Middle East Economic Survey
VOL. LI
No 33
18
Speculation Not So Fundamental? A Critical Review of CFTC’S Interagency Task Force Report on Crude Oil Markets
The following article by Ali Aissaoui, Head of Economics & Research at the Arab Petroleum Investments Corporation, is published concurrently in APICORP’s monthly Economic Commentary, dated August 2008. The opinions are those of the author only. Comments and feedback may be sent to research@apicorp-arabia.com
At the end of July 2008 the US Commodity Futures Trading Commission (CFTC), whose regulatory oversight of the futures markets has come under intense scrutiny, posted on its website an ‘Interim Report on Crude Oil’ that offers a fresh perspective on major factors and forces affecting the market1. The report, which has been prepared by a CFTC-chaired interagency task force (ITF) on commodity markets, refutes the proposition that speculative activity has systematically driven changes in oil prices.
Judging from initial reactions, the report has not yet found its full way to appropriate audiences outside the US. Yet, the report should be relevant in the context of the broader debate on what has changed in the oil markets. The arguments have polarized substantially. One school of thought considers that the main cause of higher prices lies in an enduring imbalance between supply and demand in the physical market. The other regards excessive speculation in futures trading as the main culprit. As part of the ongoing debate, this article reviews ITF’s findings. Part one examines the likely context and motivations behind the report, part two presents the task force’s approach and main findings, part three provides critical comments focusing on the most significant omissions and ambiguities.
Context And Motivations
No matter whom the audience is, the ITF report should be considered in the context of the US, where the same opposing schools of thought have cut through the traditional political divide. For instance, it was a mix of republicans and democrats who first blamed OPEC for higher oil prices. The No Oil Producing and Exporting Cartels Act, which they introduced in 2007, was to amend the old anti-trust law (the Sherman Act of 1890) to allow the US government to sue OPEC in a federal court. As more credence was later given to the second side of the argument, some democrats took the lead in focusing attention on CFTC. As a result, several attempts have been made at nursing pieces of legislation aimed at getting CFTC to increase its regulatory oversight of the futures market and bring more transparency to the activities of the different participants. The latest and most notable such piece is the Senate’s Stop Excessive Energy Speculation Act, which would require the CFTC to set limits on the amount of speculative trades that can be made by participants not involved in price risk management, and extend CFTC’s control to the over-the-counter markets and other exchanges exempt from the same oversight as the New York Mercantile Exchange (Nymex).
It is highly unlikely, however, that the task force, which includes staff from CFTC, the Departments of Agriculture, Energy, and Treasury, the Federal Reserve, the Federal Trade Commission, and the Securities and Exchange Commission, has been motivated by political expediency. It would also be cynical to consider the ITF report as a self-justification in response to US domestic criticism.
Approach And Main Findings
ITF examined both fundamental factors in the global oil market and activity in the West Texas Intermediate (WTI) light sweet crude oil futures contracts traded on Nymex during the period January 2003 through June 2008. The fundamental factors include the evolution of demand and supply and how such parameters as price inelasticity, macroeconomic variables, geopolitical uncertainties and producers’ policies have interfered. For the futures market ITF used both published and first-hand unpublished data to analyze the detailed structure of the market. In doing so, the task force performed extensive econometric tests to determine the incidence of traders’ positions and prices and the direction of causality between the two.
ITF’s key finding is that current oil prices and their sharp increases in recent years have essentially reflected tight market conditions and the expectation of continued imbalance between supply and demand. Moreover, the task force’s analysis of the crude oil futures market does not support the suggestion that speculation has systematically driven changes in prices.
In analyzing the fundamentals of the market, the authors have found that demand and supply have changed in important ways during the period under scrutiny. They pointed out that the “world economy has expanded at its fastest pace in decades, and that strong growth has translated into substantial increases in the demand for oil, particularly from emerging market countries.” On the supply side, the report has noted that “production of oil has responded sluggishly, compounded by production shortfalls associated with geopolitical unrest in countries with large oil reserves.” Accordingly, prices have increased to reflect the resulting shift in demand-supply balance.
On the activities that occur within CFTC’s realm, the authors of the report contend that although trading activities and the number of traders in the crude oil futures market have significantly increased, they broadly coincided with the run-up in oil prices. More specifically, they argue that “if a group of market participants has systematically driven prices, detailed daily position data should show that that group’s position changes preceded price changes.” But their analysis suggests 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.”
The ITF report, which is said to reflect the collective knowledge of some of the US government’s best economists, is indeed especially informative and offers new insights into the structure and functioning of the crude oil futures market. The report, however, suffers from significant omissions and ambiguities, chief of which are the effects of US policy-related factors on market fundamentals, the implications of backwardation in futures markets and the non-explicit extension of the causality analysis to test a perceived speculative bubble.
The Effects Of US Policy-Related Factors
Not unexpectedly, given the intended domestic audience of the report, key interfering US policy-related factors have been suppressed or obscured. This is particularly the case of US policy in the Middle East (the war in Iraq for instance is briefly referred to as a mere strife). It is also the case with dollar interest rates and exchange rates. Although their impact on oil prices has reasonably been dealt with in the report, the authors could not attribute it to adverse US monetary and fiscal policies. It will suffice, however, for our review to keep to the thread of the authors’ arguments.
Figure 1: Countries Most Responsible For The Acceleration Of Global Oil Demand, 2003-2007
Source: APICORP Research using BP Statistical Review (June 2008).
While focusing on the fundamentals of the market, the authors have emphasized strong economic growth in China, India and the Middle East to perpetuate the thesis that these emerging economies have been most responsible for the acceleration of global demand. In so doing, the authors have somewhat deflected attention from the US. As illustrated in our own Figure 1 above, among the 10 first oil-consuming countries, whose individual consumption growth has been higher than 100,000 b/d during the period 2003-2007, the US – by far the world’s largest oil-consuming country – ranks second to China.
Furthermore, the report cites price control and subsidies, and the resulting artificially low oil product prices, as being responsible for higher consumption growth in these emerging economies. While this point is particularly relevant, it becomes even more so for the low level of US taxation on transportation fuels, which is omitted as well. As illustrated in our own Figure 2 below for the year 2007, the US percentage of taxes in gasoline prices was 13% compared to 30% in neighboring Canada and an average of 57% in Western Europe. As a result, the average US gasoline price (using purchasing-power parities or PPPs) was half the European average of $1.60/liter. In the US measurement standard, this translates into $3/gallon in the US against $6/gallon in Western Europe.
Figure 2: Gasoline Prices And Taxes In Major OECD Consuming Countries, 2007
Source: APICORP Research using IEA data (Q1 2008).
The far-reaching issue of end-user taxation is politically taboo in the US, particularly in the election season. Not surprisingly, therefore, like many US policy analysts before them, the authors of the ITF report have kept silent on the issue. However, should the global imbalance between scarce supply and growing demand persist in the future, as the ITF report conjectures, it would be time for US policy advisors to consider seriously prescribing the bitter pill of increasing taxes on transportation fuel (to the level afforded by consumers in other OECD countries) as a way to rationalize consumption and imports. By the same token, this would contribute towards reducing the huge federal twin deficit, ensure sounder monetary policy and fiscal policies, and mitigate their rippling-out effects upon the rest of the global economy.
Implications Of Backwardation
In analyzing crude oil futures markets the authors of the ITF report have found that during the last four years, the term structure of futures prices has been steadily shifting upward (Figure 3) and that, with a few exceptions, futures prices have been mostly in backwardation (a market condition – opposite to contango – in which a futures price is lower in the distant delivery months than in the near delivery months). Indeed, it is well known from statistical observation that, by comparison to other commodities, crude oil futures contracts trade in backwardation more often than not. The authors, however, have refrained from investigating the implications of such a structure for both inventories levels and speculative activities.
Figure 3: Term Structure Of Oil Prices
When noting that “leading OPEC members shifted toward a tight inventory policy” (ITF Report, page 7) without further elaboration, the authors of the report have most likely in mind OPEC policy response in the aftermath of the oil crisis of 1998, when prices dipped below $10/B and, most recently, during the 2006 US inventory overhang. In both cases OPEC’s apparent success in reversing downward price trends has been attributed to its ability to force inventory drawdown in the major consuming countries, which translated into a shift from a contango to backwardation, discouraging further stock builds.
Figure 4: Returns Of Futures Contracts As A Function Of Backwardation
The shift to backwardation has most likely caused a surge in speculative commodity investments as well2. Figure 4, taken from Morgan Stanley’s literature, plots total returns on futures contacts of various commodities as a function of their annual average backwardation (relative futures basis). It suggests that backwardated commodities, chiefly crude oil and petroleum products, tend to generate superior returns via inter alia higher roll yields. This explains why oil-based commodity indexes have been so successful in attracting huge speculative funds from passive, mostly institutional, investors looking for alternatives to traditional asset classes. A roll yield is the futures basis earned by investors as (rolled forward) futures contracts draw to a close and futures prices converge to the spot price. To address the dynamic nature of commodity futures, investment banks have recently introduced fine-tuning mechanisms to maximize the roll yield, which encouraged, in the wake of the US subprime crisis, further demand for oil-backed futures contracts. Whether or not this process has contributed to initiating a speculative bubble is certainly worth investigating.
No Evidence Of A Speculative Bubble?
The tricky task of testing the dynamic relations of speculative positions and market prices has most probably been shouldered by CFTC’s economists. As noted in the methodological appendix of the ITF report, they performed extensive Granger-causality tests to examine whether or not “various groups of traders change positions in advance of price changes” to which they conclude in the negative. Since position changes came in advance of price changes, could this be interpreted as evidence of the non-existence of a “speculative bubble?” Until the task force states it explicitly and clearly, readers would find it hard to interpret their analysis to be suggesting precisely that.
The ambiguity may also persist in the absence of clear characterization of a speculative bubble. This concept has often been used to describe persistent market overvaluation followed by market collapse. In a thorough discussion on the mechanisms and factors that start and reinforce a speculative bubble, Robert Shiller defines it as “an unsustainable increase in prices brought on by investors’ buying behavior rather than by genuine, fundamental information about value.”3 While this definition makes perfect sense in the context of equity markets, that given by CFTC in its online ‘Guide to the Language of the Futures Industry’ may suit better the case of futures markets:
A rapid run-up in prices caused by excessive buying that is unrelated to any of the basic, underlying factors affecting the supply or demand for a commodity or other asset. Speculative bubbles are usually associated with a ‘bandwagon’ effect in which speculators rush to buy the commodity (in the case of futures, ‘to take positions’) before the price trend ends, and an even greater rush to sell the commodity (unwind positions) when prices reverse.
In the current oil market environment, there has been a growing perception among well-informed market monitors of the existence of such a bubble. This perception has been reinforced most recently as oil prices moved down on an abrupt trend (from $147/B on 11 July to $113/B on 11 August), which is seen as a possible sign of a bubble bursting. Although CFTC had in the past recognized and tackled similar cases,4 nowadays its economists prefer to refer to “excessive speculation”, which they define as “based on trading that results in sudden or unreasonable fluctuations or unwarranted changes in the price of commodities underlying futures transactions.”5 Whatever the case, CFTC economists and the interagency task force they lead should seize the opportunity to address, explicitly and fully, this testing issue.
Conclusions
In defying conventional expectations, crude oil markets and prices have puzzled and polarized oil analysts, economists and policy advisors alike. As the controversy has stimulated further research, valuable papers have recently been produced that deserve our attention and appreciation. CFTC’s interagency task force report is no less worthy of interest. The authors have shared rare professional skills and insights that will greatly enhance our understanding of structurally changing and volatile markets.
Obviously, it was not the intention of the present review to weigh for or against ITF’s assertion that speculation has not systematically driven changes in oil prices. The review, however, has highlighted significant omissions and ambiguities, which do not appear to stem from the report’s interim nature only. The most obvious are the effects of US policy-related factors on market fundamentals, the implications of futures market backwardation for both low inventory levels and soaring speculation, and the absence of explicit affirmation or negation of a speculative bubble. As work continues, CFTC and the interagency task force should broaden their analysis and target a wider audience in order to validate and legitimize their conclusions.
Notes:
1. US Interagency Task Force on Commodity Markets, ‘Interim Report on Crude Oil’, July 2008. The report can be downloaded from CFTC’s website (www.cftc.gov).
2. Ali Aissaoui, ‘Backwardation and the Surge in Commodity Investments: OPEC’s Policy Dilemmas Reconsidered’ (MEES, 10 September 2007).
3. Robert J Shiller, ‘Irrational Exuberance’, Princeton University Press, Princeton and Oxford, 2000, Page 5.
4. The most publicized is the ‘silver bubble’ of late 1979 and early 1980 on the New York Metals Market – Comex, which later merged with Nymex. At that time, CFTC imposed speculative position limits after concluding on the inefficiency of raising trading margins.
5. Jeffrey Harris, ‘CFTC Chief Economist’s Written Testimony before the Senate Committee on Energy and Natural Resources’, 3 April 2008.