The Oil Market: Is It 2008 All Over Again?

Shortly, after my days of trading I witnessed local gasoline prices steadily rise from a low of $1.50 to $3.98 per gallon over the years. During the bull market of 2008, I can recall sitting at my trading desk watching oil going higher and higher everyday wondering when it would stop. Finally it did, peaking just shy of $150. Conversely, this year it was around $123 yet gasoline prices were almost at the national average of $4.11 back in 2008. So what’s going on?

I remember hearing in the financial media that speculators had driven the price appreciation and there were even talks of market manipulation. Judging by the hyperbolic price action it seemed plausible. I can’t recall any asset that moved so fast so quickly and while I held onto economic fundamentals as the primary culprit there seemed to have been something else going on. Fast-forward to today and like a recycled fashion fad, the same thinking seems to pervade the current administration and the larger population about financial oil market mechanics. Even those in the investing community have testified before Congress pointing to speculation as the culprit. There’s also been a push by G20 nations in light of the latest crises for increasing financial market regulation. Despite this, it seems that what was happening then is being re-lived and so the question arises, are oil market speculators re-living 2008 all over again?

First, let’s define what a speculator is. The most general economic definition "is the purchasing of a commodity not for current consumption but future use in anticipation of rising prices." So then, what are the functions of speculators? In short, they provide the futures market with liquidity to hedgers and assisting in price discovery. They also act as a signaling mechanism for inventory buildup to avert production disruptions by curbing current consumption thereby preventing shortages by stabilizing prices and smoothing out production flow. Now that we know what they do let's counter these false accusations and provide evidence of their real effects as it relates to the 2003-2008 period.

• From 2003 to 2008 there was an influx of money flows from Index Funds into the oil futures market which led to some co-movement among asset classes. A causation of increasing money flows into oil futures from these funds did not imply the causality of subsequent oil price increases. The academic evidence shows that the opposite is true.
• Statements made about the daily trading volume being several times the daily physical production are also invalid according to Lutz Kilian of the Center for Economic Policy Research:

  …Academic research shows this ratio - after taking into account the number of days to delivery for the oil futures contract – is a fraction of about one half day of daily oil usage…" and he “…concludes that the existing evidence is not supportive of an important role of speculation in driving the spot price of oil after 2003.”

  Stanford University Food Research Institute Studies, Holbrook Working in the 1960’s devised his Working Ratio, a percentage of excess short and long hedging demand which is a far better measure of speculation. A comparative analysis to other commodity data shows that oil remained at about midrange given its historical experience.
• Speculation has been evidenced during 1979, 86, 90, and 2002 but not 2003–2008 by structural economic models explaining the evolution of real prices of oil. Instead, evidence suggests that economic fundamentals forecast spot price increases better than futures and static models of investors are inconsistent with dynamic models of storage with spot and futures prices being jointly and endogenously determined.

To summarize,Professor of Economics at the University of Oregon, Mark Thoma concludes that, “…extensive research has produced a near-consensus among academic experts that speculation has not been a key driver of recent oil price fluctuations.”

Judging by the lack of rigor in the limited accusations that I have heard and my previous intuition about synchronized global growth back in early 2008, the notion of oil speculation being the main tenet of rising oil prices or just outright market manipulation displays an ignorance in the functioning of both futures and oil markets. While it seems that res ipsa loquitur, I’m not 100% convinced based on the small sample of evidence presented here. To paraphrase William of Ockham, “the simplest answer is usually the correct one” and so it could it be entirely possible that it was just an anomalous event of a confluence of factors with no real underlying conspiracy or is there something overlooked and we’re trying to find that which is not there?

Sources: Economist’s View and Vox, April 2012

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