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Speculation demystified: virtuous volatility

Oil traders in Houston © BP PLC

Speculation can actually temper volatility while not affecting oil prices

2 November 2012

This article appears in the latest issue of IEA Energy: The Journal of the International Energy Agency.

By Bahattin Buyuksahin

In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating price levels. From April 2012 to June 2012 alone, Brent crude oil prices gyrated between USD 125 and USD 89 per barrel.

Higher volatility adversely affects oil-exporting countries’ fiscal revenues and investment, reducing confidence in the economy, while it worsens inflation and growth prospects for oil importers.

In 2011, the Group of 20 (G20) nations called for policy options to combat increased volatility in commodity markets in general, and in oil markets in particular. In response, a G20 experts group emphasised the importance of improving data transparency in both financial and physical markets as well as phasing out inefficient fossil fuel subsidies. The experts group also urged the use of country-specific monetary and fiscal responses to support inclusive growth in order to mitigate the impacts of excessive price volatility.

However, it is important to note that volatility itself is not the main problem. Instead, the main challenge would be elevated price levels combined with higher volatility.

Volatility is nothing new for oil

Oil prices, like those of many other commodities, are inherently volatile, and volatility itself varies over time. Because of inelastic supply and demand curves, at least in the short run, any shock to demand or supply will lead to large changes in oil prices. Much recent attention focused on how annualised average volatility peaked in January 2009 at 92%, followed by a rapid decline to relatively low levels. However, the historical peak for volatility was in January 1991, at an average annualised 116%.

In 2012, average annualised volatility was relatively stable at about 23% until mid-March. Note that from January to mid-March, oil prices increased from USD 110 per barrel to USD 128 per barrel. Volatility in Brent prices surged especially in June 2012, reaching an annualised rate of more than 34% – at the same time that the price level declined by more than USD 15 per barrel.

This pattern – volatility increasing as oil prices decline and volatility declining as oil prices increase – is consistent with the empirical evidence for stock markets. Increased volatility when oil prices decline can be explained by the fact that falling oil prices often accompany deteriorating global activity and resulting uncertainties for global oil demand, such as the collapse in demand observed immediately after the demise of the investment bank Lehman Brothers in September 2008. On the other hand, increasing oil prices imply improving economic activity and greater stability. Thus, oil shows smaller daily price fluctuations, i.e. lower volatility.

Although policy makers and market participants generally point to peak oil prices in 2008, the average Brent oil price for all of 2008 was USD 96.94 per barrel, peaking at USD 144 per barrel only on 3 July 2008. Moreover, oil prices were above the USD 100 threshold level for only 128 days of the year. Brent oil prices averaged USD 61 per barrel after that September, when the worst financial crisis since the Great Depression hit the global economy. By contrast, from mid-February 2011 to June 2012, oil prices averaged more than USD 100 per barrel.

Given the fragile state of the global economic recovery, the impact of high oil prices on growth, especially in importing countries, is potentially more severe now than in 2008. High oil prices already threaten to aggravate the economic slowdown by widening global imbalances, reducing household and business income and boosting inflation.

Blaming the speculators

In the meantime, high oil prices have once again brought attention to the role of speculators in oil markets.

Producers, consumers and policy makers increasingly blame speculators for fluctuations in commodity prices, particularly for energy, even though a futures market lacking speculators to place counter-investments against the price-hedging transactions of physical market players would arguably be much more volatile. Perhaps inadvertently, some commentators even associate speculative activity with manipulation. Speculation and speculators have become so unpopular that some proposals seek an outright ban on speculation in commodity exchanges, especially oil markets.

But just what constitutes speculation?

In general economic terms, buying or selling any asset in the anticipation of a price change constitutes speculation. In this sense, the distinction between hedging and speculating in futures markets is not so clear. Traditionally, traders with a commercial interest in, or an exposure to, a physical commodity have been called hedgers, while those without an underlying exposure to offset have been called speculators. However, hedgers may also “take a view” on the price of a commodity or may not hedge in the futures market despite having an exposure to the commodity, choices that could be considered speculative.

In this broader view of speculation, motorists who tank up their cars in anticipation of higher prices amid fear of future oil supply disruption can be considered speculators. If their prediction is correct, though, the motorists actually are smoothing out supply availability between the present and the future, thereby reducing price volatility by putting upward pressure on prices when oil is abundant, while putting downward pressure on oil prices when oil is scarce. The same principle applies to other speculators.

If speculation is stabilising oil prices, why do politicians seem so worried about the impact of speculators? For example, as part of initiatives to strengthen oversight of energy markets, US President Barack Obama declared in April, “Rising gas prices mean a rough ride for a lot of families. We can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage and driving prices higher, only to flip the oil for a quick profit.” He was arguably referring to speculation by financial institutions, such as hedge funds and commodity index traders. The increased participation of traditional speculators as well as other financial institutions in commodity derivatives markets has led to claims that the trading activities of these speculators destabilise markets.

Primer on speculative-stabilising theory

It is obvious that there is a tight link between physical and financial oil markets. If speculators anticipate higher demand for oil in the future based on information coming from physical markets, then futures prices will increase. In turn, spot prices will rise because some oil will be pulled off the market today due to the anticipation of higher prices in the future; however, that oil comes back to the market again in a future period of relative scarcity, leading to a lower future spot price than what would have otherwise occurred without inventory accumulation.

The connection between inventory level and price level tends to moderate the volatility unless speculators are wrong. If they are wrong, they incur a loss, so they have every incentive to be right in their anticipation. This is why speculators would normally be expected to reduce volatility, without having any effect on the long-run price level, which is determined by supply and demand. In other words, traditional speculative-stabilising theory suggests that profitable speculation must involve buying when the price is low and selling when the price is high, and therefore irrational speculators or “noise traders” acting on irrelevant information will not survive in the marketplace.

No smoking gun

But some theoretical models find some reasons for concerns about hedge fund and index trading activities, in which noise traders, speculative bubbles or herding can drive prices away from fundamental values and destabilise markets. Ultimately the question of whether these speculative groups destabilise markets or simply supply needed liquidity becomes an empirical issue.

Recent research indicates that increased participation of commodity swap dealers and hedge funds has improved linkages between crude oil futures prices at different maturities, providing long-term hedging opportunities that would not otherwise have been possible. Furthermore, ample research shows that volatility in the crude market is reduced by the activity of speculators in general, and hedge funds and commodity swap dealers in particular.

Of course, these traders might attempt to move prices and increase volatility over short intervals of time. However, research using state-of-the-art econometrics finds no systematic evidence that speculative activity leads to movements in oil prices. In a 2012 paper, The role of speculation in oil markets: What have we learned so far?, that reviewed the existing literature on the impact of speculation in oil markets, the economists Lutz Kilian, Bassam Fattouh and Lavan Mahadeva concluded that “the existing evidence is not supportive of an important role of speculation in driving the spot price of oil after 2003. Instead, there is strong evidence that the co-movement between spot and futures prices reflects common economic fundamentals rather than the financialisation of oil futures markets.”

Speculators should not be viewed as distorting prices. Rather, they are essential participants for the proper functioning of commodity derivatives markets who provide necessary liquidity, thereby reducing market volatility. Recent regulatory measures, such as speculative position limits, aimed at limiting the participation and reducing the risk-bearing capacity of speculators, will potentially have adverse consequences, such as reducing liquidity, raising hedging costs and amplifying volatility in energy markets.

Michael Dunn, a Commissioner of the Commodity Futures Trading Commission in the United States until last year, perhaps best summed up the debate on position limits when he said in October 2011 that “my fear is that position limits are, at best, a cure for a disease that does not exist or a placebo for one that does. At worst, position limits may harm the very markets they are intended to protect.”

The International Energy Agency (IEA) produces IEA Energy, but all analysis and views contained in the journal are those of individual authors and not necessarily those of the IEA Secretariat or IEA member countries, and are not to be construed as advice on any specific issue or situation.

Bahattin Buyuksahin, senior analyst for price formation in the IEA Oil Industry and Markets Division, has more than seven years of experience in oil and energy finance, covering the spectrum of energy derivatives markets, from the financialisation of commodities to the evolving regulatory framework.


Homepage picture: © GlobalObsession

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