Banks and hedge funds have bet billions of dollars on oil in the last decade, but it's not clear whether they're driving up the cost of crude



With gas averaging around $4 a gallon nationally, President Obama wants voters to know he feels their pain at the pump. And so, in a brief policy speech yesterday, he turned to the Democrats' favorite folk medicine for dealing with rising oil and fuel costs -- clamping down on speculators. 

"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," the president said. "We can't afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick."

Is Obama fighting a straw man here? Are unscrupulous speculators really making a quick buck at the expense of America's families? And would his proposals really have any impact? The evidence is mixed.  


In the popular imagination, an oil speculator is a sort of all-purpose villain, an oil-sucking leech from the sewers of Wall Street. The real picture is more complicated.

When we talk about speculation, we're talking about the futures market. That's where companies and investors go to buy and sell contracts for oil that will be delivered at a later date. For companies that use a lot of petroleum, such as refiners, futures are an essential way to protect, or "hedge," against the risk of price increases down the road. The Commodity Futures Trading Commission, the government agency in charge of policing the oil markets, calls these companies "commercial buyers." Everyone else? They're "non-commercial buyers." 

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These non-commercial traders are the speculators we hear so much about. They're in the market purely to gamble on price swings. This may sound malevolent, but they play an important role by making it easier for everyone, including the companies who really are using oil, to make trades. It's widely acknowledged that without a certain amount of speculation, the market would break down. 

The question is, how much speculation is too much? And is there even any such a thing? 


As Obama acknowledged in his speech, the world oil market is fundamentally shaped by the economic forces of supply and demand. And right now, there are plenty of rational reasons why the price of oil should be high, from temporary supply disruptions in various oil producing nations, to demand from the developing world, to the threat of conflict with Iran.

But there's also good reason to believe supply and demand isn't the entire story. 

In the last decade, banks and hedge funds have poured billions and billions of dollars into commodities, and oil in particular. Much of this money has been in the form of so-called "commodity-index funds," which let investors buy a set basket of commodities such as oil, wheat, and copper. The enormous growth of these funds came to the public's attention in 2008, thanks largely to Senate testimony by hedge fund manager Michael Masters. At the time, oil was surging towards $150-a-barrel, leaving policy-makers grasping for explanations. Masters blamed the funds, which he estimated had grown from $13 billion at the end of 2003 to $262 billion in March 2008. For perspective, in 2004, the futures market value of all 25 indexed commodities was $180 billion.

Here's a chart from his printed testimony. That growing red eye? Those are index funds . 


Index funds aren't like traditional speculators. First off, because the amount of money they bet on each commodity is set at a fixed percentage, they don't necessarily respond to supply and demand changes in individual markets. More importantly, unlike traditional speculators, index funds never sell futures,* they only buy. As a result, the theory goes, they create permanent increases in demand. 

When oil prices plummeted to $30 a barrel after the financial crisis, many became even more suspicious of the role speculators might have played. After all, even in a crisis, could supply and demand really justify such an enormous price swing? Last year, Stanford Professor Kenneth Singleton examined the role of index funds in the mid-aughts oil boom, and found that the more money investors poured into the market, the more prices seemed to rise. Meanwhile, researchers from the Federal Reserve Bank of St. Louis concluded that speculators were responsible for about 15 percent of the price spike. Goldman Sachs, widely regarded as the titan of oil trading, has estimated that every million barrels of oil held by speculators adds six to ten cents to the price of oil. 

All of this makes perfect sense, if you believe futures prices, the cost of oil shipped tomorrow, can effect "spot prices," the cost of oil shipped today. Not everybody takes that for granted. In 2008, Paul Krugman argued that the only way the futures market could impact real supply and demand was if traders started hoarding oil with the hope of selling it for more later. He didn't see any evidence that was happening. But this argument ignores one of the quirks of the petroleum market. For various reasons, oil traders set spot prices -- again, that's oil shipped immediately -- based on futures prices. So when futures go up, oil should theoretically get more expensive across the board. 

Again, not everybody agrees. Some very highly regarded oil economists, including the University of Michigan's Lutz Kilian, have argued that we simply don't have sound evidence that speculators drove up prices in the last decade. These researchers have used sophisticated econometric models to attack some of the evidence cited by the anti-speculator crowd. According to this camp, for instance, it's not clear that changes in futures prices can predict changes in spot prices. Nor is it clear that speculators are creating artificial demand, or just responding to market forces. Speculators may have had an impact in recent years, they say, but we haven't sussed it out. 


All of this brings us back to Obama and the plan he announced yesterday. Essentially, the president would increase penalties for "market manipulation," give more resources to the CFTC to police the markets, and allow the agency to raise margin requirements, which are the amount of cash investors have to deposit for each trade.

The market manipulation bit is window dressing. Although individual traders have indeed managed to accumulate massive oil future positions, few people seriously believe that illegal manipulation is shaping the market today. The extra money for the CFTC isn't a game-changer, either.

Increasing margins, however, could have some impact. By forcing investors to lock more money in each trade, it limits their potential returns. That would make oil less attractive, and perhaps cool down the market. Currently, margin requirements are set by the exchanges where oil is traded, not by the government. 

So if you believe investors really are overheating the oil market, Obama offered up a reasonable, though not particularly dramatic, remedy yesterday. But ultimately, the price of oil is rising mostly because of two factors: supply and demand. Neither Obama nor anybody else has the power to change either in a hurry.


*Obviously they do sell when they liquidate their positions. But in general, index funds take long-term long positions, as opposed to traditional speculators, which will short oil. 

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