Index investors are a stabilising force on crude prices, at least for now

Are speculative traders responsible for pushing up crude oil prices? Many, particularly in US congress, are arguing that they are. But traders and others who follow the markets tend to disagree, usually pointing out that the commodity futures markets, unlike cash stock markets, are not trading in a finite number of items, but are merely trading contracts that are eventually settled based on physical supply and demand.

The CFTC recently began publishing weekly figures that shed some more light on who is doing what in the sometimes opaque energy commodity markets, by breaking up categories of traders into four categories according to their involvement with the physical or financial sides of markets.  Market participants and commentators interpreted the data in a variety of ways: Barclays Capital, for example, said it indicated speculative traders (as opposed to those who deal in physical oil) were not unduly influencing prices; while others were less convinced that the new categories revealed anything of value at all.

Another set of figures published by the CFTC, published only quarterly, reveals the net positions of index investors - which includes index funds, swap dealers, pension funds, hedge funds and mutual funds. This data, according to Philip Verleger, energy analyst and economist, underlines the lack of influence that these investors have on energy prices.

First, Verleger price changes in both net index positions and the WTI crude oil contract. Far from moving in the same direction, they tend to move in opposite directions:

To get a more definitive answer, however, Verleger plots the percentage changes in both net index positions and WTI prices over the past two years. Each point represents the quarterly change. As he explains, a positive correlation would see dots cluster along a trajectory from the lower left-hand to the upper right-hand corners of the chart — showing that negative moves in index positions correlate to negative moves in the crude contract price, and vice versa.

However, this is what it actually shows:

As Verleger writes:

While there are only seven observations, the negative relationship is clear. The variation in price explains half the variance in open interest.

In fact, calculating the net positions of all investors against price changes shows a similarly strong inverse relationship between prices and interest.

The conclusion, then, is that passive investors exert a stabilizing influence on oil price fluctuations. They buy as prices fall, thereby supporting efforts of producers to keep prices up, and sell when prices rise, supporting the interests of consumers who do not want high prices.

However unlike many commentators concluding that financial investors or speculators are not the villains of oil prices, he does not think this means the CFTC is utterly wrong to consider new regulation for commodities markets. The correlation in fact might have been different if there had been a big inflow of cash into commodities futures – which there wasn’t.

This leads to the following caution: commodity investors will remain a stabilizing force in energy markets as long as there is not a sharp upswing in the amount of new money.

At the moment, in crude oil futures, this does not seem to be the case (whether it is the case in other energy markets might be another story). But Verleger says CFTC chairman Gary Gensler was correct to call for more transparency in commodities futures, and: “Regulators should be prepared to act if the data reveal that excessive amounts are starting to come into the futures market.”

Related links:

New CFTC trader categories: what do they tell us about speculators? (FT Energy Source, 08/09/09)
Dresdner/Commerzbank blames energy speculators (FT Alphaville, 21/08/09)
In defence of energy speculators (FT Alphaville, 05/08/09)

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