Speculators Stabilize Oil Prices: Here's Proof 37 comments
an article to
-
Font Size:
-
Print
- TweetThis
"It's not the things you don't know what gets you into trouble. It's the things you do know that just ain't so" -- variously attributed to Will Rogers, Mark Twain or Yogi Berra
The effect of commodity index funds on commodity prices has been a hot topic lately: from congressional hearings, to proposed tougher CFTC regulation and hearings going on right now, to breathless articles in Rolling Stone.
The popular wisdom is that commodity index fund investors, being long-only, tend to drive prices higher, that they raise the price level far above what it would be otherwise, both in the long and the short term (a view well represented by, for example, Jeffrey Korzenik). The popular wisdom also holds that commodity index fund investors generally increase volatility, ie they buy high (and cause prices to rise even higher) and sell low (and cause prices to fall even lower).
Certainly, the huge increase in popularity of commodity ETFs and index funds over the past few years, combined with the historically high commodity prices and extreme volatility of commodities over the same period, would seem to support this view. Just because two things occur at the same time, however, doesn't mean that one caused the other.
I will use data from the United States Oil Fund ETF (USO), which is the largest futures-based (as opposed to physical) commodity ETF. USO holds assets that have recently ranged roughly from 1 to 4% of total open interest on the major oil futures contracts (NYMEX, WTI, Brent).
As a player in the global oil market, USO is huge; yet it is far from being the largest single player, and definitely not enough to move the market by itself. USO is more likely to be used as a vehicle for small/individual investors, rather than institutional investors (who might prefer an index fund such as PIMCO Commodity Real Return, or using futures to track GSCI directly).
It is nevertheless a reasonable assumption that the type of investor behavior seen here would be representative of commodity index fund investors in general, both large and small, in oil and in other commodities.
Without further preamble, here is the monthly data on USO total holdings (red line) and unit price (blue line; tracks front month oil futures), since the fund's inception in April 2006:
The presented data utterly refutes the hypothesis that commodity fund speculators as represented by USO had anything to do with the oil price spike in mid-2008. The USO holdings at the time when oil prices peaked, in June-July 2008, were 7.6 million units, less than at the beginning of 2008, and three times less than at the beginning of 2007.
We can break down the behavior of USO investors into five periods, as follows:
- April 2006 to January 2007: prices falling, USO investors are net buyers
- January 2007 to February 2008: prices rising, USO investors are net sellers
- February 2008 to June 2008: prices rising even further (this is the infamous oil spike), USO investors net neutral
- June 2008 to February 2009: prices fall (by 76%), USO investors are net buyers (holdings increase by 17x, yes seventeen-fold)
- February 2009 to May 2009: prices rise, USO investors are net sellers
This illustrates that over periods on the order of months to years, USO investors consistently act to stabilize prices: they buy into falling prices and sell into rising prices. Another name for that behavior, of course, is "buy low, sell high".
There is no evidence whatever to link USO investors with the oil price spike of 2008. They were net sellers of oil during the initial part of the price spike, and stayed on the sidelines during the later part. After the spike, during the period June 2008-February 2009, the data suggests that USO investors prevented an even greater crash in oil prices; in fact, at the low point of oil prices in February 2009, USO held more than 4% of the total oil futures open interest in the world.
There are excellent theoretical arguments for why commodity index speculators cannot directly affect the overall price level. In a nutshell, they never take delivery, and hence have no effect on supply and demand. By investing in the front month(s), and having a predictable roll, they can encourage front-running which can indirectly steepen the contango curve, thus making storage profitable.
This makes sense on an intuitive level: the strategy that index speculators are trying to reproduce using futures is simply holding the commodity itself, and so inevitably their participation in the markets makes it profitable for someone else to physically store the commodity.
But that has associated storage costs, and the index fund investors end up paying for those through a negative roll yield. The footprints of index speculators in the market can thus be seen not in higher prices, but in a steeper contango curve, and beyond a certain point in physical inventory buildups. Inventory buildup can affect the overall price level; but that is the only link between index speculators and overall prices.
In order to prove that index speculators drive up prices, one has to show inventory buildups; and then the effect of index speculators is only as large as the effect of any inventory buildup they can be shown to cause.
As predicted by this theoretical discussion, the futures curve did change from backwardation to a steep contango during the period (July 2008-February 2009) of post-spike falling prices during which USO total holdings increased seventeen-fold. Again as predicted, at the same time the oil storage trade (ie: buy physical oil and store it, sell futures) became really popular, even leading to floating oil storage (exemplified in these articles: [1] [2] [3]).
By indirectly causing a steeper contango and an inventory buildup, USO investors probably did cause higher oil prices; but they did so in February 2009, not in July 2008; at the bottom, not at the top.
In the interest of completeness, there is exactly one instance in the available data of USO investors not acting so as to stabilize prices: in October 2009, there was significant net selling into falling prices. Considering the environment of absolute panic in the commodities markets at the time, it is understandable that some USO investors lost their nerve. They were buyers the previous month, and resumed buying en masse the next month, however.
The inevitable conclusion is that restricting this type of speculation will increase volatility in the commodities markets. As a trader, I would certainly benefit from this; but as an impartial observer, I have to conclude that the proposed CFTC position limits and other restrictions on commodity index speculators would have precisely the opposite of the intended effect.
Disclosure: Oil futures position equivalent to a long straddle; no position in USO.
Related Articles
|
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largestSee all
increase in followers
in the last 7 days
Fastest Climbers » -
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most active
Instabloggers.-
1
David Fry
-
2
TraderMark
-
3
Don Dion
-
4
Cliff Wachtel
-
5
Mike Havrilla
Top Instabloggers » -
1
-
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
On Aug 02 08:32 PM User 422955 wrote:
> Another article mistitled. We can blame the SA editors, as usual.
>
>
> The article concerns only one ETF. All other speculators are ignored.
> Many other speculators must be in and/or out of the market. I have
> no idea how they affect possible "bubbles."
Unlimited speculation should only occur in commedities that do not affect the entire economy.
We all need energy, so that needs to be tightly regulated. If you want to drive AAPL to $500, that's fine. Our economy does not rely on AAPL shares to function.
But we can't allow the same "great fool" game to be played by oil speculators, as every dollar increase is a dollar taken out of the hands of the working class Americans, who don't have the funds to participate in the fun.
On Aug 03 03:29 AM Terry Rowe wrote:
> God bless speculators !! I imagine without their efforts that oil
> could have doubled during the first 4 months of this year, on declining
> demand! Why don't we allow speculators to control the price of milk,
> HIV drugs, etc.? Think of the "good works" they could perform for
> us!!
So, were one truely attempting to explain the run up in prices, look to where the evidence is, not where it is not.
Look at Goldman's positions and timing and compare that to the price run up. Throw in a few of their market analyst calls. Then get back to us with your results.
> Look at Goldman's positions and timing and compare that to the price
> run up. Throw in a few of their market analyst calls. Then get back
> to us with your results.
I will look at their market calls. I don't have a source for their positions, do you? Some of that info may come out during the SemGroup bankruptcy proceedings, but that might be a while.
On Aug 03 11:26 AM Storm Cat wrote:
> "The CFTC has granted Wall Street banks [like Goldman Sachs] an exemption
> from speculative position limits when these banks hedge over-the-counter
> swaps transactions.
>
> Right. The exemption was granted to permit banks to hedge the transactions
> they enter into with Oil & Gas companies (who are hedging production).
> Why should a bank's hedge of such a transaction be included as a
> speculative position when it is plainly "Commericial" in nature.?
>
>
> I do agree that classifiying a bank entirely as "commericial" yields
> inaccurate data because they do also take speculative positions.
> However, the broad brush you are using overestimates the magnitude
> of the distortion.
>
> "The really shocking thing about the Swaps Loophole is that Speculators
> of all stripes can use it to access the futures markets. So if a
> hedge fund wants a $500 million position in Wheat, which is way beyond
> position limits, they can enter into swap with a Wall Street bank
> and then the bank buys $500 million worth of Wheat futures. "
>
> Except that the vast majority of HFs don't execute a position of
> such magnitude on a linear basis (ie, long/short). Moreover, banks
> don't take unlimited credit risk on HFs. Such a position (long/short)
> would most likely need to be fully collateralized making it cost
> prohibitive. Moreover, the counterparty would need an ISDA agreement
> and credit/risk limit approval
>
> " Another example of the effects of speculators in the crude oil
> commodities market was the “ Rogue Trader” who with a 16 million
> barrel order of crude, pushed up the price of crude oil $4 in the
> blink of an eye."
>
> I trade oil for a very large bank. No salesman would execute an
> 18MMbbl order without insuring it is authorized. Moreover, an order
> like that isn't executed "in the blink of an eye". It is executed
> quietly and slowly over the course of one or more trading sessions.
> Finally, a "rogue" trader can and does happen in ALL markets.
> We all need energy, so that needs to be tightly regulated.
Judging by Paul and Terry there is quite a bit of populist anger just about ready to boil over. I can't help but thing that if my article described who *was* responsible for the spike, rather than who wasn't, the reception might have been a lot more positive. I guess we all need someone to blame.
The problem is, there isn't necessarily anyone to blame. It could be Goldman or whoever (that seems like a popular theory), but it could be just supply and demand. I'm all in favor of position reporting for swaps similar to open interest reporting for futures, that will certainly clear the air as far as off-exchange bets are concerned.
However, if it *was* Goldman or some other evil market manipulator, then why didn't consumption decrease or production increase? Apparently, nobody was willing to use less oil just because it was expensive? Also, nobody was willing or able to produce more oil and sell it at the inflated prices? If I was Saudi Arabia, could you think of any conceivable reason I wouldn't pump and sell as much oil as possible into both the cash and futures markets as long as the price was over $100? Would you guys like to offer a theory about that?
My message is basically very simple: whatever you want to do, back off from the little guys (USO investors), they were helping stabilize the market, not yanking it around.
I see the CFTC hearings as being anti-USO, not anti-Goldman. If the rules pass in a way that pushes ETFs and funds out of the market, or forces them to use swaps, you *will* get extra volatility. Don't say you weren't warned.
Funds that service only small investors should be exempt from any positions limits, provided this restriction is actually enforced.
and demand started tanking in 2006, and got really deflating in 2007. before we ever had that big price spike.
what we can tell is this. a market that had maybe 9 billion before 2006, explodes in to closer to 200 billion?
now inflation usually is defined as to much money chasing not enough or very much product/commodity.
which is what happened here
On Aug 03 03:18 PM Rayden wrote:
> On Aug 03 02:24 PM Paul H. M. wrote:
To give an example, say that commodities investors are always spending $100. In Period 1, they buy 5 units at $20. In Period 2, they buy 20 units at $5.
According to this "analysis", these commodities investors have stabilized the market by buying when prices are falling. But they've really just been spending the same amount! You need to fix your methodology.
"demand started tanking in 2006, and got really deflating in 2007." - that would be a resounding no: US oil consumption was 20.802 mbpd in 2005, 20.687 in 2006 and 20.680 in 2007. Sure, demand wasn't growing, but it wasn't dropping either; meanwhile, prices roughly doubled.
"supply doesn't change that quickly" - Saudi Arabia has a claimed capacity of 11 mbpd, but have been producing only 8-9 mbpd recently. So there is an "instant" supply of around 2mbpd, if you believe that.
"then there is all of that oil that ended up in tankers and any place else it could get stored" - yes, there was. However, that happened after the spike, not before.
On Aug 03 05:06 PM dw57 wrote:
> don't think its supply an demand. supply doesn't change that quickly
> (short of major bombs being dropped). and all of the so called news
> that happened in this time frame had been going on for decades. and
> then there is all of that oil that ended up in tankers and any place
> else it could get stored. or those who drove the price never ever
> took delivery. the purpose of these markets as was sold to every
> one, was to try and reduce the volatility not increase it. but it
> was really also just for those who actually will take delivery (can
> you say airline? trucking company?) and those who produce (so they
> knew how much demand there was and could project production). banks
> and other financial companies aren't in eitehr category
>
> and demand started tanking in 2006, and got really deflating in 2007.
> before we ever had that big price spike.
> what we can tell is this. a market that had maybe 9 billion before
> 2006, explodes in to closer to 200 billion?
>
> now inflation usually is defined as to much money chasing not enough
> or very much product/commodity.
> which is what happened here
> Isn't this chart extremely misleading because you're using number
> of units for the red line? I think you should be using AUM or some
> sort of metric that encompasses how much in dollars these ETF investors
> are spending.
Number of units is the correct measure. It is actually a rough approximation to number of futures contracts. Consider what happens normally, the fund rolls over their front month futures to the same dollar value of next month futures, which is (ignoring roll yield for now) roughly the same number of contracts. New unit creation causes more futures to be bought, and unit redemption causes futures to be sold. So, aside from changes in the number of futures caused by the roll yield, the only thing that causes net futures buying or selling is unit creation or redemption. The changes in number of units have been very much greater than the effect of the roll yield, so I have essentially chosen to ignore the roll yield in this analysis. I feel that is a reasonable approximation.
So we're paying extra for no good reason other than to line the pockets of a few speculators.
While banks use TARP money to bid up oil, they're sucking up all the stimulus funds that should have been spread throughout the economy to spur jobs, innovation, and repair badly aged infrastructure.
It's easy to call any type of regulation "populist" (as a way to make is sound like evil socialism), but overpaying for a oil when there's a surplus is just holding back any type of economic growth that would otherwise be possible.
Why not simply require those who bid on oil to have the means to take delivery? If only people who could actually take delivery were bidding on oil, that would cut down on the "greater fool" type of run-up that we're experiencing in oil.
On Aug 03 03:18 PM Rayden wrote:
> On Aug 03 02:24 PM Paul H. M. wrote:
• Enough participants
• Enough Transparency
• Enough Access to News and Information
• Standardized Contracts
Liquid markets are efficient markets. Come on in speculators, the water’s fine…but play fair.
I'm completely open to other theories about speculators affecting markets, but I'd hope they could provide the same level of analysis and detail.
It's just a few with more capital than the rest that can drive up the prices at will.
On Aug 04 12:55 AM Commercial Mortgage Loans wrote:
> Speculators are not a problem as long as a market has:
>
> • Enough participants
> • Enough Transparency
> • Enough Access to News and Information
> • Standardized Contracts
>
> Liquid markets are efficient markets. Come on in speculators, the
> water’s fine…but play fair.
I am a commodities/macro speculator. I've been trading for my own account for about 12 years now so I must be doing something right.
According to USO website, it holds three contracts with assets a bit more than 2 billions dollars. USo does not represent the role of speculator, hence, the whole article is a dilusional and self serving. USO has lost 43% since inception, while Ryden is doing something right. It is obviously not what USO does!
> Isn't this chart extremely misleading because you're using number
> of units for the red line? I think you should be using AUM or some
> sort of metric that encompasses how much in dollars these ETF investors
> are spending.
> On Aug 03 09:41 PM Rayden wrote:
> Number of units is the correct measure. It is actually a rough approximation to number of
> futures contracts. Consider what happens normally, the fund rolls over their front month
> futures to the same dollar value of next month futures, which is (ignoring roll yield for
> now) roughly the same number of contracts. New unit creation causes more futures to be
> bought, and unit redemption causes futures to be sold. So, aside from changes in the
> number of futures caused by the roll yield, the only thing that causes net futures buying or
> selling is unit creation or redemption. The changes in number of units have been very
> much greater than the effect of the roll yield, so I have essentially chosen to ignore the roll
> yield in this analysis. I feel that is a reasonable approximation.
This is ridiculous. Number of USO units is an extremely poor approximation to the numbers of futures contracts given the big swings in USO’s price. You really think that the bank on the other side of the futures contract looks only at the units and not the market value? That would be insane.
> This is ridiculous. Number of USO units is an extremely poor approximation to the
> numbers of futures contracts given the big swings in USO’s price. You really think
> that the bank on the other side of the futures contract looks only at the units and
> not the market value? That would be insane.
I think you don't understand how a commodity ETF works. USO must buy/sell futures when the number of units increases/decreases; except for the roll, they cannot buy/sell futures under any other circumstance. The number of futures contracts typically *does not change* when USO's price swings, only when the number of units changes; therefore the price swings are irrelevant. The other side of the contract (I think you mean a swap?) is also irrelevant.
> USO must buy/sell futures when the number of units increases/
> decreases; except for the roll, they cannot buy/sell futures under
> any other circumstance. The number of futures contracts typically
> *does not change* when USO's price swings, only when the
> number of units changes; therefore the price swings are irrelevant.
> The other side of the contract (I think you mean a swap?) is also irrelevant.
It is relevant considering that the huge performance discrepancy. Since the beginning of 2007, USO is -50.3% and the front month oil contract is -19.6%.
Furthermore, this doesn’t address my main point—why are you treating an investor purchase of 1 unit of USO at $110 the same as an investor purchase of 1 unit at $35? If you’re looking to measure the impact of investor fund flows on underlying commodity prices, this is clearly incorrect.