The Role of Hedging and Speculation in Recent Oil Price Formation Through Futures Markets

Abstract

Abstract This paper considers the role of hedging and speculation on future oil prices. In July 2008, oil prices topped over $140/bbl then tanked to below $50/bbl by December of the same year. Many including officials, suppliers and consumers blamed futures markets, especially the speculators, for the oil price volatility (Buyuksahin 2012). Shenoy (2011) relates the increase of non-commercial traders and contract volumes to the price fluctuation. Further, Shenoy (2011) disregards the market fundamentals and claims they cannot justify the high prices. However, others find market fundamentals to be more important. U. S. Energy Information Administration (EIA) (2007) and Krugman (2013) cite activities that have caused oil prices to increase and state reasons that support market fundamentals. These factors include geopolitics, rapid world economic growth, decreasing production, little surplus oil production capacity and inelastic oil demand. In this paper we investigate whether we agree with these latter papers that the big price increase from 2007 to mid-2008 is better explained by market fundamentals. Financial theory shows us that for speculators and the futures market to raise current cash prices, they must induce shifts in demand or supply in the cash market. Such shifts can come from inventory changes in the cash market or from producers shifting their production profiles. Thus, if futures prices are bid up by speculators and high futures prices are causing commercials in the cash market to increase inventories or producers to reduce production, then speculators are contributing to the price increase. There are three links in the chain that we need to investigate to support the speculator story. First, speculator positions in the futures market must be reinforcing the futures price changes; they must be buying when prices are increasing and selling when prices are falling. Second, the futures price must be inducing players in the cash market to be shifting their positions in a pattern consistent with changing future prices. If future prices are higher, buyers of crude should be buying and putting crude into inventories and sellers of crude should be withholding production and increasing spare capacity. If future prices are lower, crude buyers should reduce purchases now and run down inventories, and sellers should increase production and lower their surplus capacity. Finally, the futures price and the spot price movements need to be lined up. Thus, we expect higher futures prices to coincide with rising spot prices and lower futures prices to coincide with lower spot prices. To support the market fundamental hypothesis, we will explain the fundamentals of how hedging and speculation affect oil prices. Such fundamentals will clarify many misconceptions and show when hedging and speculation reduce price volatility and make the market more efficient and when they do not. Finally, we will consider oil price volatility since 2004 with particular emphasis on the oil price spike in 2008, which was followed by a significant collapse. We will consider if the three links in the chain above hold and support the hypothesis that speculators were responsible for the big price run-up and collapse as well as other less notable price movements since 2004.