The US Federal Trade Commission has issued a rule that aims to crack down on market manipulation in the oil market. It looks like US legislators are committed to giving the CFTC, the body that is to regulate commodity markets, extra powers to sanction unwanted speculative behavior. In itself, this looks like a good idea. Anyone interested in fair market conditions is glad to know that a strong regulator is there to enforce that fairness. Moreover, we observe that financial markets have become increasingly complex which calls for more sophisticated (enforcement of) regulation. The products that are being traded have been designed by financial engineering and have become so ‘sophisticated’ that even those to deal with them daily, fail to grasp there complexity and hence the risk that they pose. To me, that is probably the most important conclusion that we can draw from the credit crisis. We need some application of the KIS (keep it simple) principle. Moreover, the market has become much less visible. The days that businessmen came together at commodity exchanges to discuss prices are long gone. Trades have gone virtual and happen with a click of the mouse. This invisibility has been increased by the growing popularity of OTC trades. Traders consciously avoid the strict rules that govern exchanges by making their trades in less visible over-the-counter environments.
On the other hand, the arguments brought forward by US legislators to motivate this move towards a stronger CFTC regulation scare me, read http://www.cftc.gov/stellent/groups/public/@newsroom/documents/file/hearing072809_sanders.pdf for an example of that. We have also suffered from the recent rises in oil prices as we saw our client’s natural gas budgets (linked to oil prices in most European countries) rise along. And I know that it is tempting to blame the evil forces of speculation for rising prices. On the other hand, I have often reflected on that question: can speculators really determine the direction of the market? Do they have the power of driving up prices even if the supply / demand situation looks healthy? I have found insufficient proof or reasoning to support that idea. The recent price spikes did coincide with supply – demand tightening. Demand for oil (mainly in emerging economies) has gone up so rapidly in recent years that oil production was unable to follow. And even if we look at what happened in the past five months, it is clear that demand for oil from China was again growing and hence we can find some fundamental support for the (almost) doubling of oil prices since March. Moreover, we have seen two big corrections of that bull trend in the oil market, one in late 2006, January 2007 and the second one started in July 2008 and ended last March. In the first case, figures indicate that this coincided with some important rises in supply and in the second case, it was a drastic drop in demand that caused it. If you are willing to really look at worldwide supply and demand data, the argument that recent oil price development was not supported by fundamentals is countered. But of course, you have to look worldwide and not just at the US data (which is tempting as the US is the only country to produce systematically clear and reliable data).
My conclusion is that if speculation is able to drive up prices without any fundamental support, it can do so only for a short period. If the supply / demand balance looks healthy, i.e. there is enough product in the market, this will drive down spot prices. Spot prices don’t lie. If the product is there in large quantities, prices go down. Speculative spot market manipulation demands the actual withdrawal of physical volumes from the market. Hence, Opec production quota could be described as such speculative behavior. If the spot prices are driven down by fundamentals, futures prices will have to follow. Recent developments have proven this. My conclusion is that speculation cannot determine the direction of the market, it cannot in itself cause markets to rise or fall. What it can do however, is accelerate the pace at which markets are rising or falling. If, for some fundamental reason, such as a slight increase in oil demand due to a quick recovery of the Chinese economy, the oil price starts to rise somewhat, speculators will ‘jump on board’. They want to make some money on that rising trend and start buying futures (go long, to say it in their terminology). By doing so, they increase demand for those futures which drives up its price. The result is an increase in volatility. This is exactly what the CFTC has told US Congress: speculators increase volatility.
A first important remark: this works both ways. The same thing happens when the price starts to fall, e.g. due to the economic crisis. The traders will start to sell their futures contracts and even sell futures contracts that they don’t even have (short-selling). By doing so, they drive down prices much faster than would have happened without them. In such cases, they even have a very healthy effect on the market. They make it difficult for producers of oil to stop the downward movement. This has been repeatedly said by Opec, the producer’s cartel which has seen its possibilities of stopping price falls by cutting supply reduced due to the sell-off of contracts in a downward market by speculators. Speculators add liquidity to a market, and by doing so, they make it more difficult for individual parties such as producers to exert market power. The Belgian power market is a good example of a market where some more presence of speculative parties could add some necessary liquidity.
But I understand the arguments of US legislators that this increased volatility is not in the interest of the US public. For consumers have a difficult time buying energy in a volatile market. Prices swing up and down so rapidly that deciding when to buy becomes extremely difficult. This certainly holds for industrial buyers, as they buy this energy in huge quantities. Just imagine that you have decided to buy 100.000 MWh of natural gas in May 2008 when the near 150 dollar oil prices resulted in European gas prices of over 40 euro per MWh. Eight months later, the falling oil prices had reduced gas prices to less than halve that. It means that you have lost more than 2 million euro by that fixing that gas price in May. The same difficulty arises in private life. If you heat your home with heating oil, deciding when to fill the tank becomes very tricky. Even when you fill the car, you can get frustrated to find out the next day that the gasoline or diesel price has come down again.
The question is: can we stop this increased volatility due to the presence of speculative money in the market without throwing away the beneficial effects of speculation, i.e. the liquidity that they provide the markets with? It looks like the US is planning to do that by limiting the positions that speculators can take (http://www.cftc.gov/stellent/groups/public/@newsroom/documents/pressrelease/genslerstatement070709.pdf). This will inevitably affect the traded volumes. I believe that the possible negative effects of this on liquidity should be well researched before any decisions are taken.
In the past years we at E&C have often derided certain events in the energy markets, the oil market in particular. One of those was the practice that certain parties, known to have huge positions in the market, launched bullish ‘forecasts’ that clearly influenced the market. I am glad to see that US legislators clearly plan to tackle such behavior and are even naming explicitly Goldman Sachs as a culprit of this practice. Let’s hope that they find a way to make an end to the practice of building up big long positions and then ensure their profitability by launching bullish analysis reports. I hope so for all those energy consumers that were tricked into buying too much last year in May due to such a Goldman Sachs report.