Sent: 24-05-2011 09:14:10
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Oil Prices: How Much Speculation?
In 1983, Eddie Murphy and Dan Akroyd demonstrated in their movie "Trading Places" how speculators can make vast profits pushing futures markets in whatever direction they choose. Armed with little more as analytical background, US politicians seem to think they can bring commodity prices down.
On 11 May, a group of 17 US senators wrote to the US Commodities Futures Trading Commission (CFTC) demanding that the Commission implement rules to cut speculation in US futures markets. Of immediate concern was the political impact of US gasoline prices trading near $4 a gallon.
The Dodd Frank legislation to reform the US financial system enacted in July 2010 required the CFTC to implement position limits in energy commodities to rid markets of speculation.
High US retail gasoline prices have coincided with a sharp rise in the volume of trade on futures markets attributed to speculators. Historically, the CFTC has disseminated statistics distinguishing between commercial and non commercial trading positions. Based on these statistics, non commercial traders now account for 23 % of the open long positions in the NYMEX crude oil futures contract, for example, compared with only 9% at the end of 2006.
In one sense, this is just a domestic US political issue but there are broader implications than which senator from Wyoming is going to be elected in 2012.
The Dodd Frank legislation requires the CFTC to come up with rules covering foreign futures markets as well as those physically located in the USA and is not confined to energy contracts. The Dodd Frank laws envisage the CFTC becoming a global regulator of markets affecting everyone who eats, drinks or travels.
To the credit of the CFTC, it has been dragging its feet on this demand. Dodd Frank gave the CFTC a statutory deadline of 180 days within which to impose new rules. Without prodding by the senators, there was no likelihood of anything happening before 2012.
Attempts to corral oil price movements rest on some flimsy analytical assumptions.
As in other commodity markets, there is ample empirical evidence of a non linear relationship between inventory levels and prices. An article in edition 50 of the ATC Digest highlighted a similar relationship between refining capacity and prices: when capacity utilisation rates are low, prices tend to rise disproportionately in response to a supply or demand disruption.
Most likely, the politicians have failed to fully comprehend the extent to which prices can rise even if driven wholly by economic forces.
An article by James L Smith in the Summer 2009 edition of the Journal of Economic Perspectives entitled "World Oil: Market or Mayhem?" put the propensity for apparently wild swings in oil prices into some analytical perspective.
He pointed out that, in the short run, price elasticities of supply and demand are extremely small so that even seemingly small changes in either supplies or demand can have big price effects.
Smith used an example of a supply shock that takes out 1 million barrels a day of production or about 1.25% of output. To restore equilibrium in the short run, the price must keep rising to the point that reduced demand and an increase in quantity supplied from other sources combine to eliminate the shortage.
If, in this example, the percentage rise in the price is called ΔP and the elasticities of supply and demand are ES and ED, respectively, the additional quantity supplied would, in percentage terms, amount to ΔP x ES and the decrease in consumption would be ΔP x ED. Since these must sum to 1.25, the price must rise by 1.25/(ES - ED) percent.
Since, according to Smith, both short-run elasticities are roughly 0.05 (and price elasticity of demand is negative), the percentage change in price could easily be as much as ten times the size of the movements in supplies that precipitated the changes.
So, we have a market prone to volatile trading even in an abstract world without speculators.
Kenneth Singleton in a March 2011 Stanford University Graduate School of Business working paper entitled "Investor Flows and the 2008 Boom/Bust in Oil Prices" has added another dimension.
Although we appear to have ever growing quantities of information about the oil market, he has highlighted the inadequacies of the information being used.
Singleton's analysis of the data has led him to conclude that all market participants are using imperfect information, including the information given out by the CFTC about the quantity of speculation. Both hedgers and speculators might act rationally in response to this information but make small correlated errors around their optimal investment policies. According to Singleton, financial markets can amplify these errors and generate volatility in securities prices that is unrelated to fundamental supply/demand information.
Both Smith and Singleton are laying the groundwork for political disappointment. Sure, there is an increase in commodity related investment products and hedge funds are more active but there is no analytical smoking gun to condemn them as the cause of extreme volatility or, consequently, high US gasoline prices.
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