Editorial: Suspicion and speculation

Evidence grows in support of the longstanding suspicion by many oil and gas operators that trading of financial instruments related to crude oil, oil products, and natural gas unduly influences prices of those commodities. In the shorthand of the day, speculation increases price volatility. In the politics of the day, speculators are demonic.

Speculators—or noncommercial traders, who seek trading profits with no intention of taking possession of what they trade—are in fact essential to market fluidity. Among other things, they assume price risks unwanted by buyers and sellers of physical commodities.

But a recent increase in speculative activity coincides with a decrease in regulation and a surge in oil and gas prices unexplained by events in physical markets. Hence the boiling suspicion, from which grows political efforts to tighten market regulation. The issue is important beyond financial dimensions of the oil and gas business. It carries a political charge capable of affecting operations.

Tracing relationships

A new study from the James A. Baker III Institute for Public Policy at Rice University traces relationships between the activity of noncommercial traders, the value of the US dollar, and oil prices. It shows that, since relaxation in the regulation of speculative trading in oil and gas derivatives, the share of market activity represented by noncommercial trading has grown. Movements in oil prices, meanwhile, have coincided with changes in the dollar's value to an extent previously not evident. The speculation and dollar-value phenomena, argue study authors Kenneth B. Medlock III and Amy Myers Jaffe, are related.

"As the market presence of noncommercial traders increased between 2003 and early 2008, the stance of these noncommercial traders has fairly consistently been to hold bullish, long positions that supported rising prices," Medlock and Jaffe write. "And, when their market share was highest, so was their net long position, which again roughly coincided (acting as a slight leading indicator) with the peak in oil prices at $147/bbl in the middle of 2008."

The increase in noncommercial activity and its orientation toward price strength occurred after enactment of the Commodity Futures Modernization Act (CFMA) late in 2000. The law exempted oil and gas financial instruments traded outside formal exchanges from regulation by the Commodity Futures Trading Commission (CFTC).

"While correlation does not imply causation, the trends evident in open-interest data are impossible to ignore," the study authors say. "It is striking that only after the CFMA was enacted did the composition of players in the market significantly change and oil prices rise to unprecedented highs." CFTC officials have testified to an absence of evidence that speculation boosted commodity prices. Medlock and Jaffe say the commission's analytical methods don't account for changes in market composition.

Since January 2001, the authors note, oil prices have been strongly correlated with the dollar's value, rising when the dollar value falls and vice versa. The correlation was negligible during 1986-2000. Medlock and Jaffe warn that "the dollar risks getting caught in a vicious cycle where continually rising oil prices feed the US trade deficit, leading to increased US indebtedness and thereby an even weaker dollar, which further drives oil prices higher."

The authors call for a review of market structures and regulations as well as of the role of government intervention—via purchase and sale of oil to and from strategic storage—in "extreme circumstances." Some of that review is under way in Congress and the CFTC.

Government's role

To much of the oil and gas industry, an increased role of government in markets is anathema. Properly so. But the market can't be said to work well when prices appear to have disengaged from physical supply and demand.

Those fundamentals couldn't explain the zoom in oil prices to extremely high levels in mid-2008, when speculative activity, according to the Baker Institute study, peaked. The price surge inflamed a political assault that remains a threat to oil and gas operations. To the extent it resulted from unbridled speculation, the industry should support whatever regulation may be needed to prevent a recurrence—though not a paragraph more.