In 2009, speculation became a hot-button issue, namely, its effect—real or exaggerated—on the energy markets. Was there too much speculation in oil, asked everyone from politicians to soccer moms, and if so, was it driving up prices up unduly?
When it comes to the oil futures markets, the answer may be no, at least according to traditional metrics, says Hilary Till, a research associate at the EDHEC-Risk Institute in France, who conducted a recent study on the topic using three years of recently released CFTC data. Ms. Till is the co-editor of "Intelligent Commodity Investing" and co-founder of a Chicago-based proprietary trading firm.
Recently, HAI Associate Editor Lara Crigger chatted with Ms. Till about her research, including what role speculators play in the markets, whether we need more transparency and whether there really is "excessive" speculation in the oil markets.
Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): In 2009 it seemed the big story was the influence speculators have in the energy marketplace. What role does the speculator play in the oil markets?
Hilary Till, co-editor, "Intelligent Commodity Investing" (Till): It's easiest for me to use the framework from Holbrook Working, who mainly wrote about the agriculture markets. His idea was that the futures markets serve a commercial purpose, for being able to hedge prohibitively expensive inventories. So there's an economic role for speculators, who take the other side of those positions. If you accept that framework, then you don't see the futures exchanges as casinos.
In 1960, it was regarded that there was an inadequacy of speculation in the agriculture markets: There wasn't enough risk capital on the other side of commercial hedging. So with data provided by the U.S. government classifying hedgers vs. speculators, you could construct ratios to see how much excess speculation you had over hedging needs. Holbrook Working created a simple ratio to do just that.
More recently, researchers at the University of Illinois Urbana-Champaign, including Prof. Scott Irwin, wrote a paper in June 2008 that showed historically what the Working T Ratio had been for agricultural futures contracts, and compared these ratios to what the current statistics have been, in order to give a perspective on whether, relative to hedging, there has been more speculation than in the past.
I used the methodology that was in their paper and applied it to the U.S. crude oil futures markets.
Crigger: Did you find there was excessive speculation in the oil futures markets?
Till: Well, first of all, we have to define the metric for "excessive" speculation. I used the Working T Index, which looks at the amount of excess speculation—that is not necessary for matching off hedging needs—divided by the open interest held by commercial participants.
At the end of October, the CFTC released three years of new data that went back to 2006. So it was only with the release of that data that you could really calculate these T indices for the U.S. oil markets.
The T Indices for U.S. oil futures markets do not look extreme, at least when compared to values for these ratios that had existed in the agricultural futures markets since 1947.
Now my paper contains a lot of notable caveats, such as I do not analyze whether speculative spread trading may have been excessive. I only examine outright position-taking. I should also note that in this paper, I don't look at the price impact of speculation; I only look at whether the level of speculation relative to hedging appeared extreme or not.
And finally, I need to be circumspect in my conclusions, since clearly if one defines excessive speculation using other metrics, then one may come to other conclusions than in my paper.
Crigger: Before the release of the new CFTC data, was it just too hard to pick out the speculators from the hedgers?
Till: Yes. The Commitments of Traders reports have always been useful, but the definition of the "commercial" category became ambiguous, because it also included swap dealers. Technically, swap dealers are hedging, because they're hedging swaps for financial participants through the futures markets. But from a traditional definition, where "hedging" is the hedging of commercial commodity exposures, swap dealers would not be considered to be hedging. So if we wanted to look at a more pure definition, it was difficult to figure this out from the existing Commitments of Traders reports.
But now, the CFTC has started to put out the Disaggregated Commitments of Traders report, where you have further granular classifications of market participants. So now you can more readily analyze what's going on.
Now, I'm only looking at U.S. oil futures markets—there's other ways to speculate on oil besides through the U.S. oil futures markets. So obviously I can't say anything about excessive speculation implemented through other venues. But on the oil side, it doesn't appear that there was excessive speculation, at least when one uses the T index.
To come to that conclusion, though, you have to aggregate futures and options positions.
Crigger: If you don't do that, what do you find?
Till: You get a different answer. I thought it was appropriate to aggregate futures and options positions together, because if you're speculating, you use both sets of instruments.
Crigger: How does this compare with what people have historically thought about futures speculators' role in the market?
Till: When you look through the literature on the futures markets, at least since the 1890s, you can find that whenever you have unexpectedly large bouts of inflation or deflation, futures traders have been cast in a very poor light.
Historically, public policy in the U.S. has been supportive of futures trading, as long as one could credibly make the case that futures markets served an economic role such as facilitating hedging or risk management, and as long as there was sufficient transparency regarding the activities of market participants.
I think things like Holbrook Working's T Index arguably help make the case that futures trading is serving a commercial purpose, since you have a metric to verify this (or not.)
I also need to add that my research is quite preliminary, but I thought bringing Holbrook Working's ideas back into the public debate on the role of speculators could potentially be useful.
Crigger: Looking at the markets now, do you think there's enough transparency out there?
Till: That's a difficult question for me to answer objectively. In addition to being a research associate at the EDHEC-Risk Institute, I'm also a proprietary futures trader, and so I love transparency, because it gives me a level playing field with the largest of commercial interests.
But thinking about the question from a public policy angle, one realizes that after financial crises through the decades, the lesson is always to have more transparency in the financial markets. If you can't trust what's going on, people make pretty suboptimal decisions. There's a whole body of academic work after various financial crises where the answer is to provide lots more transparency. Now whether people are capable of analyzing all the public information that's out there, whether people actually read prospectuses and go to the CFTC and SEC Web sites for information in the public domain, that's another issue.
But as a proprietary futures trader, I'm amazed at the wealth of transparent information out there. If I want to know what's going on in any of the structured products for commodities, for example, I can keep up with developments through the SEC's EDGAR database.
With over-the-counter derivatives, the more they go on-exchange, the more you have access to information about the nature of market participation—speculative and otherwise—and of course, I'd welcome that.
Crigger: Some critics argue that if you force too much transparency or too much regulation, investors will take their money elsewhere—particularly to other places where there just isn't as much regulation.
Till: Historically, that has been true. Look at the establishment of the eurodollar market in London back in the mid-1950s. As there was more regulation over interest rates and banking practices here, you had more of the dollar market migrating to London. So there is a tradition of that happening.
But after such an unfortunate financial crisis in 2008, we're not really in a situation anymore of saying, "Well, I don't like the rules, I'm going to take my marbles and play elsewhere." We're in a world where we're wondering how we coordinate these things so that the excesses that blew up last year don't happen again. The situation in September, October 2008 was so extreme, you really had a collapse in world trade, post-Lehman Brothers. Things were sufficiently severe in the fall of 2008 that at least for now, the effort for each country, including in the U.S., is coming up with intelligent regulation.
The last frontier in transparency is obviously what will happen with over-the-counter derivatives and whether and how they will have to go on-exchange.
Crigger: Thank you for your time.