IS SPECULATION THE REASON FOR OIL PRICE HIKES?
Srinivasan Krishnamurthy and Richard S. Warr are both associate professors of finance in the Poole College of Management at N.C. State University.
Is speculation the reason for oil price hikes?
RALEIGH There’s been some speculation lately that Wall Street speculators are driving oil prices to unreasonably high levels – that there’s a direct cause and effect relation between the amount of speculative activity in oil and the price paid for oil by consumers. We’d like to shed some light on how speculators trade in the oil market and whether their activities could affect the price at the pump.
Broadly speaking, there are two types of traders in the oil markets and both trade primarily oil futures. A futures contract is just a simple agreement between two parties to buy and sell a quantity of oil at a future date at an agreed upon price.
The first type of traders, “Hedgers,” are firms that are either producers or consumers of crude oil (e.g., refiners and airlines) and who seek to guarantee a future selling or buying price. The second type, “Speculators,” are usually institutions (e.g., hedge funds, banks) or individuals who don’t have a direct use for the oil. They are simply betting on the level of oil prices by trading in oil futures. If they think that the price of oil will increase, they will buy futures; if they think it will fall, they will sell futures.
A key provision of oil futures contracts is that they allow cash settlement. This means that when it is time to settle up on the futures contract (i.e., one party sells and the other buys), no oil actually changes hands. Instead, one party either pays or receives cash based on the difference in the previously agreed upon futures price and the actual price on the settlement date. This feature of futures contracts makes them attractive for speculators.
If the speculators simply settle their futures contracts by exchanging cash and do not actually buy or sell the oil, their trading does not directly affect the supply or demand of oil, which raises the question: How can their trading affect crude oil prices?
Just because speculators are not actually buying or selling oil doesn’t mean that their actions will not affect what is called the spot price – or the price paid today for a barrel of oil. If speculators buy oil in the futures market, they could drive the price of oil futures higher, relative to the spot price. In such a case, it may become profitable for someone to buy oil today and store it and then sell it in the future via the futures market at the higher price.
Thus speculative buying in the futures markets could increase the spot or current price. However, just because it is theoretically possible for trading by speculators to move the spot price, it doesn’t mean that they actually are doing so.
There are at least two reasons why speculation in oil futures is unlikely to have a significant long-term effect on spot prices.
First, high oil prices would induce oil producers to increase supply, as oil production becomes more profitable. At the same time, consumers would reduce their consumption (buy more fuel-efficient cars, drive less, etc.). This combination of an increase in supply and a reduction in demand will dampen oil prices.
Second, and perhaps more important, futures contracts are a zero sum game. This means that for every buyer of oil futures there must be someone willing to sell. Therefore, if bullish speculators seek to bid up future oil prices to excessive levels, they must find other investors who are willing to sell at that price. These sellers stand to profit handsomely if future oil prices are not as high as the bullish speculators expected. It is this aspect of futures contracts that limits the ability of bullish speculators to push prices far above fundamentals for the long term.
It is unlikely that speculation is causing high oil prices. Indeed a more obvious explanation is based simply on supply and demand considerations. Consider the comments of The International Energy Agency on May 19: “Despite a near -10 percent correction since 5 May, oil prices remain at elevated levels driven by market fundamentals, geopolitical uncertainty and future expectations.” Notably, Wall Street speculators were not mentioned.
Last year, global oil demand increased by 3.4 percent, twice the historic growth rate of the past decade. In Europe and the U.S., demand this year has slowed, in part due to high prices, but in China, demand was increasing at nearly 10 percent annually as of February. Add to that decreased production in Libya, and higher oil prices are an unsurprising result.
Srinivasan Krishnamurthy and Richard S. Warr are both associate professors of finance in the Poole College of Management at N.C. State
