John Kemp’s latest column takes a shot at bullish oil analysts for shifting their focus from spot prices to forward prices to the spread between the two, and back again.
“The focus seems to be (arbitrarily) shifting depending on which market segment is more consistent with a basically bullish story…” he writes. The time spread is a function of the spot and the forward markets – so which of those two is driving the market momentum?
The answer, apparently, 10 or 15 years ago would have been that spot prices drove the forward markets. But in recent years it is the forward markets – dominated, incidentally, by hedge funds and swaps dealers – that are the cart pulling the horse.
That’s quite strong stuff, given the current debate over speculation in energy commodities.
Kemp made this case at more length in another column from a month ago, where he pulled out some striking evidence of the shift in the source of oil price momentum. Some of it is based on a study by MIT economist John Parsons.
The big break occurred in 2004, when correlations between forward prices and spot prices strengthened considerably:
This change, Kemp writes, coincided with the explosion in futures and options trading, that was particularly focused on longer-dated contracts:
The result has been a marked lengthening in the maturity profile of the futures and options market, and a significant deepening of volumes and improvement in liquidity in forward dates up to two or three years ahead:
(Click through for larger image). Kemp adds (emphasis ours):
Hedge funds and swap dealers account for all the growth in open interest and liquidity at forward dates beyond one year. There has been no increase in the open interest directly attributable to manufacturers or producers, though it is possible many of the swap dealers’ positions at longer maturities have been assumed on behalf of producers and end-users[.]
This all means that expectations about the future is driving prices – rather than fundamentals of supply and demand – which is really a here-and-now thing, after all. And that, Kemp concludes, all goes a long way towards explaining why oil prices plummeted in the second half of 2008 as expected (when sentiment was focused on the financial crisis) and recovered extremely strongly in 2009, despite the persistent lack of demand (future sentiment focused on the recovery and possible medium-term shortfall due to an investment slump and resulting production squeeze).
Is this necessarily a bad thing? The movement of short-term supply-and-demand dynamics of oil markets has tended to wreak havoc with the long-term investment decisions that are needed to guarantee stable supply. That’s been blamed for many of the more extreme highs and lows of oil prices in recent decades.
Still, it does give significant weight to arguments that financial speculators, not industry, are driving oil prices higher right now.