THE SYMMETRY OF SPECULATION
By David HaleFounder and Chairman
Global Economics
Prior to the recent drop, the sharp rise in oil prices during the past six months came as a profound shock to the global economy. It is driving infl ation to double-digit levels in many developing countries. Continued high oil prices could set the stage for a U.S. recession this autumn. Infl ation concerns already have led the U.S. Federal Reserve to signal an end to its accommodative monetary policy.
Certainly, sharply rising oil prices are being driven by large increases in demand from developing countries. Since 2000, global oil consumption increased from 76.34 million barrels per day to 85.22 million barrels per day. North America accounted for 17.7 percent of the growth in global demand after 2000, while Europe accounted for just 6.4 percent. The major growth in consumption occurred in Asia (51.7 percent), the Middle East (17.9 percent) and Latin America (7.0 percent). China alone accounted for 37 percent of total demand growth.
The International Energy Agency (IEA) estimates global demand will continue to grow by 1.6 percent per annum over the next fi ve years, from 86.9 million barrels per day in 2008 to 94.1 million barrels per day in 2013. The IEA expects rising supply to boost spare capacity to 4 million barrels per day in 2010, but stronger demand to then reduce this excess to minimal levels in 2013. Of course, there are some potential wildcards in the supply outlook - for example, oil discoveries off the south coast of Brazil, in Ghana and Uganda could add millions of barrels to the supply by 2015.
Some members of Congress allege that commodity speculators have caused oil prices to rise sharply - specifically, that hedge funds and commodity index funds have created a large new fl ow of money into the markets, driving up prices. This concern about growing speculation is sometimes compounded by regulatory issues. For example, Michael Greenberger, a law school professor and former Commodity Futures Trading Commission (CFTC) director, criticized the CFTC at a congressional hearing for not effectively monitoring or controlling the Intercontinental Exchange (ICE), which trades oil futures on its London-based ICE Futures Europe exchange. He believes that speculative funds have used the London market to evade restrictions which exist in the U.S. market.
THE CFTC LOOKS TO THE DATA
The CFTC contends that the role of hedge funds and commodity index funds has been exaggerated, since the non-commercial share of total open interest has increased only marginally, from 34 percent to 35 percent over the past three years. In addition, non-commercial traders create liquidity. CFTC data shows that traditional commercial traders generally need to protect against price declines and so take short positions to hedge. They rely on non-commercial traders to take the opposite side of their trades. In addition, much of the growth in open interest contracts is concentrated in futures contracts that expire after 12 months and demand is growing for even longer-term contracts, refuting criticism of speculators as short-term traders.
"A trend during the past few years in crude oil markets is that swap dealers now hold signifi cantly larger positions in crude oil futures," said Jeffrey Harris, the CFTC's chief economist, when he testifi ed before Congress. "These dealers, who sell over-the-counter swaps to their customers (such as pension funds buying commodity index funds or airlines seeking to hedge jet fuel costs), turn around and hedge their price exposure with long futures positions in crude oil and other commodities. This development has expanded the ranks of commercial traders. Traditional commercial traders predominantly hedge long cash positions using short futures contracts. Conversely, swap dealers (also classified as commercial traders) frequently hedge short swap positions with long futures contracts. Our studies consistently find that when new information comes to the market and prices respond, it is the commercial traders (such as oil companies, utilities, airlines, etc.) who react first by adjusting the futures positions. When these commercial traders adjust their futures positions, it is speculators who are most often on the other side of the trade."
The CFTC data is complex. The numbers for non-commercial traders include hedge funds and other managed money, but do not include swap dealers. Based on the longstanding classifi cation of swap dealers as hedgers (they hedge over-the-counter exposures with futures), the CFTC has classifi ed them as commercial traders. Most index funds execute via swap dealers, so they would be captured primarily by the swap dealer positions. Congressional staff rearranged the CFTC data to include swap dealers with noncommercial traders. When these two numbers are combined, the staff estimates that speculator positions increased from 37 percent of open interest long positions in 2000 to 71 percent recently. The CFTC countered by noting that the 71 percent includes both long and short positions held by swap dealers and speculators. According to the CFTC, swap dealers as a whole have close to a neutral position in the crude oil market - equally long and short.
The two leading commodity indexes used to create index funds, the S&P-Goldman Sachs and Dow Jones-AIG indexes, have energy weightings of 75 percent and 40 percent, respectively. If we assume index funds have $260 billion of assets, these weights would produce an oil commitment of $117 billion. Such an investment would be equal to 877.5 million barrels of oil. As global oil consumption is 31 trillion barrels per annum, it is difficult to believe that demand of 877 million barrels could have a major impact on prices.
"Many believe that speculators, particularly index funds and other large institutional investors in our markets, are responsible for the high price of crude oil," said James Newsome, then-president of the New York Mercantile Exchange (NYMEX), in congressional testimony earlier this year. "However, data analysis conducted by our research department confi rms that the percentage of open interest in NYMEX crude oil futures held by non-commercial participants relative to commercial participants actually decreased over the last year, even at the same time that prices were increasing. In addition, non-commercials are relatively balanced between long (buy) and short (sell) open positions for NYMEX crude oil futures. Thus, non-commercial participants are not providing disproportionate pressure on the long side of the crude oil futures market."
Barclays Bank oil analyst Paul Horsnell also appeared to agree with the CFTC in a July 2008 Financial Times interview. "This year has seen more speculative money exit than enter the oil market. Currently, the scale of long (net buyers) by non-commercial oil market participants is roughly the same as it was last July, when prices were 65 percent lower. So we do not think that speculative fl ows have played any signifi cant role."
The CFTC has taken the congressional criticism very seriously. It announced that it is imposing new rules on the ICE market in London, to take effect in October 2008. The CFTC will require that trades placed on the ICE futures market adhere to the same position limits and reporting standards as trades in the United States. The new rules apply to ICE's West Texas Intermediate crude oil contract, which is linked to the NYMEX contract. The CFTC also is in the process of conducting further studies on the role of index funds and other transactions being conducted through swap dealers. Results of the CFTC study are scheduled to be released on September 15, 2008.
OTHER TRENDS OF NOTE
The large increase in the value of commodity contracts since 2000 has resulted from the need to hedge against shocks in both supply and demand. The rise of China as a major industrial power appears to have created a "super cycle" in prices, which took many investors and other market participants by surprise. The large decline in the value of the U.S. dollar during recent years added to the lure of commodities as an infl ation hedge.
Oil price increases will continue to provoke debate about the character of the oil market and the potential for price manipulation. Available data indicates that the market has expanded signifi cantly during the past eight years, but there does not appear to be a major imbalance between commercial and non-commercial traders. Instead, they appear to be playing a complementary role by helping to offset each other's trades. In addition, non-commercial traders appear more willing to short the market. If Congress attempts to restrict non-commercial traders with tighter limits on margin debt, oil prices could be driven higher as the magnitude of short-selling declines.
Oil prices have surprised practically all analysts by rising sharply this year. Declining U.S. gasoline consumption and the decision of many developing countries to hike oil prices during the summer should ultimately help to restrain prices if there are no new geopolitical shocks in the Middle East. But as a result of the magnitude of this year's price shock, investors will remain apprehensive until they actually see a major price correction in the oil market.
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