Seeking Common Ground on Oil Market Drivers*

As part of their remit covering joint activities set out in the Cancun Ministerial declaration of March 2010, the IEA, IEF and OPEC jointly hosted their second annual workshop on linkages between physical and financial oil markets in Vienna on 29 November 2011. Over 100 participants attended from across the spectrum of research institutions, major oil producers and consumers, the financial sector, regulators and policy makers. Participants reviewed recent studies on commodity price formation, the role of price reporting agencies, developments in regulatory reform in the energy derivatives markets, and emerging issues and key challenges. A full joint report on the workshop will be provided to IEF Ministers ahead of their next meeting in Kuwait in March 2012. The following represents the IEA’s version of key take-aways from the Vienna event.

Regulation beyond Mandate?*

In a contentious 3-2 vote on 18 October, the US CFTC Commissioners approved final rules on federal speculative positions limits on commodity futures, options and swaps positions of speculators for 28 commodities. These include NYMEX natural gas, crude oil, gasoline and heating oil, along with a number of metals and grains contracts.

Commodities: No Longer an Asset Class in their Own Right?*

Investors, seeking to diversify their portfolio and hedge against rising inflation, have increased their exposure to commodities by directly purchasing commodities, by taking outright positions in commodity futures, or by acquiring stakes in exchange-traded commodity funds (ETFs) and in commodity index funds. This pattern has accelerated in recent years. According to index investment data collected by Barclays Capital for US and non-US assets under management, commodity index investment has increased from $55 billion in late 2004 to $431 billion in July 2011.

Bahattin Buyuksahin's Research in the Media

Bahattin Buyuksahin’s research on the role of speculators in crude oil prices, with Jeff Harris of the Syracuse University, was the focus of an article on SeekingAlpha.com. The article discusses Buyuksahin and Harris’ research, summarizing their conclusion: “They do not dispute a correlation between speculative activity and oil price – the participants in the oil futures market increased dramatically during the oil price spikes of 2007-8 - but they do not assume causation..” ViewFull Article (1/5/12)

My Discussions on "Investor Flows and the 2008 Boom/Bust in Oil Prices" by Ken Singleton

On August 24, 2011, I discussed Prof. Ken Singleton's new research paper, entitled "Investor Flows and the 2008 Boom/Bust in Oil Prices" at the  U.S. Energy Information Administration's "Financial and Physical Oil Market Linkages Workshop"  in Washington, DC. You can find my discussions here.

Commodity Index Traders -- The New Whipping Boys?*

An August CFTC conference in Washington DC was organised to highlight and discuss recent academic research on key issues affecting commodity markets. The conference came at a time of intense debate surrounding recent CFTC rulemaking.  Several conference panelists argued that speculators in general, and commodity index traders (CITs) in particular, have affected the functioning of commodity markets and caused oil price swings that cannot be explained by energy market fundamentals – especially during the 2008 financial crisis.  However, in the presentations of that set of papers, we failed to see any detailed accounting for those very fundamentals.  In contrast, the few papers at the conference that focused on fundamentals found no clear-cut evidence of speculators driving prices away from their fundamental values.

Do Institutional Traders Predict Bull and Bear Markets?

I will be presenting our new research paper (joint work with Celso Brunetti and Jeffrey Harris), entitled "Do Institutional Traders Predict Bull and Bear Markets?", at the American University, Washington DC, on October 13,  at the International Monetary Fund  in Washington DC, on October 14, 2011 and at the European Central Bank in Frankfurt, Germany on November 10, 2011. 

Abstract:     
We analyze the role of hedge fund, swap dealer and arbitrageur activity in a Markov regime-switching model between high volatility bear markets and low volatility bull markets for crude oil, corn and Mini-S&P500 index futures. We find that these institutional positions reflect fundamental economic factors within each market. More importantly, institutional positions also contribute incrementally to the probability of regime changes displaying the synchronization patterns modeled in Abreu and Brunnermeier (2002; 2003). Conditioning on hedge fund activity and arbitrageur activity significantly improves our probability estimates, demonstrating that institutional positions can be useful in determining whether price trends resembling bubble patterns will continue or reverse.

OTC Market Regulations: Where Do We Stand?*

Market participants still await final rules which will govern global OTC derivatives markets. Meanwhile, according to the latest Bank of International Settlements (BIS) survey, total notional value of all OTC derivatives reached $601 trillion at the end of December 2010, of which $2.92 trillion (0.5%) was commodity–related derivatives. However, at their peak at end‐June 2008, the total notional value of commodity derivatives had reached a far higher $13 trillion, or 2.5% of the total market. Although the size of commodity‐related over the counter derivatives contracts is relatively small compared to the overall OTC derivatives market, new regulations will have important implications for commodity markets in general, and energy markets in particular.

Is WTI Weakness Purely Physical?*

Prices for crude oil benchmarks WTI and Brent have historically been related. In general WTI light sweet crude oil sold at a 5% premium to Brent crude oil between 1994 and 2010. However, this relationship between WTI and Brent crude oil totally collapsed in 2011. Brent crude oil sold at an average premium of $13/bbl in 1H11, or 13%, reaching $23/bbl in mid-June.

Volatility in Crude Oil Prices*

Prices for oil, like those for many other commodities, are inherently volatile and volatility itself varies over time. In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating, price levels. In the last nine months alone, crude oil prices have fluctuated in a wide range from $75/bbl to $125/bbl. However, careful examination of historical patterns shows that the volatility observed during 2008-2009 is actually lower than the peak observed in 1990‑1991.

Exchange Rates and Oil Prices*

US dollar weakness in recent years is frequently cited as one reason for high oil prices. It is very common to see the financial press suggesting that a weak dollar has pushed oil prices higher. Empirically, there is clearly an inverse correlation between oil prices and exchange rates – that is, other things being equal, oil prices rise if the dollar falls. An assessment of the dynamic conditional correlation (DCC) and of the one-year rolling average correlation between the daily change in the oil price and the daily change in the nominal effective exchange rate shows that this relationship has been relatively strong in recent years, although the negative correlation has been declining in recent months. What is less clear, though, is the direction of causality. Several econometric techniques suggest that causality may run from the oil price to the exchange rate, rather than the opposite.

How Transparent Are Crude Oil Derivatives Markets?*

Increased volatility, higher crude oil prices and the arrival of new financial participants in the crude oil market during the last decade have raised the question of whether financial players have an impact on commodity prices and price volatility. Unfortunately, limited publicly available data in both physical and financial markets makes it very hard to provide a definitive answer. Understanding the linkages between physical and financial markets on price formation requires more complete information on both than is currently available. Traders in derivatives markets rely on signals from current and expected physical fundamentals , but these signals can be distorted by imperfect or delayed information flows Therefore, it is crucial to have more timely and reliable information from physical markets in order to address the observed volatility as well as to determine the influence of different market participants on prices.

Does “Paper Oil” Matter? Energy Markets’ Financialization and Equity-Commodity Co-Movements

My coauthor Michel Robe and I presented our new research paper, entitled "Does 'Paper Oil' Matter? Energy Markets’ Financialization and Equity-Commodity Co-Movements", at Universidad Carlos III in Madrid on May 25 and at the ISTCE Business School's Annual Conference on Commodities and Energy Markets in Lisbon on May 27, 2011. 

Abstract:

We construct a uniquely detailed, comprehensive dataset of trader positions in U.S. energy futures markets.  We identify considerable changes in the make-up of the open interest between 2000 and 2010 and show that these changes impact asset pricing.  Specifically, dynamic conditional correlations between the rates of return on investable energy and stock market indices increase significantly amid greater activity by speculators in general and hedge funds in particular (especially, funds active in both equity and energy markets).  The impact of hedge fund activity is markedly lower in periods of financial market stress.  Our results support the notion that the composition of trading activity in futures markets helps explain an important aspect of the distribution of energy returns, and have ramifications in the debate on the financialization of energy markets.  

The Role of Financial Players on Financialisation of Commodities

On May 6 2011, I presented at the symposium of the Scientific Council, organised by AMF and CRE.  My presentation was entitled  "The role of financial players on financialisation of commodities." It was based on my two related articles:

• The Role of Speculators in the Crude Oil Futures Market
• Speculators, Prices and Market Volatility

Mechanics of the Derivatives Markets

This supplement to the April 2011 OMR is designed as a reference document for member governments and subscribers. It forms part of an ongoing work programme examining the mechanics of oil price formation and the interactions between the physical and paper markets. Further research will be forthcoming in the OMR, the MTOGM and in the form of stand‐alone papers in months to come. The work programme is being supported by contributions from member governments, most notably those from Japan and Germany. We are grateful for that support. Further impetus for this work comes from the joint work programme the IEA is undertaking alongside the IEF and OPEC secretariats, as requested by IEF, G8 and G20 Ministers.  

The work is overseen by David Fyfe, and the supplement’s main author is Bahattin Buyuksahin, to whom all enquiries should be addressed.

Volatility: How to Measure It*

Prices for oil, like those of many other commodities, are inherently volatile. In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating, price levels. In the last six months alone, oil prices have fluctuated in a wide range from $75/bbl to $125/bbl.

Volatility: Not Unique to Exchange-Traded Commodities*

Fluctuations in commodity prices, particularly in crude oil prices, have been hotly debated in recent years. Some argue that underlying market fundamentals, especially the unexpectedly strong demand shock attributed to continued strong economic growth in Asia and other emerging economies, is the main reason for the resurgence of commodity prices and for the fluctuations in prices since 2004. Others argue that speculative activity in commodity derivatives markets is the main force behind surging commodity prices. They further claim that commodities have become a new asset class in investors’ portfolios, and prices are now more affected by macroeconomic news rather than by commodity-specific physical market conditions.

Pre-emptive Moves Against Speculation*

Speculators have never been popular, and they may never have been as unpopular as they are today. Increasingly they are blamed for fluctuations in commodity prices, particularly in energy prices, even though a market lacking speculators to take the other side of price hedging transactions for physical market players would arguably be one that would be much more volatile.

Institutional Investors Embrace Commodities as New Asset Class*

Investor interest in commodities, including oil, has risen dramatically over the last decade and commodities have become a new asset class in institutional investors’ portfolio. Partly, this development is due to diversification benefits. In addition, the development of new investment vehicles, such as exchange traded funds, has allowed individual investors to get exposure to movements in commodity prices. Due to the storage and trading costs associated with direct physical investment in commodities, the main vehicle used by investors to gain exposure is via commodity indices (baskets of short maturity commodity futures contracts that are periodically rolled over as they approach expiry), exchange traded funds or other structured products. These instruments provide generally long-only exposure to commodities.