Two sides of the oil speculation coin

Commodity regulators (the Feds who oversee trading of wheat, oil, natural gas etc.) this week are expected to put out a new version of a report that spells out the kind of positions the biggest traders are holding. Called the Commitments of Traders report, it says how many market participants are long (holding positions where they believe the prices will go up) or short (betting prices will drop). Right now the COT (as it’s called by all the cool kids) is a pretty vague document that provides a rough idea of what the sentiment is of the largest players in the market. So the new one aims to provide more data (but could also confuse the heck out of everyone).

oil_traders_long Oil traders at the New York Mercantile Exchange. (AP Photo/Richard Drew)

Why should we care? Because there’s a lot energy being expended trying to figure out why oil prices in particular hit those record highs last year when many felt they weren’t justified by the fundamentals of supply and demand. Many (including the head of the CFTC) believe it’s the fault of speculative traders betting big, pushing prices up for big profits.
Some researchers at Rice University’s Baker Institute say that appears to be the case. Their look at the COTs says that since 2000 the number of speculators in the market has surged such that they make up half the oil market. They admit the topic is complicated and there’s a lot more data crunching to do (and they have plans for a more detailed report this fall), but they believe the connection between the price swings and surge in speculators is clear. They also believe the speculation helped contribute to a weaker dollar.
The CFTC has said in the past there is no conclusive proof of a connection between speculators and the high prices, but the Rice study says the commission looked at price volatility in a relative short time frame, which could miss the impact of speculators.
In an interview with the New York Times, one of the authors, Amy Jaffe, said the CFTC decision to downplay the role of speculators in past reports was ” ‘politically motivated’ because the agency ‘didn’t want to be blamed for not having proper oversight of the markets.’ ”
They argue the Federal government can and should intervene to keep speculation at bay, pointing to an early 1990s use of drawing oil from the Strategic Petroleum Reserve as a successful effort to dissuade investors from speculating on prices above $40. In comparison, they say, the government was actually continuing to fill up the SPR last year as the record-breaking prices loomed.

“This policy signaled to oil market participants and OPEC that governments would not use strategic petroleum stocks to ease prices under any circumstances expect major wartime supply shortfalls. This allowed speculators to confidently expand their exposure in oil market futures exchanges without fear of repercussions and revenue losses from a surprise release of U.S. or IEA strategic oil stocks,” the Rice study concludes.

Craig Pirrong, a University of Houston finance professor, strongly disagrees (to say the least) with the findings of the Rice study.
He doesn’t believe the COT is much use as a data tool for collecting information on what’s really going on in the markets nor to make the speculator/price connection. Rather using a statistical analysis that’s more than a bit over my head, he suggests U.S. monetary policy might have played a bigger role in the price spikes.
He also argues that a good piece of the increase in speculative trading traffic is in the form of spread positions, which “involve the purchase and sale of oil for different delivery dates.” In those trades the trades “… are speculations on the shape of the oil forward curve, not on the absolute price level.”
Regardless of the roles speculators play, it seems clear the CFTC intends to put limits on how big a role speculators can play in energy markets in the future. The general tone from most of the commission at the close of recent hearings was that they will impose limits.
A recent University of Illinois study seems to indicate that speculative limits on commodities aren’t so effective. But why should some data get in the way of a decision?