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.
The debate on linkages between financial and physical oil markets has evolved over time. Opinion remains polarised between those seeing the majority of recent price move being due to oil market fundamentals and those who see speculative activity and the financialisation of commodities as amplifying price shifts in the short run. However, participants have different views on the concept of financialisation and what is meant by ‘short run’, making it difficult to agree on the true impact of speculative activity, on oil prices.
Some participants dated financialisation back to the rapid growth of commodity index investment around 2004, while others argued that the emergence of hedge funds, index funds, electronic trading and exchange traded funds (ETFs) and exchange traded notes (ETNs) were part of the process and therefore started around 2002. Furthermore, there was no consensus on what constitutes the ‘short-run’. Most market participants consider short-term to mean an intra-daily, or at most weekly, time horizon. However, some argued that prices might overshoot equilibrium levels for prolonged periods of time and that the extent of overshoot can be extreme.
While entrenched views on the role of speculation and fundamentals were evident, a majority of experts tended to view speculators as playing a more limited role than fundamentals, at least over longer periods of time. Market participants emphasised the important role of commodity derivatives markets in providing price discovery and transfer of risks, while acknowledging the strong linkages between financial and physical markets. They argued that physical and derivatives markets work in an integrated fashion. If futures prices did not reflect the underlying cash market, these should converge during the delivery period unless the delivery mechanism is itself broken. It was stressed that futures prices are not a particularly good predictor of long-run commodity demand and supply and therefore should not be used for price forecasting purposes, but instead for the transfer of risk. Physical market players extensively use derivatives markets to hedge price risks that arise in the period between production and delivery to consumers. As prices can be highly volatile, it is important that derivatives markets are highly liquid so that hedging can be matched to physical pricing. Therefore, the presence of speculators is necessary for derivatives markets to function properly. The natural question is, of course, whether speculators can affect commodity prices.
Before attempting to answer this question, market participants recognised that the distinction between hedging and speculation in futures markets is less than clear-cut. 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. Therefore, it is difficult to separate hedging from speculation. Keeping this fact in mind, alongside the limitations of the data employed by academic research, the weight of evidence shows no short run relationship between changes in commodity prices and changes in speculative positions. However, a few studies found a significant impact from investment flows by non-user participants on prices and volatility of commodities.
Participants agreed that the physical oil market is highly competitive, with physical prices determined by supply and demand. No oil firm can pass on any losses or gains from hedging or speculation on the financial markets in the form of higher or lower physical prices. To affect physical prices, futures prices must impact upon physical supply and demand. But how can futures prices impact physical supply and demand? The majority of experts agreed that the most important mechanism is through cash and carry arbitrage. If speculators correctly foresee an upcoming shortage (a future increase in demand or reduction in supply), they will bid up futures prices. With futures prices higher than spot prices, this sets off cash and carry arbitrage. Oil is pulled off the market and put in storage at times of relative abundance, and is brought back to the market in a later period of relative scarcity. In these circumstances, price swings that would have occurred from a shift in supply and demand are moderated. That is to say, the market works and the price swing is less than it would have been otherwise. However, if speculators were wrong about their prediction of coming shortage, oil may be pulled off the market in time of relative scarcity and brought back in a time of relative plenty. In this situation, cash and carry arbitrage exacerbates the price swing. In either case the impact is on the short-term price pattern and not on the long-run level of prices. Speculators can increase the price swings only if their predictions are incorrect. However, speculators have a strong incentive to correctly forecast market shifts. In this case, cash and carry arbitrage moderates price fluctuations. There might be other channels for financial players to affect physical supply and demand. If physical market players get irrational signals from futures prices, then their actions based on irrational signals will feedback into irrational expectations.
Participants agreed that intra-daily volatility in oil prices increased over the last year. However, there was a clear disagreement on the causes and remedies for such intra-daily volatility. As expected, those who saw speculative activity and the financialisation of commodities as amplifying price moves in the short run argued that speculative trading as well as high frequency traders play a major role in intra-day volatility. They argued that limiting high frequency traders and speculative activity are necessary to abate volatility in oil prices. However, others argue that volatility is related to uncertainty over the health of the global economy, as oil prices naturally track any macroeconomic news, particularly news coming from euro-zone countries. The geopolitical risk premium also added to volatility in oil prices. In addition, the lack of supply chain flexibility amplifies the natural volatility in prices. They further argued that data gaps, especially on physical demand, supply, inventories and transportation, contribute to price volatility. Participants emphasised the importance of improving data transparency in both financial and physical markets to reduce price volatility. Markets participants generally noted that eliminating the geopolitical risk premium by promoting favourable conditions for investments is necessary to reduce volatility in oil prices.
The need for dialogue between industry and price reporting agencies was emphasised by some market participants. Some argued there is a need for an oversight and appeal agency when there is disagreement between industry and price reporting agencies. However, others argued that the role of price reporting agencies is well defined, and that the current structure works, leaving no need for government regulation.
Market participants also voiced their concerns about the unexpected consequences of the credit crunch, affecting the European banking system, in the form of lack of finance for spot crude and product cargoes which can be traded only with a letter of credit opened by a bank. The European banking system which is used to finance trade no longer has access to liquidity. The absence of liquidity in the Euro-zone system suggests that oil traders cannot easily access credit, thereby limiting oil trading activity.
Participants stressed that the correlation between individual commodities and other asset classes, including equities and exchange rates, has been gradually increasing over the last few years. Some suggested that hedge funds played an important role in causing this cross market linkages. However, others argued that the increase in correlation is concentrated among indexed commodities, which suggests that this has more to do with the attractiveness of commodity index investments.
Market participants argued that the emergence of ETFs or ETNs-type investment vehicles is less likely in oil markets as opposed to metals markets. The key difference is that it is extremely easy to store metals, with the exception of aluminum, with a minimal cost of storage. However, crude oil is an entirely different commodity and the costs involved in storage are enormous because oil takes up much more physical space. Overall, there is limited storage capacity available compared to the level of daily supply.
Market participants also emphasised that as soon as assets (stocks, bonds, houses or commodities) become sophisticated enough to be transacted in the market, economy-wide speculative beliefs will emerge, which can be transmitted into asset prices. This is the cost of progress. Since the oil market is part of large financial assets markets, there is no easy way to extract the oil market from the larger financial community. Therefore, it cannot be considered in isolation and well-designed rules are needed to bring efficiency and transparency to the commodity derivatives markets.
Since the US financial reform package, formally the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), the CFTC has put forward 18 final rules. The CFTC have already proposed rules on regulation of dealers. There are various rules on clearing and trading mandates. The purpose of the rules on clearing and trading is to reduce risk by moving “standardised“ derivatives onto clearing houses and to execute standardised swaps with more pre-trade transparency. The provision on trading oversight and market transparency includes regulation of swaps trading platforms (swap execution facilities (SEFs) and designated contract markets (DCMs)) and various post-trade transparencies. The provision on transparency to regulators includes reporting data on swap trades to regulated swap data repositories (SDRs), which are required to register with the CFTC, or reporting data directly to the Commission if there are no SDRs accepting the data. The final key element of the Act is the position limit on certain commodities.
The European Commission also issued several communications regarding commodity markets and raw materials. The first vehicle related to energy markets is the regulation of wholesale energy market integrity and transparency, so called REMIT, published in July 2011. The REMIT aims to prevent market abuse and manipulation in wholesale energy markets and to increase transparency for trading on those markets. The European Commission issued three proposals on financial markets that have an impact on commodity derivatives. The first deals with the regulation of OTC Derivatives (European Market Infrastructure Regulation (EMIR)). On 15 September 2010, the European Commission published its final proposal, which sets out to increase stability within OTC derivative markets by introducing a reporting and clearing obligation for eligible OTC derivatives as well as common rules for central counterparties (CCPs) and for trade repositories. The second proposal, published on 20 October 2011, aims to update and strengthen the existing framework to ensure market integrity and investor protection provided by the Market Abuse Directive (MAD). The third proposal deals with the transparency and oversight of the financial markets in the European Union (Markets in Financial Instruments Directive (MiFID), with final proposals also published on 20 October 2011. Specifically, proposals call for standardisation of all OTC derivative contracts traded on organised venues, narrowing of exemptions for commodity firms in line with G-20 commitments, creation of a new trading venue category (“organised trading facility – OTF”), more transparency of trading, including pre- and post-trade transparency, a position reporting obligation by type of participants, and position limits or some other type of position management.
While market participants emphasised the need for more international coordination to ensure consistent and effective oversight in OTC markets, they also argued that some of the proposed regulations might have unintended consequences in the market place. These include:
- Hard position limits will severely constrain trading activity which would lead to increased, rather than reduced, volatility. Liquidity in futures markets, and especially in swaps markets, would be unnecessarily impaired.
- Commodity trading belongs to two worlds: physical and financial, and to avoid unintended consequences, there is a need for more specific regulation on commodities than is encompassed by broad financial regulation.
- OTC markets are for professionals; not for retail investors. The role of brokers is primary in providing transparency. Transparency will disappear if trading is forced to move into platform- based trading systems with a view of pre-trade transparency. Moving swaps onto platforms may create increased volatility due to higher volume as experienced in regulated markets when electronic trading was introduced.
- Regulatory arbitrage opportunities might undermine the impact of new regulations in countries where more stringent rules are to be implemented.
*IEA Oil Market Report-December 2011