Index Funds Don't Drive Oil Prices

Includes: OIL, USO
by: Elliott Gue

Futures market speculators are a favorite scapegoat for politicians looking to assign blame for rising oil and energy prices. The rapid run-up in oil prices from late 2007 to mid-2008, and their subsequent collapse into year-end, has invited even more attention to the machinations of crude oil speculators.

But data released on Friday by the Commodities Futures Trading Commission (CFTC) backs up what I’ve been saying for a long time: Futures market speculation is not the main driver of oil prices over the longer term. In fact, there is evidence that traders have been acting counter-cyclically in recent quarters, selling oil futures into major run-ups in price and buying on declines.

For years, the CFTC has released a weekly Commitment of Traders (COT) report that details the market positions of Commercial and non-Commercial traders. Commercial traders are usually companies involved in the industry--for example, an oil producer that uses the futures market to hedge future production and lock in prices. The non-Commercials are speculators--traders looking to profit from a rise or fall in the price of oil.

It’s important to remember that speculators aren’t the nefarious ne’er-do-wells portrayed in the popular press. Rather, these traders serve the critical functions of boosting market liquidity, buying market risk from commercials and improving price transparency.

Most of the attention focused on speculators in recent months isn’t aimed at small futures traders but at so-called index speculators.

Over the past few years, investors have decided that commodities are a valid asset class, just like stocks and bonds. In a traditional portfolio, an investor might decide to allocate some percentage of his or her assets into stocks, some into bonds of various types, and to keep some cash. For more and more investors, however, commodities are becoming part of that allocation.

As a result, financial institutions have created a number of products designed to track the performance of specific commodities or of popular commodity indexes such as the Goldman Sachs Commodity Index (GSCI).

Because crude is the most heavily weighted commodity in the majority of commodity indexes, the argument goes that the steady flood of cash into commodities indexes is behind the big surge in prices of crude oil since 2005. The fact that until recently the weekly COT reports released by the CFTC didn’t break out the activities of index speculators added an aura of mystery to their activity.

To help track the activities of futures market speculators, the CFTC decided to enlarge and add more detail to its COT reports, starting with last Friday’s weekly installment. The CFTC also released additional historical data on index speculators going back to late 2007.

More specifically, the CFTC now breaks down traders into four categories: Producer/Merchant/Processor/User; Swap Dealers; Managed Money and Other Reportables. The first category includes firms involved in the production or wide-scale use of crude oil that purchase futures contracts to hedge their exposure to prices--the basic spirit of the prior “Commercials” category.

Swaps are a type of over-the-counter derivative contract. Oil producers often use swaps to hedge their production, while hedge funds and index traders also use swaps to speculate on the commodity market.

Swap dealers are primarily financial institutions that buy and sell these derivative products to their customers. These financial institutions, in turn, often use the public exchange-traded futures markets to hedge the commodity exposure that arises from swap transactions. Previously, swap dealers had been included in the Commercials category.

Money managers are registered commodity-trading advisors and commodity funds. These funds and managed accounts invest money into futures markets on behalf of clients.

As the name suggests, Other Reportables are traders that don’t fit into any of the other three main categories but have positions large enough to be classified by the CFTC.

I always applaud greater transparency and granularity in market and economic data, and I’m pleased to see the CFTC’s latest enhancement of its COT report. Going forward, tracking the activity of speculators and hedgers will now be subject to less inference and assumption and based more on reported fact.

More interesting from a short-term perspective is the decision to include specific historical data on the activity of index speculators going back to Dec. 31, 2007. The CFTC will continue to provide this data on a quarterly basis and will likely step up the frequency down the line. The following graph shows the net position of index speculators in terms of total futures contracts held going back to the end of 2007.

Click to enlarge

Source: CFTC

At the end of 2007, crude oil prices were around USD96 a barrel, before rising to over 101 on March 31, 2008, and USD140 a barrel by the end of June 2008. This big rally in crude oil sent US retail gasoline prices to well over USD4 a gallon, and condemnation of speculators in the media and among lawmakers reached a fever pitch.

But note what happened to the positions of index futures traders over this period. In late 2007, index traders were long 413 thousand futures contracts but actually reduced their long exposure to crude oil down to 366 thousand contracts by the end of June 2008. That is, futures index speculators were selling the rally in oil when they supposedly were driving up the price of crude oil.

The picture is no different if you look at index speculators’ share of the open interest on oil futures markets.

Click to enlarge

Source: CFTC

Although the changes are admittedly more subtle, index speculators’ share of total futures market open interest stood at 29.2 percent at the end of 2007 and fell to 28.3 percent at the end of June. In other words, at the very time many are saying that index speculators became the drivers of real market prices, they were becoming less important actors in these markets.

Also interesting is the activity of these speculators after crude oil prices reached record heights. As you can see in the above graph, index traders began to boost their exposure to crude oil in late 2008 and in the first quarter of 2009; in other words, these traders bought the dip in crude oil, taking advantage of depressed prices.

By the end of the first quarter of 2009, index speculators controlled a record 39 percent of the total open interest in crude oil futures.

That pattern holds true today. Crude oil prices are on the rise again, trading at around USD70 by the end of the second quarter. True to form, index speculators trimmed their exposure by 18,000 contracts in the second quarter of 2009.

The data released by the CFTC covers a relatively short period of trading activity and the past seven quarters certainly don’t represent a “normal” trading market. But I haven’t seen any real evidence that persistent buying by index speculators was behind the oil price run-up of early 2008 or the subsequent decline. If anything, these traders’ activity would have served to dampen--not promote--futures market volatility.

My view remains that increased disclosure from the CFTC will ultimately kill the argument that rising oil prices are a function of speculation. Ultimately, investors will need to focus their attention on the fundamentals of supply and demand--the main driver of higher crude oil prices.

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