Saturday, June 18, 2011

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.

CFTC data and classifications

Data limitations are not restricted to physical oil markets. Energy derivatives markets are also partially opaque. The best available data comes from the US Commodity Futures Trading Commission’s (CFTC) Commitments of Traders Report, which break down each Tuesday’s positions held in the aggregate by “large traders” (those whose positions are above a certain threshold). Those data are published every Friday as part of the CFTC’s Commitments of Traders (COT) or Disaggregated Commitments of Traders (DCOT) reports. Both publications separate reportable large traders into “Commercials” and “Non-commercials”.

DCOT reports further disaggregate commercials and non-commercials into two groups: producers and swap dealers for commercials, and managed money traders and other reportables for non-commercials. A trader's positions in a given commodity are classified as commercial if the trader uses futures and option contracts in that particular commodity for hedging, as defined in CFTC regulations. To ensure accurate and consistent classifications, the CFTC may reclassify a trader based on additional information about the trader’s use of the markets. “Non-commercials” comprise many types of mostly financial traders, such as hedge funds, mutual funds, floor brokers, etc.

Still, the CFTC’s reports are not perfect. For example, non-commercial traders are typically viewed as speculators. On this basis, some observers argue that commercial swap dealers, who use futures markets to hedge over-the-counter positions with financial traders, should also be considered as speculators, since they lack direct exposure to the underlying commodity. In fact, swap dealers commonly take positions for commodity index funds that view commodities as a distinct asset class, raising concerns that these funds could convey herding behaviour from unsophisticated traders into futures markets. Insofar as the client base of swap dealers also includes traditional hedgers, however, the issue is not clear.

Differentiating hedgers and speculators

Furthermore, the distinction between hedging and speculation in futures markets is less clear than it may appear. Traditionally, traders with physical commodity exposure have been called hedgers, while those without a physical position to offset have been called speculators. In practice, however, commercial traders may “take a view” on the price of a commodity or may not hedge in the futures market despite having an exposure to the commodity, positions that could be considered speculative.

Traditional speculators can be differentiated based upon the time horizons during which they operate. Scalpers, or market makers, operate at the shortest time horizon – sometimes trading within a single second. These traders “make markets” by standing ready to buy or sell at a moment’s notice. The goal of a market maker is to buy contracts at a slightly lower price than the current market price and sell them at a slightly higher price, perhaps at only a fraction of a cent, to profit on each contract. Skilled market makers can make a profit by trading hundreds or even thousands of contracts a day. Market makers provide immediacy to the market. Without a market maker, a market participant would have to wait until the arrival of a counterparty with an opposite trading interest.

Other types of speculators take longer-term positions based on their view of where prices may be headed. “Day traders” establish positions based on their views of where prices might be moving within minutes or hours, while “trend followers” take positions based on price expectations over a period of days, weeks or months. These speculators can also provide liquidity to hedgers in futures markets. Through their efforts to gather information on underlying commodities, the activity of these traders serves to bring information to the markets and aid in price discovery.

While hedging and speculating are often considered opposing activities and are generally identified with commercial and non-commercial traders, respectively, in practice both groups can contribute to price discovery in futures markets. Futures prices reflect the opinions of all traders in the market. Moreover, the actions of those who can, but choose not to enter the futures market can also contribute to price discovery. For example, a commercial trader holding physical inventory, but choosing not to hedge using futures markets (by taking a short position) not only withholds downward pressure on the futures price, but may also signal that prices are expected to rise in the future.

COT and DCOT identify trader categories based on self-reported lines of business collected and audited by the CFTC. The public reports do not provide any indication of the intraday activities of many traders. Specifically, because the CFTC’s reports are based on end-of-day positions, scalpers’ and day-traders’ activities are not discussed in these reports. Furthermore, the CFTC’s public reports fail to differentiate between traditional and non-traditional hedgers in the commercial category, due to active non-traditional commodity speculative activity by some commercial traders in the same commodity market. In order to increase transparency, the CFTC should consider re-classifying some of the commercial traders based on their trading patterns (as well as their hedging exemptions or their cash positions). Furthermore, it may be advisable to discuss the cash positions held by commercial traders to understand the size of their true hedging needs. In order to increase transparency in futures exchanges, more frequent (daily) release of the end of day positions held in the aggregate by different trader groups, as well as more refined information by contract maturity (rather than the current aggregation of all maturity contracts), are needed.

Outside influences on futures markets

Activities that occur in other markets and other instruments can also affect futures markets. There are three potential activities that might impact futures trading on US exchanges: (i) the trading of OTC derivatives contracts; (ii) the trading on exempt commercial markets (ECMs); and (iii) the trading on foreign boards of trade. Futures markets traditionally comprise only one venue for hedging price risk. In the context of risk management, market participants may be involved concurrently in over-the-counter (OTC) transactions, trades on ECMs and transactions in foreign markets. Crude oil traders, for example, can hedge cash market positions using a combination of futures, swaps, bilateral forward contracts, cleared broker and ECM transactions.

Since transactions on the OTC market primarily deal with privately‐negotiated contracts, the OTC derivatives market is essentially opaque, with information typically available only to the negotiating parties. Some argue that this lack of public information prevents an appropriate assessment of overall risks by market participants and precludes them from taking the necessary measures against default risks. In order to increase transparency in OTC markets, recent regulatory proposals in the United States and Europe require mandatory reporting of almost all OTC transactions to trade repositories or regulators. More transparency in OTC derivatives is to be welcomed, even if some participants argue that hiding volumes in OTC markets is very difficult since traders know their counterparties.

US regulations adopted in 2008 require significant price discovery contracts traded on ECMs to be subject to certain regulatory requirements, including position-reporting requirements to CFTC. The 2010 Dodd-Frank Act goes further, eliminating the category of ECM from the US Commodity Exchange Act (CEA). Therefore, they have to be registered as either as a swap execution facility or a designated contract market, which will lead to full dissemination of positions established in any contract by traders in these markets. As a result, the so-called Enron loophole in derivatives markets is finally eradicated.

Foreign boards of trade should also be encouraged to start providing detailed information on large trader positions in order to increase market transparency. This is crucial, since some similar contracts are traded in more than one exchange in different countries. For example, the WTI Light Sweet Oil contract is not only traded on NYMEX but also on ICE Europe. ICE Europe started to provide detailed large trader information to CFTC in recent years; however, market participants do not have any data on positions in some key contracts (such as Brent crude on ICE Europe, where most of the trade takes place).

Transparency in both the physical and financial markets is essential to better understand possible linkages between both markets. The 2008 financial crisis has spurred efforts to address limited data availability in commodity derivatives markets. Nevertheless, more international coordination is needed to make headway in increasing the availability of timely and reliable data in physical markets too.

**IEA Oil Market Report-May 2011

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