and users of commodities can hedge their price risk. For example, a corn farmer can lock in the price of his crop by shorting (selling) corn futures months before the crop is actually harvested and brought to market. A jeweler who buys gold on a regular basis can lock in his price of gold months in advance by buying gold futures. The list of potential hedgers spans many industries around the globe and grows continually.
The hedger is not in the market to make a profit on its futures positions. Rather, the hedger is in the market in the hopes of insuring a profit on the commodity it produces, deals in, or uses. Often times, the futures market goes against the hedger, and margin calls must be met to cover losses. The potential for margin calls is a price hedgers are more than willing to pay to have futures markets which provide a mechanism by which they can protect their profit margins.
Another basic point to understand is that each time a hedger needs to buy or sell, there has to be another entity to take the opposite side of the trade. Speculators (as described above) provide the liquidity in the futures markets so that hedgers can get their trades executed. If a corn farmer wants to hedge his crop today by shorting corn futures at the lofty price of $7.00 per bushel, there will be speculators who believe corn prices are going even higher and will buy and take the other side of the trade.
Thus, there is no doubt that speculators provide an invaluable service in creating liquidity in the commodity futures markets across the board and always have.
Are Speculators Controlling Oil Prices?
The question many are asking, in light of the explosion in commodity prices over the last 12-18 months, is whether speculators have caused commodity prices – particularly energy and food - to soar far beyond the levels that are justified by supply and demand?
Merrill Lynch says no. ML says these markets are being driven primarily by the underlying supply/demand fundamentals, not by speculators. Robert Samuelson apparently agrees. I would argue, however, that soaring commodity prices are being driven higher by a combination of factors, including increased interest from speculators.
In the oil market, for example, the supply/demand fundamentals include such obvious things as how much oil is being produced versus how much oil is being consumed. Clearly, global oil consumption has risen significantly in recent years, while exploration and development of new sources of oil have lagged. That suggests higher oil prices.
In addition, there are numerous other factors beyond production versus consumption that affect the prices of commodities. There are various “risk premia” built into energy and other commodity prices including, in some cases, weather, war (or the risk of war), geopolitical factors, inflation/Fed policy/interest rates, transportation risks/costs, insurance and storage costs, etc. Many analysts believe there is a geopolitical premium in oil prices simply because of the instability in the Middle East and the war in Iraq. I happen to agree.
Many analysts also believe, and I agree, that the significant growth in the number of speculators in the futures and derivatives markets has served to add yet another premium to oil and other soaring futures prices. The question is, how much? The answer is, no one knows.
There are those who believe (honestly, I suppose) that crude oil prices would still be around $50-$60 per barrel if it weren’t for the speculators. At $140 per barrel, that would mean a speculative premium of $80-$90 per barrel. In my view, that is hogwash! At the other end of the spectrum, there are those who believe there is no premium due to the increased number of speculators in the markets today. I don’t buy that either.
Commodity prices have a long history of overshooting, both on the upside and the downside. There is no precise way to determine just how much of the overshoot is the result of speculators jumping in the market. If I had to guess, I would venture that no more than 10% of the current price of oil is due to speculative froth.
Some argue that the speculative premium is much higher because they say most institutional investors only buy futures. This is not true, in my opinion. One reason I would cite for the speculative premium being so low is the fact that many institutional investors are not in a “long-only” strategy. Much of the institutional money in the oil futures markets is from large pension funds and retirement funds that have allocated money to commodities in recent years.
Much of the pension/retirement fund money that has been allocated to commodities has been invested with registered Commodity Trading Advisors (CTAs), such as those we use in the commodity funds my company sponsors. There are very few successful CTAs that use a long-only strategy. Most CTA strategies are just as likely to be short as they are to be long.
Notice in the New York Mercantile Exchange (NYMEX) crude oil futures chart above that daily trading volume and the open interest (total open contracts) have roughly doubled over the last two years as more and more speculators entered the market (see lines near bottom of chart).
But keep in mind that for every contract that is bought “long,” another market participant has to sell “short” to complete the trade. Obviously, the short sellers have been taking it on the chin for months on end, but remember that many short sellers are hedgers who are merely shorting the market to insure a profit margin.
Finally, Should Speculators Be Stopped?
There are many in the public who are urging politicians in Washington to “do something” to bring down oil and gasoline prices. As noted earlier, Congress has held hearings and heard arguments on both sides. Some argue that speculators should be prohibited from trading in the commodity futures markets altogether. That would kill the futures and derivatives markets, plain and simple. Hedgers – producers, dealers and users - would have no way to lock in prices in advance.
Despite that risk, on June 18, a bill was introduced by Senators Joe Lieberman (I – CN) and Susan Collins (R-MN) that would prohibit pension funds, hedge funds, index funds and institutional investors in general from trading in the commodity futures markets. This bill is dangerous and misguided, and I do not believe it will see the light of day.
Another frequent argument for controlling speculation is that the NYMEX should raise the margin requirement for speculators to buy and sell crude oil futures. Currently, the NYMEX margin required to hold a crude oil futures contract (long or short) is just under $12,000 for non-members. The contract size is 1,000 barrels of crude, and at a price of $140 per barrel, the contract represents $140,000. So the margin requirement is just under 10% of the contract value, which is consistent with many other margin requirements for commodity futures contracts.
The problem is that if the NYMEX were to raise the margin requirement significantly, many participants – hedgers and speculators – would move their oil trading to foreign commodity futures exchanges that offer lower margin rates. Given this real possibility, it will be interesting to see if the US Commodity Futures Trading Commission decides to force the NYMEX to raise its margin requirements for oil and possibly other commodity futures markets as well. Personally, I think this also would be a serious mistake, as would most of the anti-free market suggestions floated in Washington hearings recently.
The bottom line is, surging world demand for oil, and lagging exploration and development of new oil sources, were a recipe for a price explosion sooner or later. Legislators in Washington are certainly in part responsible by restricting where we can drill for oil and prohibitive regulations on refineries. As a result of these factors and certainly others discussed above, oil prices have skyrocketed.
As discussed earlier, commodity prices – and oil in particular - have a history of overshooting, both on the upside and the downside. In my view, oil prices have overshot on the upside, and may continue to do so. But it certainly is not solely or primarily because speculators are buying oil futures contracts.
There are those who contend that oil and gasoline prices are in a “bubble,” not unlike the tech stock bubble in the late 1990s. I would argue that the soaring prices of energy are far more supported by supply and demand than the “dot.coms” ever were. Nevertheless, I do believe oil prices have overshot on the upside and will come down hard at some point.
When that happens, many of the speculators - especially those on the long side who came late to the party - will get their noses bloodied. If history is any indicator, oil prices should fall harder at some point than most people expect as speculators sell their long positions and head for the exits. They drive prices marginally higher on the way up and marginally lower on the way down. That’s the way markets work… Hope this helps.
Very best regards,
Gary D. Halbert
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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.