Could More Regulation Prevent Oil Price Swings?
U.S. Regulator Considers Action Against Energy Market Speculation
Aug 23, 2009
Over the past two years, oil prices have been on a roller-coaster ride, from the dramatic peak of nearly $150 per barrel in July 2008 to a free-fall to just below $40 per barrel in January 2009. As oil prices have inched their way back up to nearly $75.00 barrel, the Commodity Futures Trading Commission (CFTC), the U.S. regulator for financial commodity markets, is looking for solutions to address oil price volatility.
Speculation and its Impact on Oil Prices
Oil prices are driven, at least in part, by traditional supply and demand fundamentals. As global GDP increased in 2007 and the first half of 2008, demand for oil increased. At the same time, due to various constraints in global oil production, supply did not increase to match rising demand causing oil prices to rise.
However, market fundamentals are only part of the story. In recent years, oil markets have become increasingly “financialized” as investors have moved into energy commodities markets to take advantage of price changes or hedge against them. The average daily trading volume of oil futures rose from four times the average daily world demand for oil in 2002 to 15 times average daily world demand in 2008.
In the economics textbook world of equally informed, risk-neutral investors, the buying and selling of oil futures contracts should have no impact on the current or spot oil price. However, without perfect information, a change in oil futures prices due to speculative buying and selling of futures contracts could cause players in the spot market to change their positions for fear that futures market participants knew something they did not. The result is a change in the spot oil price.
While the actual impact speculation in the futures market had on spot oil prices is greatly debated, a recent policy brief from Mohsin S. Khan of the Peterson Institute for International Economics argues that without speculative activity via financial markets, oil prices would have been in the $80-90 per barrel range for 2008. At their peak on July 11, 2008 oil prices reached $147 dollars per barrel.
Addressing “Excessive Speculation”
While the CFTC initially published a report in July 2008 attributing price swings to fundamental, the commission now believes important part in oil price movements and began hearings in July 2009 to determine the best way to address “excessive speculation”.
The main way the CFTC is considering combat “excessive speculation” is through imposing stricter “position limits” or caps on how many futures contracts an entity can buy (take a net long position) or sell (take a net short position).
Currently, the CFTC imposes position limits on agricultural commodities like soybeans and cotton, leaving position limits for energy commodities under the authority of the exchanges on which they are traded. While the CFTC can take action if exchanges are not being stringent enough, it has rarely taken action. The CFTC is also considering imposing position limits on market participants that have previously been granted exemptions from the regulation.
Would the Regulation Work?
Many have criticized the calls for increased regulation of oil markets. One concern is that market participants will find ways to maneuver around the regulations either by trading less transparent markets such as through oil swaps or move to less regulated foreign markets. Another concern is that the CFTC could set position limits too low, potentially disrupting the market.
Despite these concerns, the CFTC is already asserting its authority to address excessive speculation in other markets. On August 21, 2009 the CFTC revoked for two major investment firms in agricultural commodities. The commission is also looking to impose limits on the rapidly growing carbon trading market.
 |
