3/2/2012: Big Bad Speculators & Little Red Riding Hoods

That "Gotcha..." moment, you know... speaking last night at a round table discussion on the future of Europe, I was confronted with a question from the audience and a fellow panelist remarks in the same vein that, roughly speaking, attributed the entire current crisis in Europe to the derivatives markets and speculative investment. More than that, the same were blamed for everything from the environmental disasters to increases in commodity prices. Some parts of the Left just love the idea of finding a "capitalist" (even arch-capitalist - aka speculative) root to every problem - the "Gotcha..." thingy of pseudo intellectualist disdain for facts as much as for 'speculators' and 'markets'.

This of course does not mean that financial instrumentation, speculation or other forces of the financial markets did not contribute to the crisis, but it is a distinct claim from the one made by those proposing that they caused the crisis single-handedly.

By sheer accident, looking through some old research papers, I came across this study from the ECB: Lombardi, Marco J. and Van Robays, Ine, Do Financial Investors Destabilize the Oil Price? (May 20, 2011). ECB Working Paper No. 1346. Available at SSRN: http://ssrn.com/abstract=1847503

The study looks into the large oil price fluctuations that were observed in the recent years. In particular, the study considers the role of financial activities in the determination of oil prices.

Per study (emphasis is mine):

"The oil futures market has indeed become increasingly liquid, and the activity of agents that do not deal with physical oil, the so-called non-commercials, has greatly increased. This led some to hypothesize that inflows of financial investors in the futures market may have pushed oil prices above the level warranted by fundamental forces of supply and demand, whereas others argue that the impact of financial activity on the oil spot market is negligible or non-existent beyond the very short term."

The paper studies "the importance of financial activity in determining the spot price of oil relative to the role of oil market fundamentals", using a sign-restricted structural VAR model. The model allows the study authors to separate financial activities into two types: stabilizing and destabilizing. This is achieved by postulating a model that links "the oil spot market to the futures market through a no-arbitrage condition", so that:

• Destabilizing financial shock is identified as one that creates "a deviation from the no-arbitrage condition, thereby ...driving oil futures prices away from the levels justified by oil market fundamentals. 
• Stabilizing financial activity is defined as "driven by changes in oil supply and demand-side fundamentals". 

In addition, the econometric framework adopted in the study allows to identify four different types of oil shocks:

• an oil supply shock
• an oil demand shock driven by economic activity 
• an oil-specific demand shock which captures changes in oil demand other than those caused by economic activity, and 
• a destabilizing financial shock (such as a spike in speculative activity).

The results suggest that 

• Financial activity in the futures market can significantly affect oil prices in the spot market, although only in the short run. 
• The destabilizing financial shock (speculation) only explains about 10 percent of the total variability in oil prices.
• Shocks to fundamentals "are clearly more important over our sample. Indeed, looking at specific points in time, the gradual run-up in oil prices between 2002 and the summer of 2008 was mainly driven by a series of stronger-than-expected oil demand shocks on the back of booming economic activity, in combination with an increasingly tight oil supply from mid 2004 on. Strong demand-side growth together with stagnating supply were also the main driving factors behind the surge in oil prices in 2007-mid 2008, and the drop in oil prices in the second half of 2008 can be mainly explained by a substantial fallback in economic activity following the financial crisis and the associated decline in global oil demand. Since the beginning of 2009, rising oil demand on the back of a recovering global economy also drove most of the recovery in oil prices."

However, the study did find that financial investors "did cause oil prices to significantly diverge from the level justified by oil supply and demand at specific points in time. In general, inefficient financial activity in the futures market pushed oil prices about 15 percent above the level justified by (current and expected) oil fundamentals over the period 2000-mid 2008, when the volume of crude oil derivatives traded on NYMEX quintupled. Particularly in 2007-2008, destabilizing financial shocks aggravated the volatility present in the oil market and caused oil prices to respectively over- and undershoot their fundamental values by significant amounts, although oil fundamentals clearly remain more important."

So some speculation is harmful to fundamentals-determined pricing, although the study does not consider the potential benefits from speculation-induced greater liquidity in the markets (which was not the core objective of the study to begin with), but largely, 5-fold increase in speculative activity accounts for just 10 percent of prices variability.