IER on Oil Speculation

60 Minutes Spectacle on Speculators
Institute for Energy Research, Jan 26, 2009

Excerpts:

The January 11 edition of 60 Minutes featured a segment on oil speculation. Correspondent Steve Kroft interviewed hedge fund manager Michael Masters and others who blamed the run-up in oil prices on hedge funds and other investors. Unfortunately, Kroft failed to interview a single person who explained the benefits of hedging and even speculation on oil contracts. The 60 Minutes takeaway message—that government should increase regulation of commodities futures markets—could actually increase volatility in the oil market and hurt consumers.

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The Benefits of Futures Markets

As we explained in an IER study issued last summer, the commodities futures markets perform a vital function by allowing parties to “lock in” a price of oil months or even years in advance. By removing their exposure to huge price swings, both oil producers and major consumers (such as refiners and airlines) can more confidently plan their future operations.

For example, the owner of an oil field might be willing to sink new wells if he expects oil prices to average at least $50 per barrel in 2010, while an airline might expand its service area to include a new city, but only if it can buy oil at less than $75 per barrel throughout 2010. If there were no futures markets, the oil producer and airline might decide to play it safe, rather than investing millions in projects that could prove unprofitable if oil prices move the wrong way. But fortunately with sophisticated financial markets, the two enterprises can hedge away this risk with futures contracts. The oil producer can sell (“go short”) futures contracts, agreeing to sell his output in 2010 for, say, $65 per barrel, and the airline can take the other side of the contracts. Both parties benefit by locking in the price of $65, rather than being subject to the volatile spot price of oil.


Successful Speculation Reduces Price Volatility

Just about everyone agrees on the benefits of futures markets when the buyers and sellers are those who physically deal with oil by the nature of their business. But even non-traditional “speculative” buyers—who plan on unloading their futures contracts before taking physical delivery—perform a useful service if they accurately forecast price moves.

The motto of the speculator is to “buy low, sell high.” (Or a more sophisticated version is to “short-sell high, cover low.”) But these actions reduce the volatility in the market, because the speculator’s buying pulls up prices when they are too low, while the speculator’s selling pushes down prices when they are too high. This is exactly what consumers want speculators to do. When the price strays from where they “ought” to be, an astute speculator comes along and knocks it back into line.

Now it’s true that many investors piled into commodities through the summer of 2008, thinking they would move ever higher—and then they had the rug pulled out from them in August and September. But we don’t need the government to impose penalties on such faulty speculation (which pushed prices the wrong way), because these investors lost their shirts! The market itself provides the appropriate reward and punishment for wise or foolish forecasts.

People often forget that for every speculator who “went long” on oil futures contracts, there was another party who had to go short. Indeed, after the 60 Minutes piece aired, investment manager Kevin Duffy reminded us of his warnings to clients over the summer that oil was overpriced. His hedge fund, Bearing Fund, shorted futures contracts and made money from the accurate call.

Another wrinkle in the typical complaint against speculators is that the statistical evidence shows the causality ran in the opposite direction. According to the CFTC’s analysis of confidential data, it was far more typical for a price change in oil to precede a change in investors’ holdings, rather than vice versa. Yes, big investors were enlarging their clients’ exposure to commodities in 2007 and 2008, but this was often because these sectors were outperforming others. So it wasn’t that a bunch of pension funds rushed into oil, and pushed up its price. Rather, the rising price of oil led to more and more investment in oil futures, by fund managers who were trying to shield their clients from skyrocketing energy prices. The process was mutually reinforcing, but the line between hedging and speculation is blurred. After all, soaring oil prices were hurting stock performance. By diversifying holdings to include commodities, fund managers were trying to limit the volatility in their clients’ returns.

A final point is that the presence of large, institutional investors provides more liquidity to the futures markets, allowing the traditional hedgers (such as producers and airlines) to use these contracts more flexibly. New regulations that restricted the ability of “speculators” to enter these markets would ironically hurt even the non-speculators because of higher bid-ask spreads.


Was It Speculators, or Supply and Demand?

A recurring theme in the 60 Minutes segment was that the price swings in oil weren’t due to the fundamentals of supply and demand, and so they must have been the fault of the insidious speculators [...].

The true situation is far more nuanced. Part of what happened on Sept. 22 was that the dollar fell sharply against other currencies; recall that these weeks involved the bailout of AIG and the collapse of Lehman Brothers. Because oil is traded internationally but quoted in U.S. dollars, a fall in the dollar translates into a higher quoted price for oil, which is perfectly consistent with “fundamentals.”

Moreover, Sept. 22 was the last trading day before the expiration of the October futures contracts. There were investors who had shorted oil—they were pushing down its price, betting that it would fall further—and they needed to unwind their positions, because they didn’t actually have physical barrels to deliver to the holders of the contracts. According to oil economist James Williams, the Nymex contracts had a delivery point of Cushing, Oklahoma, but the inventories in Cushing were low because of the hurricane drawdown. The situation led to a “short squeeze” where short-sellers were trying to buy back their positions and were scrambling for the unusually tight supplies. Thus the 60 Minutes piece is right that speculation was involved that day, but it’s the opposite of their interpretation: The people pushing down oil prices hit a temporary snag, caused by a physical bottleneck, and so the price popped back up briefly.

Masters’ analysis of the EIA data is also misleading. It is true that world oil supply had been steadily increasing every quarter since the beginning of 2007, while world oil demand finally peaked in the fourth quarter of 2007 and then began falling in 2008. But what Masters neglects to mention is that world oil demand was always higher than supply, up until April 2008, as the EIA data (XLS spreadsheet) show.

The market price of oil during this period did exactly what consumers would want. Starting in 2006, the world began consuming more barrels of oil per day than producers could deliver to market. The deficit was covered by drawing down on previously accumulated stockpiles. In this environment of a supply crunch, the market price needed to rise rapidly in order to call forth greater supply and curtail demand.

Even as late as the first quarter of 2008, on average there was more than a million barrel a day deficit, where world oil demand exceeded supply. Of course the “fundamentals” would drive higher prices in this environment. And then, after years of rising oil prices in this deficit environment, the situation finally reversed in April 2008. From that point on, world oil output had finally caught up with and overtaken demand. A few months later, the price of oil crashed back down. The presence of large investors definitely influenced the movement of prices, but ultimately the explanation based on supply and demand is accurate.

Even the sudden collapse of oil prices may be partially or completely attributable to “real” forces in the economy. The economic outlook changed considerably in the late summer of 2008, meaning that oil consumption will not grow nearly as quickly over the next few years as forecasters previously believed. The dollar has also strengthened tremendously because of the “flight to safety” by investors around the world. The rising dollar translates into lower oil prices, quoted in U.S. dollars.


Conclusion

Institutional investors rushed into the commodities futures markets as oil prices steadily rose from the fall of 2007 through the summer of 2008. This correlation led many analysts to conclude that the hedge funds were causing the prices to rise. But a more careful analysis shows that the situation was more nuanced, with price rises (fueled by legitimate, fundamental supply and demand) leading rational investors to diversify their holdings by gaining exposure to the energy sector.

In any event, it is wrong to assume that giving government bureaucrats more power will somehow make financial markets more transparent or efficient. Masters and the folks at 60 Minutes should read up on how the SEC ignored letters about Bernie Madoff’s Ponzi scheme that a suspicious analyst in the private sector began sending them back in 1999. In the private sector, speculators who make bad forecasts lose money, big time. In contrast, the SEC will probably see its budget increased even though it ignored a reputed $50 billion swindle for 9 years.

Many investors overshot the rise in oil prices, and the market punished them accordingly. But record oil prices really were driven by the fundamentals of supply and demand. Futures markets, and large institutional investors who use them, provide a valuable service to consumers by actually reducing volatility in the long run. It’s too bad that 60 Minutes seems to have overshot in their finger-pointing, but there won’t be any market correction for them.