It is intuitively fairly easy to argue that speculators drive up prices and create volatility: it falls naturally into a sort of good guys/bad guys narrative where the speculators make commodities more expensive for the ‘commercial’ participants, such as oil companies, airlines and manufacturers and those who service them.
The main defence of speculators, for those who haven’t heard, is that commodities users who want to hedge their exposure to future price volatility actually need the speculators – otherwise, who else is going to take the bets required for those hedges?
Interestingly, the CFTC’s own research has so far failed to find evidence that speculation causes price shifts.
It looked into the matter last year and, using the Granger causality tests – an established statistical formula – concluded that it couldn’t prove speculators were pushing up prices. From the CFTC’s interim report published in June:
To date, there is no statistically significant evidence that the position changes of any category or subcategory of traders systematically affect prices. This is to be expected in well-functioning markets. On the contrary, there is evidence that non-commercial entities alter their position following price changes. This is also expected because new prices convey information affecting the prospects and the risks of those entities. This being an interim report, the Task Force intends to examine these findings further as it continues its work. However, to this point of the examination, the evidence supports the position that changes in fundamental factors provide the best explanation for the recent crude oil price increases.
So the speculative traders are effectively following price leads set by the commercial traders: fair enough. But what happens when traders do not fit comfortably into one category? Many commercial traders also engage in what is usually called ‘speculative’ trading.
The CFTC acknowledges this in its report:
In classifying traders as commercial or non-commercial rather than hedgers and speculators, the CFTC recognizes that the ultimate motivations for trading futures by commercial and non-commercial traders cannot be observed. That is, while a commercial trader may be matching a futures position against a cash market price risk, it is not known whether such a trader is doing so on a routine basis in order to minimize ongoing price risks or doing so selectively based on specific market expectations. Thus, some of the trading information captured by the commercial trading category may reflect activity that could be characterized more as speculative rather than hedging.
Many commercial traders participate in futures markets to profit, as well as to hedge their own exposure – BP, for example, makes quite sizeable profitsfrom this, and it’s by no means alone. Craig Pirrong argues at SeekingAlpha that this is why commercial (or physical) traders who also engage in speculative trading sometimes voice support constraints on speculators - not in spite of their participation in speculative trading, but because of it: with purely speculative traders constrained, those that straddle both commercial and speculative roles can make more of their advantage.
It could make for some interesting submissions to the CFTC’s hearings.
For speculators, there’s always the onion defence (FT Energy Source, 07/07/09)