Linkages between physical and financial oil markets were the focus of a second annual workshop hosted by the International Energy Agency, International Energy Forum, and the Organization of Petroleum Exporting Countries last month in Vienna, IEA reported in its most recent monthly oil market report. This was part of the organizations’ remit covering joint activities set out in the Cancun Ministerial declaration of March 2010.
Participants—including research and financial institutions, major oil producers and consumers, regulators, and policy makers—reviewed recent studies on commodity price formation, the role of price reporting agencies, developments in regulatory reform in the energy derivatives markets, etc.
IEA outlined some key takeaways from the workshop.
“The debate on linkages between financial and physical oil markets has evolved over time. Opinion remains polarized between those seeing the majority of recent price move being due to oil market fundamentals and those who see speculative activity and the financialization of commodities as amplifying price shifts in the short run. However, participants have different views on the concept of financialization and what is meant by ‘short run’, making it difficult to agree on the true impact of speculative activity on oil prices,” IEA said.
The majority of experts tended to view speculators as playing a more limited role than fundamentals, at least over longer periods of time. Market participants emphasized the important role of commodity derivatives markets in providing price discovery and transfer of risks, while acknowledging the strong linkages between financial and physical markets.
Market participants recognized that the distinction between hedging and speculation in futures markets is less than clear cut. Traditionally, traders with physical commodity exposure have been called hedgers, while those without a physical position to offset have been called speculators. In practice, however, commercial traders may “take a view” on the price of a commodity or may not hedge in the futures market despite having an exposure to the commodity, positions that could be considered speculative.
Cash and carry arbitrage was seen as the most important mechanism through which futures prices can impact physical supply and demand.
If speculators correctly foresee an upcoming shortage, they will bid up futures prices higher than spot prices, which sets off cash and carry arbitrage. Oil is pulled off the market and put in storage at times of relative abundance and is brought back to the market in a later period of relative scarcity. In these circumstances, price swings that would have occurred from a shift in supply and demand are moderated.
However, if speculators incorrectly predict a coming shortage, oil may be pulled off the market in time of relative scarcity and brought back in a time of relative plenty. In this situation, cash and carry arbitrage exacerbates the price swing.
Consequences of regulation
While market participants emphasized the need for more international coordination to ensure consistent and effective oversight in over-the-counter markets, they also argued that some of the proposed regulations, including the Dodd‐Frank Wall Street Reform and Consumer Protection Act as well as proposed European Commission regulations, might have unintended consequences in the market place. These include:
• Hard position limits will severely constrain trading activity which would lead to increased, rather than reduced, volatility.
• Liquidity in futures markets, and especially in swaps markets, would be unnecessarily impaired.
Commodity trading belongs to two worlds: physical and financial, and to avoid unintended consequences, there is a need for more specific regulation on commodities than is encompassed by broad financial regulation.
OTC markets are for professionals; not for retail investors. The role of brokers is primary in providing transparency. Transparency will disappear if trading is forced to move into platform-based trading systems with a view of pretrade transparency. Moving swaps onto platforms may create increased volatility due to higher volume as experienced in regulated markets when electronic trading was introduced.
Regulatory arbitrage opportunities might undermine the impact of new regulations in countries where more stringent rules are to be implemented.