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Thursday, September 15, 2011

Speculation, Fundamentals, and Oil Prices

Mark Jickling
Specialist in Financial Economics

Rena S. Miller
Analyst in Financial Economics

Neelesh Nerurkar
Specialist in Energy Policy

High oil prices affect nearly every household and business in the United States. During the course of 2008, oil prices doubled to more than $145 per barrel and then fell by 80%. In early 2011, there was a run-up of about 20%, sending gasoline prices to near 2008 highs. Few would rule out the possibility of similar price swings in the months to come. What explains oil price volatility?

Some consider price movements such as those of 2008 and early 2011 to be more extreme than warranted by the fundamentals of supply and demand. Their explanation for unstable commodity prices focuses on financial markets for derivatives contracts linked to the price of oil—futures, options, and swaps. Many market participants are pure financial speculators, who never deal in physical oil, but earn large profits if they can correctly forecast price trends. Critics claim that such traders can drive oil prices above fundamental levels, resulting in a “speculative premium” that imposes unjustified costs on consumers. Although the relationship between speculation and commodity prices has been studied extensively, consensus has not emerged as to whether speculative trading causes unusual oil price volatility.

An examination of Commodity Futures Trading Commission (CFTC) data reveals a strong correlation between weekly changes in positions held by “money managers” (a category of speculators that includes hedge funds) and weekly changes in the price of oil. Price falls, conversely, have tended to coincide with reductions in money managers’ long positions. This statistical relationship is weaker for other classes of speculators and for commercial hedgers. However, the existence of a correlation does not imply causation—money managers could be price-followers rather than price-setters.

Another explanation for oil price volatility looks to the fundamentals of oil production and energy consumption. Rapid global economic growth led to rising demand for oil, and supply could not keep up at previous oil prices. Because oil supply and demand do not respond much to price changes, at least in the short-term, some argue that relatively small changes in supply or demand can trigger significant price movements. An interagency task force led by the CFTC found that the 2003-2008 increase in oil prices was largely due to fundamental supply and demand factors.

The role of speculators in oil and other commodity markets has attracted congressional interest. Staff reports by the Permanent Subcommittee on Investigations of the Senate Committee on Homeland Security and Government Affairs found that excessive speculation has had “undue” influence on wheat price movements and in the natural gas market. A 2011 report by the minority staff of the House Committee on Oversight and Government Reform argues that “addressing excessive speculation offers the single most significant opportunity to reduce the price of gas for American consumers.” Legislation before the 112th Congress (S. 1200 and H.R. 2328) would authorize and direct the CFTC to take certain actions to reduce the volume of speculation in oil and related energy commodities. Another bill, H.R. 2003, would impose a tax on oil futures, swaps, and options that were not used for hedging commercial risk.

This report provides background on financial speculation in oil, the workings of oil derivatives markets, and the different types of firms that trade in those markets. It reviews the concepts of manipulation and excessive speculation, and it briefly describes the fundamental factors that affect oil prices.

Date of Report: September 2, 2011
Number of Pages: 32
Order Number: R41986
Price: $29.95

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