A booming world economy demands more industrial commodities, and at the top of that list is oil. For example, continuous growth in emerging countries such as China and India increases the aggregate world demand for oil and, consequently, its price.
Expected future shortfalls in oil supply, relative to demand, motivate the storage of oil for future use. Either the possibility of a sudden shortage in production or of a new source of demand can create an expected shortfall. For example, uncertainty about future oil supply may arise from political instability in key oil-producing countries, such as Nigeria, Iraq, Venezuela, Libya or Iran.
Such uncertainty increases demand for storing oil, driving up the current price. Speculation is the act of purchasing something today with the anticipation of selling it at a higher price at a later date. Financial markets allow traders to speculate on oil prices in the following way: Traders buy a contract for oil to be delivered at a later date a futures contract , sell the contract before the oil is due for delivery and use the proceeds to purchase another futures contract for delivery at a more distant date.
Expectations that the price of oil will be higher in the future motivate investment funds to take positions in these contracts, and as demand for futures contracts increases, so does their price, which also moves the current oil price.
Figure 2 illustrates the degree to which oil price trends over various parts of are attributed in our model to each of the four elements discussed above. We identify periods by the beginning and end of distinctive trends, rather than by evenly spaced time intervals, in order to best capture the net contribution each factor made to each trend.
The black line shows the modeled percent change in real oil prices during each time period, and the bars illustrate the percentage point contribution made by each of the four elements. During the past decade, just as historically, global demand was the primary driver of oil prices: The blue bars representing the contribution of global demand are the largest and show the greatest co-movement with the total change in oil prices. Moreover, the decline in the real price of oil in the second half of can be traced predominantly to the sharp reversal in worldwide demand that resulted from the financial crisis and ensuing global recession.
Figure 2 also reveals, however, that speculative demand did materially contribute to the increase in oil prices from to mid In particular, the contribution from speculation to rising oil prices red bar exceeded the combined contribution of global supply and inventory demand purple and green bars from to mid Overall, we estimate that speculation accounted for about 15 percent of the measured rise in oil prices from to mid It is noteworthy that this trend began in , which is when significant investment from index funds started to flow into commodities markets.
The mere belief that oil demand will increase dramatically at some point in the future can result in a dramatic increase in oil prices in the present, as speculators and hedgers alike snap up oil futures contracts.
Of course, the opposite is also true. The mere belief that oil demand will decrease at some point in the future can result in a dramatic decrease in prices in the present as oil futures contracts are sold possibly sold short as well , which means that prices can hinge on little more than market psychology.
Basic supply and demand theory states that the more a product is produced, the more cheaply it should sell, all things being equal. It's a symbiotic dance. The reason more of a good was produced in the first place is because it became more economically efficient or no less economically efficient to do so. If someone were to invent a well stimulation technique that could double an oil field 's output for only a small incremental cost , then with demand staying static, prices should fall.
Actually, there have been periods of time when supply has increased. Oil production in North America was at an all-time zenith in , with fields in North Dakota and Alberta as fruitful as ever. This is where theory pushes up against practice. Production was high, but distribution and refinement were not able to keep up with it. The United States has built an average of one refinery per decade construction has slowed to a trickle since the s. There's actually a net loss : the United States has two fewer refineries than it did in Since the beginning of oil's rise as a high-demand commodity in the early s, major peaks in the commodities index have occurred in , , and Oil peaked with the commodities index in both and Note: there was no real peak in oil in because it had been moving in a sideways trend since and continued to do so through Then there's the problem of cartels.
Although the organization's charter doesn't explicitly state this, OPEC was founded in the s to—put it crudely—fix oil and gas prices. By restricting production, OPEC could force prices to rise, and thereby theoretically enjoy greater profits than if its member countries had each sold on the world market at the going rate.
Throughout the s and much of the s, it followed this sound, if somewhat unethical, strategy. To quote P. O'Rourke, "certain people enter cartels because of greed; then, because of greed, they try to get out of the cartels. Energy Information Administration , OPEC member countries often exceed their quotas, selling a few million extra barrels knowing that enforcers can't really stop them from doing so.
With Canada, China, Russia, and the United States as non-members—and increasing their own output—OPEC is becoming limited in its ability to, as its mission euphemistically states, "ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers. Rather, supply, demand, and sentiment toward oil futures contracts, which are traded heavily by speculators, play a dominant role in price determination.
Cyclical trends in the commodities market may also play a role. Regardless of how the price is ultimately determined, based on its use in fuels and countless consumer goods , it appears that oil will continue to be in high demand for the foreseeable future.
Accessed Jan. CME Group. Bureau of Labor Statistics. Government of Canada. Energy Information Administration. Congressional Research Service, " The U. American Petroleum Institute. Council on Foreign Relations. Foreign Policy: — Peter Sainsbury. CreateSpace Independent Publishing Platform, University of Cambridge. Oil Price. Energy Trading. Your Privacy Rights. When weekly position changes are plotted against changes in price in the following week instead of the same week, as in Figures 2 though 5 , the correlation essentially disappears.
In other words, managed money trades may cause prices to rise or fall in the week they are made, but they do not appear to trigger longer price trends. The same is true over other time horizons. For example, Figure 6 shows changes in money manager positions and price changes four weeks later. The data suggest that there is no correlation between whether hedge funds and other money managers buy or sell this week and what happens to prices over the next month.
Figure 6. If derivatives speculators have mispriced oil during recent years, there are two ways this could have happened. The first is through deliberate manipulation of the price by a group of market participants.
Knowing action to create artificial prices is a violation of the Commodity Exchange Act, and the regulators and exchanges have market surveillance programs to detect attempted manipulation. The second possibility is much harder to evaluate: do derivatives markets in their normal operation have the potential to distort prices?
Section 4a a of the Commodity Exchange Act describes "excessive speculation" as "an undue and unnecessary burden on interstate commerce," but there is no statutory or regulatory definition of the term.
There is an extensive literature on the relationship between speculation and commodity prices, but the question is not settled—the data are subject to conflicting interpretations. The Commodity Exchange Act CEA , the statute which governs the regulation of commodities and futures markets, makes it a felony to manipulate or attempt to manipulate the price of a commodity, including one for future delivery.
Section of the Dodd-Frank Act P. On April 21, , President Obama announced that the Attorney General was assembling a team to root out any fraud and manipulation in the oil markets that might be contributing to higher U.
In May , the CFTC filed an enforcement action against three energy trading firms and two individuals, charging them with a series of manipulations between January and April a period when prices were rising rapidly.
They did so by buying large quantities of physical oil, causing market participants to revise downwards their estimates of the amount of oil available to settle maturing futures contracts. This perception of limited available supply drove up the price, allegedly earning the defendants profits from a long position in futures.
Then, having taken profits from the long position, the traders liquidated their physical oil holdings very rapidly, depressing the price and allowing them to profit from a short position in futures. Their futures positions were calendar spreads—a long contract for one month and a short contract for another month.
The CFTC complaint does not state how much or even whether the alleged scheme affected the price of oil itself—since the defendants were trading spreads, the absolute price level was less important to them than the difference between the various month contracts. Thus, although manipulations do occur in futures markets, this case even if all allegations are proven appears to involve short-term price dislocations that do not explain the price run-up in , as it continued after the alleged manipulation ended.
There are two opposing theoretical views on speculation. The first is that it tends to stabilize prices and make the price-setting mechanism more efficient; the second is that at times speculation causes price trends that cannot be explained by fundamental economic factors. People who argue that speculation is generally destabilizing seldom realize that this is largely equivalent to saying that speculators lose money, since speculation can be destabilizing in general only if speculators on the average sell when the [commodity] is low in price and buy when it is high.
To make money, speculators must be able to buy low and sell high. By so doing, they smooth out the peaks and troughs of commodity prices. If they are unable to do this successfully, if their price forecasts are more often wrong than not, they will be driven out of the market by their losses.
This benevolent view of speculation is generally supported by empirical research into the effects of futures trading on cash market prices. Although the issue cannot be regarded as settled, numerous studies have found that the existence of a futures market either has no effect on or tends to reduce price volatility in the underlying commodity. For example, a recent Federal Reserve study compared price movements over the period in industrial metals for which there is a futures market and metals for which no futures contract exists.
Instead, commodity spot price changes are driven by world economy activity and financial investors are merely responding to these price changes. The Task Force's preliminary assessment is that current oil prices and the increase in oil prices between January and June are largely due to fundamental supply and demand factors.
During this same period, activity on the crude oil futures market—as measured by the number of contracts outstanding, trading activity, and the number of traders—has increased significantly.
While these increases broadly coincided with the run-up in crude oil prices, the Task Force's preliminary analysis to date does not support the proposition that speculative activity has systematically driven changes in oil prices. More specifically, the report found 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. From an opposing theoretical perspective, speculation is seen as a potential source of price instability. Describing the behavior of investors, J. Keynes distinguishes between enterprise, the activity of forecasting the long-term yield of assets, and speculation, the activity of forecasting the psychology of the market.
As speculators, he wrote, " A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield. More fundamentally, Keynes wrote that "when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.
If speculators bring new fundamental information to the market, their trading should not only be profitable but should make the price discovery mechanism more efficient. When prices appear to diverge from economic reality, when a price bubble forms, many conclude that speculators are distorting the price-setting mechanism.
There are several explanations for how price bubbles expand—irrational exuberance, positive feedback, 32 herding, and so on—but the process by which bubbles start and end remains little understood.
How is it possible to know at any given moment whether speculation is playing a stabilizing role or whether markets are behaving irrationally? Which model of speculation best describes reality? The Commodity Exchange Act states that speculation may distort prices when it becomes excessive. The term "excessive speculation" does not provide a precise tool for distinguishing between beneficial and harmful speculation—"excess" is in the eye of the beholder—but it does provide a framework for analyzing the impact of speculation on the oil market.
Section 4a a of the Commodity Exchange Act declares that "[e]xcessive speculation in any commodity The point at which speculation becomes excessive is left to the regulator to determine: there is no statutory definition or benchmark.
To many observers, phrases like "sudden or unreasonable fluctuations" and "unwarranted changes in the price" aptly describe the oil markets of and When oil prices are high and volatile, and there have been no dramatic supply shocks, many blame financial speculation.
The case against oil speculators, or rather the case that oil speculation has become excessive, rests principally on two arguments. First, there is said to be too much speculative trading. While it is generally acknowledged that hedgers benefit from the presence of speculators willing to take on the risks that hedgers wish to avoid, the argument is made that financial traders have overwhelmed the market.
Rather than simply provide liquidity to hedgers, speculators now account for the majority of contracts. As Table 1 shows, commercial hedging positions account for less than half of all crude oil contracts outstanding. The tail, in this view, is wagging the dog. This view is supported by studies from the staff of the Permanent Subcommittee on Investigations PSI of the Senate Committee on Homeland Security and Government Affairs, which found that excessive speculation has had "undue" influence on wheat price movements 35 and in the natural gas market.
Amaranth's trading demonstrates that excessive speculation can distort futures prices not only in the next month or two, but for many months into the future. Currently, the major focus of the CFTC and the exchanges is to prevent excessive speculation from disrupting orderly trading of a contract near the expiration of that contract. The CFTC and the exchanges need to be vigilant to ensure that traders' speculative positions in futures contracts several seasons, or even several years, in advance are not distorting prices.
Also, a report by the minority staff of the House Committee on Oversight and Government Reform argues that "addressing excessive speculation offers the single most significant opportunity to reduce the price of gas for American consumers. When financial institutions and investors as a group move funds into commodity markets, prices move.
Even though increased financial speculation does not rise to the level of illegal manipulation, critics argue that the economic impact is the same. In theory, higher volumes of speculative trading should not necessarily lead to more price volatility, if financial speculators base their trading decisions on the same factors as those of other market participants. But do they? The second part of the case that excessive speculation is destabilizing is that speculators do not trade on the fundamentals.
The argument is that because financial speculators never produce or take delivery of physical oil, they bring to the market strategies and expectations that, in Keynes' phrase, "do not really make much difference to the prospective yield" of the asset.
As a result, prices are subject to violent swings even though there has been no significant change in underlying supply and demand. When oil prices are high, it is common to speak of a "speculative premium," meaning that the market price is higher than what the fundamentals of supply and demand justify, and that the excess is caused by uninformed speculation. I would give you just one benchmark.
Now, nothing had changed in the global supply the next day, so what was the market reacting to? It was reacting to some level of insecurity about what the future supply was going to be. So that is people pricing into the global market what they believed their cost is going to be sometime in the future, building in their concerns and their worries about other possible supply disruptions and the ability of the market to respond to that. In other words, possible future supply and demand events are properly factored into today's price, even though those events may never occur.
Present-day supply and demand conditions are fundamentals, but so are expectations about the future. In general, free markets are expected to distinguish between relevant fundamental information and extraneous "noise" that causes prices to drift away from fundamental values. The argument that speculation is distorting the oil market is based on one or both of two presumed mechanisms: 1 excessive speculation by financial traders is economically if not legally equivalent to price manipulation, and 2 speculators introduce unwarranted volatility by trading on information unrelated to fundamentals.
The next section of this report briefly analyzes the fundamentals of the oil market and suggests that sharp swings in the price of oil do not necessarily mean that prices are not based on fundamentals.
A number of factors have contributed to higher prices for oil and other energy commodities. Rapid global economic growth led to rising demand for oil, and supply could not keep up at previous prevailing oil prices. In theory, this contributes to prices rising until some consumers no longer buy oil and producers provide more supply, putting the market in balance again.
But oil supply and demand is inelastic to price changes, especially in the near-term, which means it may take a larger percentage change in prices to incentivize relatively small changes in supply or demand. Global economic growth increased demand for oil. Economic growth is the leading driver of oil demand. See Figure 7. These countries were going through the energy-intensive process of industrialization, which required greater use of energy sources such as oil and coal. Oil supply growth, on the other hand, faced a number of hurdles.
Oil resources in key oil exporting countries like Mexico, the United Kingdom, and Norway had been depleted and were in decline. Other key sources of oil supply experienced supply disruptions that reduced production. Examples included strikes in Venezuela in , periodic militant attacks in Nigeria particularly since , and hurricanes in the Gulf of Mexico sometimes shutting down offshore U.
Further, some countries with abundant oil resources maintained or raised new barriers to private investment in oil exploration and production, such as increasing the national oil company's control of the energy sector, raising industry taxes, or effectively nationalizing shares in some oil producing assets.
This cartel of oil exporting countries varies its production level in an attempt to control oil prices. OPEC countries thus collectively maintain spare oil production capacity that can act as a cushion to oil markets in the event of disruptions or other surprising developments that require more oil.
This contrasts from production in non-OPEC countries, which is usually at maximum capacity. OPEC did cut production at several key points when prices were falling during the s. But generally OPEC members increased their output over the period when prices were rising.
Perhaps more importantly, the organization ran low on spare capacity between and Low spare oil production capacity reduces the capacity to cushion against future supply disruptions or other market surprises. A rising price for a good provides consumers with an incentive to consume less of that good and provides producers an incentive to supply more, which in turn can moderate the price increase. But in the oil market, supply and demand quantities can be relatively unresponsive to price changes, especially in the short run.
As a result, it takes large swings in price to correspond to relatively small changes in consumption and production. Oil is essential for economic activity and there are limited near-term substitutes. Consequently, households and industrial consumers may absorb much of the cost increases, reducing spending on other goods or reducing savings.
Rapid economic growth in developing countries meant rising incomes could absorb higher energy costs. Further, some countries had subsidies that insulated consumers from the price increase during the s.
Some developing countries have subsequently reformed their pricing system to reduce the fiscal burden of subsidies and reduce consumption. In advanced economies, incomes were already relatively high, allowing consumers to absorb higher costs for a time, albeit at the expense of other economic priorities—a painful adjustment particularly for low-income households as well as businesses and workers in industries where oil-related expenditure is a relatively significant part of the budget.
Consumers could not easily reduce their consumption through efficiency improvements—the equipment that uses oil is expensive and upgrading or replacing it can require large upfront costs and take time. Examples include cars, home heating, airplanes, and industrial equipment. These factors all contribute to global demand that is inelastic to prices: consumption did not decline in proportion to the increase in prices.
In fact, except for and —when the recession dragged down global demand—oil consumption has increased every year since Global oil consumption increased by roughly the same amount in the decade of the s as it did during the s, despite oil prices being at much higher levels.
Consumption in mid has recovered from the recession, surpassing previous highs to reach record levels. Underlying these developments is a shift in consumption growth from the advanced economies to developing economies see Figure 8.
Oil supply is also slow to respond. Oil production assets are expensive, and developing large new fields can take many years. As a result, supply can also be inelastic to prices in the short run. This tendency is exacerbated by several factors.
As easy-to-develop resources have been depleted, the oil industry has moved into resources that are more complicated, expensive, and difficult to exploit, such as the oil sands in Canada or deepwater offshore developments. Where abundant easy-to-develop resources are still available, countries sometimes restrict where and how oil development and production can take place in pursuit of other national objectives, including environmental and resource management priorities.
Nations may limit access to oil resources to preserve them for future generations, maintain government control of the energy industry through a national oil company, or maximize long-term revenues from energy resources. Alternatives to oil, like biofuels, electric or gas vehicles, and coal- or gas-to-liquids technology have also faced challenges that have made them difficult to scale up.
Some are expensive, require significant long term investment in infrastructure, lack sufficient technical advances, or have other potential negative impacts consider ethanol contributing to higher food prices or coal-to-liquids emitting significant greenhouse gases. Even with higher prices, many of these technologies still required public support and were thus subject to policy and political uncertainties and constraints.
With supply and demand adjustment constrained, there was little to dampen the price increase, unlike what might take place in a more price-elastic market. However, demand is relatively elastic to income.
When the U. Again because supply is inelastic to price movements, few producers curtailed supply when prices were falling. In the event, OPEC responded by making a policy decision to curtail output to support prices. These cuts reached markets in early Cuts, along with the economic recovery, contributed to subsequent price increases.
In recent months, geopolitical disruptions again came to the forefront of the market. Supply disruptions and fears of future disruptions in the Middle East and North Africa, coupled with economic recovery and the persistence of supply constraints, have contributed to oil prices reaching levels seen in the first half of Legislation before the th Congress S.
The tax would be levied at 0. Supply and demand issues—market fundamentals—played a central role in the increase of oil prices in recent years.
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