What's Suddenly Wrong with the Oil Market? Part 3:
Open disagreement about 'speculation'
29 Jul 2009 in Regulatory Economics, Regulatory Policy
On July
8 we
blogged on a commentary published in the Wall Street Journal under the
joint bylines of UK Prime Minister Gordon Brown and French President
Nicolas Sarkozy. The two European leaders alleged
that speculation had damaged the world crude oil market by
making
it "dangerously volatile." We surmised that the sudden interest in oil
market speculation, which seemed to have come out of the blue, was
instead highly coordinated. There is now more evidence supporting that
hypothesis, but some indication that it is encountering resistance.
Our review of the Brown-Sarkozy op-ed showed that "it is almost certain that something else motivates their interest in regulating the world oil market." We wrote, quoting a revealing sentence in the Brown-Sarkozy piece:
Upstream investment world-wide is already down by 20% over the past year. And with some sources of supply in decline, such as Alaska and the North Sea, the resource we will all need as the economy recovers is being developed in neither an adequate nor a timely way.
We followed up on July 11 with a discussion of a very similar kind of government supervision of market supply ad prices: USDA marketing orders on milk, fruits, vegetables, and certain specialty crops. Agricultural marketing orders keep supply down, consumer prices high, and protect existing firms from the competition that new entrants would provide.
In the US, the move for "government supervision" of speculation is now underway. Ironically, it's not moving at all in the UK even though Prime Minister Brown is its chief advocate.
In July 2008, the Commodity Futures Trading Commission issued an interim report from an interagency task force which concluded that speculation in oil markets was not responsible for the run-up in prices.
The report assembled data showing that oil market speculators respond to price changes rather than lead them:
If a group of market participants has systematically driven prices, detailed daily position data should show that that group’s position changes preceded price changes. The Task Force’s preliminary analysis, based on the evidence available to date, suggests that changes in futures market participation by speculators have not systematically preceded price changes. On the contrary, most speculative traders typically alter their positions following price changes, suggesting that they are responding to new information – just as one would expect in an efficiently operating market.
The Wall Street Journal reported on July 28 that the UK Financial Services Authority "has found no evidence that speculators are behind big swings in oil prices, as politicians in the U.S., the U.K. and elsewhere have suggested, according to people familiar with the matter":
The FSA's conclusions come as the U.S. commodities watchdog appears to be on track to smack down what it sees as "excessive speculation." The Commodity Futures Trading Commission has recently proposed a sweeping package of reforms to ensure the "fair, open and efficient functioning of futures markets," including more reporting requirements for hedge funds, application of caps on energy investors and elimination of existing waivers.
...
"More than they ever were before, [investors] are looking to the global economic climate and nobody is sure on that, and that is perhaps driving the volatility," he said.
Given that view, the FSA doesn't believe that limiting the size of trading positions would be "beneficial" for the market, said a person familiar with the matter. Still, the FSA acknowledges it doesn't have a "full explanation" as to why the market has moved the way it has, said a person familiar with the matter.
The FSA's conclusion contradicts British Prime Minister Gordon Brown, who has linked the recent rises in oil to speculation.
The FSA report appears to have been completed but it has not been released.
Now comes CFTC chairman Gary Gensler, who has organized a series of hearings into the effects of speculation in the crude oil market. Gensler appears to have prejudged the matter, however. In his opening statement before yesterday's hearing, Gensler promoted a specific policy solution for "excessive speculation" (setting strict position limits in energy markets) without first showing that this is in fact occurring. Thus, the purpose of the hearing appears to have been to debate the scale and scope of new regulation, not to evaluate whether any new regulation is needed:
...
To the extent that financial parties, such as money managers, hedge funds and swap dealers, participate in the futures markets, position limits have the potential to increase liquidity by reducing the positions of the largest traders. Position limits can enhance liquidity by promoting more market participants rather than having one party that has so much concentration so as to decrease liquidity.
I believe we must seriously consider setting strict position limits in the energy markets. This morning’s hearing and the two to follow will help inform this Commission of the merits of possible new rules to set limits to protect the American public.
The Wall Street Journal says the CFTC "plans to issue a report next month suggesting speculators played a significant role in driving wild swings in oil prices -- a reversal of an earlier CFTC position that augurs intensifying scrutiny on investors."
Why the report will be issued after the hearings on Gensler's proposed regulation of position limits is not clear. Normally, analysis precedes decision-making rather than following it.
