By Lutz Kilian
A popular view is that the unprecedented surge in the spot price of oil during 2003–08 cannot be explained by changes in economic fundamentals, but was driven by the increased financialisation of oil futures markets.1 It is well documented that, starting in 2003, there was an influx of financial investors such as index funds into oil futures markets. At about the same time, both spot and futures prices of crude oil began to surge, soon reaching unprecedented levels and peaking at a record high in mid-2008. A popular view among pundits and policymakers is that this sustained oil price increase was facilitated by the financialisation of oil futures markets. Non-academics such as Michael Masters and George Soros testified before the US Congress that financial investors were taking speculative positions that resulted in rising oil futures prices, which in turn were responsible for a surge in the spot price of oil. The accuracy of this view is not obvious at all and much of the academic debate centres on the evidence, if any, supporting this hypothesis.
One reason that the Masters hypothesis has received a lot of attention among policymakers is that it seems to provide an obvious remedy to the problem of rising oil prices. To the extent that financial speculation is the cause of the problem of rising oil prices, policies aimed at controlling trades in oil futures markets can be expected to prevent increases in the price of oil. This interpretation has informed recent policy efforts to regulate oil futures markets as part of a larger effort by the G20 governments to impose more control on financial markets. While these policy reactions are perhaps understandable within the broader context of the global housing and banking crisis, they are not based on solid evidence.
In a recent CEPR Discussion Paper (Fattouh et al 2012), my co-authors and I review the evidence in support of the Masters hypothesis from a variety of angles, mirroring the evolution of the academic literature on this subject. The study concludes that the existing evidence is not supportive of an important role of speculation in driving the spot price of oil after 2003. Instead, there is strong evidence that the spot and futures prices responded to the same economic fundamentals.
Discussions about the role of speculation often degenerate into blanket generalisations because it is rarely clear how speculation is defined. The most general economic definition of a speculator is anyone buying crude oil not for current consumption, but for future use. What is common to all speculative purchases of oil is that the buyer is anticipating rising oil prices. Speculative buying may involve buying crude oil for physical storage leading to an accumulation of oil inventories, or it may involve buying an oil futures contract, provided an oil futures market exists. Either strategy allows one to take a position on the expected change in the price of oil. Standard theoretical models of storage imply that there is an arbitrage condition ensuring that speculation in one of these markets will be reflected in speculation in the other market (Alquist and Kilian 2010).
It is immediately clear that speculation defined in this manner need not be morally reprehensible. In fact, speculation may make perfect economic sense and indeed is an important aspect of a functioning oil market. For example, it seems entirely reasonable for oil companies to stock up on crude oil in anticipation of a disruption of oil supplies because these stocks help oil companies smooth the production of refined products such as gasoline. The resulting oil price response provides incentives for additional exploration, curbs current consumption, and helps alleviate future shortages. Hence, it would be ill-advised for policymakers to prevent such oil price increases.
In the public mind speculation has a negative connotation because it is viewed as excessive. Excessive speculation might be defined as speculation that is beneficial from a private point of view, but would not be beneficial from a social planner’s point of view. It follows naturally that the public has an interest in preventing excessive speculation. The broad definition of speculation we discussed earlier makes no distinction between socially desirable and undesirable speculation. Indeed, determining whether speculative trading is excessive is difficult.
One strand of the literature defines speculation in terms of who is buying the oil. Traditionally, traders in oil futures markets with a commercial interest in or a physical exposure to oil have been called hedgers, while those without a physical position to offset have been called speculators. The distinction between hedging and speculation in futures markets is less clear than it may appear, however. First, the oil futures market cannot function without speculative traders providing liquidity and assisting in the price discovery. The presence of speculators defined as non-commercial traders tells us nothing about whether speculation is excessive. Second, in practice, commercial traders may take a stance on the price of a commodity or may not hedge in the futures market despite having an exposure to the commodity. Both positions could be considered speculative. Likewise, efforts to detect speculators on the basis of high ex post profits are not compelling. After all, speculators take risky positions and the return on holding oil must reflect that risk.
Another argument has been based on the relative size of the oil futures market and the physical market for oil. For example, it is often asserted that the daily trading volume in oil futures markets is several times as high as daily physical oil production, fuelling the suspicion that speculators are dominating this market. Academic research, however, shows that this ratio – after taking account of the number of days to delivery for the oil futures contract – is a fraction of about one half of daily US oil usage rather than a multiple, invalidating this argument.
An alternative approach due to Holbrook Working (1960) has been to quantify speculation as an index measuring the percentage of speculation in excess of what is minimally necessary to meet short and long hedging demand. A high Working index number, however, does not necessarily indicate excessive speculation. One benchmark in evaluating this index is the historical values of this index for other commodity markets. By that standard the index numbers for the oil market even at their peak remain in the midrange of historical experience. Moreover, there does not appear to be a simple statistical relationship between this index of speculation and the evolution of the price of oil. For example, the correlation between the Working index of speculation and daily price changes is near zero.
Sometimes excessive speculation is equated with market manipulation. For example, it has been asserted that financial traders are herding the market into positions from which they can profit, resulting in excessively high oil prices in the spot market. It is important to stress that market manipulation and speculation are economically distinct phenomena. The increased financialisation of oil markets does not by itself mean that market manipulation is on the rise, and there is no widespread evidence of market manipulation in oil futures markets.
In short, there is no operational definition of excessive speculation. Indeed, existing academic studies have focused on indirect evidence of excessive speculation rather than direct evidence. The academic literature allows several conclusions:
1. There is clear evidence of the increased financialisation of oil futures markets. Whether this financialisation also was responsible for increased co-movement among different asset prices continues to be debated. Although there is some evidence of increased co-movement across asset classes, that co-comovement is also found in markets in which index funds do not operate and for which there are no futures exchanges, which is suggestive of an explanation based on common economic fundamentals. Indeed, there is evidence that price increases were somewhat higher for non-exchange traded commodities than for exchange-traded commodities, consistent with the view that financialisation actually dampened price increases.
2. There is no compelling evidence that changes in financial traders’ positions predict changes in the price of oil futures. Conflicting results in the literature in this regard can be traced to the use of datasets in some studies that are too aggregated to be informative about these predictive relationships or otherwise inappropriate. To the extent that any evidence of predictive power from index fund holdings to oil futures prices has been found, that evidence has not been based on rigorous real-time analysis and the extent of the out-of-sample gains has yet to be quantified. Finally, evidence of predictability is not evidence of causation. This predictive power, if any, may arise simply from traders’ positions responding to the underlying fundamentals of the oil market, for example.
3. Contrary to widely held beliefs that increases in oil futures prices precede increases in the spot price of oil, there is no evidence that oil futures prices significantly improve the out-of-sample accuracy of forecasts of the spot price of oil. This result holds whether one is forecasting the nominal price or the real price of oil. In contrast, there is evidence that models based on economic fundamentals help forecast the spot price of oil out of sample.
4. The simple static models that have been used to explain how an influx of financial investors may cause an increase in the spot price of oil are inconsistent with dynamic models of storage. Economic theory tells us that both spot and futures prices are jointly and endogenously determined.
5. The oil price–inventory relationship tells us nothing about the quantitative importance of speculation in oil markets. In particular, the absence or presence of speculative pressures in the oil market cannot be inferred from studying oil inventory data without a fully specified structural model.
6. Structural economic models of oil markets that nest alternative explanations of the evolution of the real price of oil (including speculative demand) provide strong evidence of speculation in 1979, 1986, 1990, and late 2002, but are not supportive of speculation being an important determinant of the real price of oil during 2003 and mid-2008. Instead these models imply that both spot and futures prices were driven by a common component reflecting economic fundamentals (Kilian and Murphy 2011). Alternative studies that claim to have found evidence of financial speculation suffer from identification problems and are uninformative.
7. There is no empirical evidence that the short-run price elasticity of gasoline demand is literally zero, as required by theoretical models that explain increases in the spot price based on speculation in oil futures markets without an accumulation of oil inventories. Recent oil demand elasticity estimates that take account of the identification problem in estimating demand elasticities from price and quantity data are considerably higher in magnitude than traditional estimates based on reduced form models.
8. Recently developed theoretical and empirical models of time-varying risk premia may help enhance our understanding of fluctuations in oil prices, but it is not clear how representative these models are for the global market for crude oil, and their ability to explain fluctuations in the price of oil has yet to be explored in full detail.
To conclude, one of the problems in this literature – and, more importantly, in the public debate about speculation – is that it is rarely clear how speculation is defined and why it is considered harmful to the economy. For example, the aim of recent regulatory changes in oil futures markets is to reduce price volatility, when increased oil price volatility was never the problem, but the persistent increases in the price of oil after 2003. Moreover, the literature has shown that the presence of index funds has, if anything, been associated with reduced price volatility. This view is also supported by historical analyses on the relationship between futures markets and price volatility. It is sometimes suggested that academics have failed to adequately address the issue of speculation in oil markets and that more research is needed to establish what seems obvious to many policymakers. This is not the case. Rather, extensive research has produced a near-consensus among academic experts that speculation has not been a key driver of recent oil price fluctuations. This finding has important implication for on-going policy efforts to regulate oil futures markets.
Lutz Kilian, Professor of Economics, University of Michigan; and Research Fellow at CEPR.
Alquist, R and L Kilian (2010), “What Do We Learn from the Price of Crude Oil Futures?”, Journal of Applied Econometrics, 25:539-573.
Calvo, Guillermo (2008), “Exploding commodity prices, lax monetary policy, and sovereign wealth funds”, VoxEU.org, 20 June.
Fattouh, B, L Kilian, and L Mahadeva (2012), “The Role of Speculation in Oil Markets: What Have We Learned So Far?”, CEPR Discussion Paper No. 8916.
Working, H (1960). “Speculation on Hedging Markets”, Stanford University Food Research Institute Studies, 1:185-220
Kilian, L and DP Murphy (2011), “The Role of Inventories and Speculative Trading in the Global Market for Crude Oil”, University of Michigan.
Krugman, Paul (2008), “Calvo on commodities”, NY Times Blog, 21 June.
Thoma, Mark (2008), “Oil prices and economic fundamentals”, Economist’s View, 26 July.
1 On this see the debate between Guillermo Calvo (2008) and Paul Krugman (2008) as well as comments from Mark Thoma (2008).