Monday, May 09, 2011

Speculators and oil prices: what experiments tell us

Another gas price spike, another wave of articles blaming "speculators." Here's an editorial in USA Today by Representative Ed Markey, D-Mass:
[W]e must crack down on speculators in the oil market. Speculative money is seeking volatile investments. Since 2003, the size of the oil futures market has increased by a factor of 17...

When this massive speculative market meets manipulators such as Saudi Arabia and OPEC, consumers get gouged. Goldman Sachs has indicated as much as $20 per barrel is due to speculation, not supply and demand. Anyone doubting the volatility and added momentum speculation brings to the market need only look at Thursday's one-day drop of 9% in the price of oil. The oil market should be governed by the principles of supply and demand, not flittering on the whims of speculators. 
Most Americans seem to agree with this idea. But is it true? Do speculators cause oil and/or gas prices to rise above their "natural" or fundamental level?

First, an important distinction. When we talk about "speculation," we're typically talking about futures contracts. If a speculator buys an oil futures contract, (s)he is not buying a barrel of oil; (s)he is buying the right to buy a barrel of oil in the future, for a price that is determined (locked in) today. This is a very different thing than hoarding, which is purchasing the actual physical commodity and storing it, with the intent to sell if in the future at a profit when the price goes up. Everyone agrees that hoarding can cause today's prices to rise; the question of whether futures contract purchases can have the same effect is far trickier. In fact, most economists will tell you that futures speculation can only raise spot-market prices if it causes physical hoarding to increase.

The key question is: If we curbed activity on futures markets, would prices stabilize?

Theoretically, it's hard to see how that would work. If' I'm a speculator who believes that oil prices will rise, I have two options to make a profit: 1) I can buy an oil futures contract, or 2) I can buy an actual barrel of oil and store it. But what if there is no futures market? In that case, I only have one way to speculate: hoard physical oil. Since it is obvious that hoarding raises prices, but not obvious that futures contracting raises prices, it seems that curbing futures speculation - as Ed Markey would have us do - would push prices up rather than down.

But enough theory; what does the data say? Fortunately, this is one area of economics where good controlled experimental evidence exists. In 1995, Vernon Smith and David Porter conducted an experiment to examine the effect of futures markets on the formation of asset bubbles. They found that when people can buy and sell futures markets, asset bubbles tend to be much smaller and rarer than when futures trading is forbidden. In 2006, Charles Noussair and Steven Tucker did a more in-depth version of the experiment, and got exactly the same result. When futures markets aren't available, spot prices bubble and crash; when futures trading is allowed, futures prices oscillate wildly, but spot prices barely budge from the correct fundamental value.

This experimental evidence is important, because it is controlled. Looking at real data usually doesn't allow you to determine cause and effect; you can observe that futures prices and spot prices tend to move together, but (unless you find a good instrument) you can't pick apart which is causing which. Even if you find a historical case of futures markets being curbed, you don't know whether what happened after that was a result of the policy change, or any one of a bazillion other unrelated events. But in the laboratory, we know that only one thing has changed. So we know that it was the introduction of the futures market that killed the bubble in the lab.

Now, you can argue that lab experiments don't have external validity; that real-world markets are so different that exactly the opposite thing happens when you allow futures markets in the real world. And maybe you'd be right. But as things stand, the weight of evidence is firmly against the idea that futures speculators raise oil prices.


  1. If oil storage is costly, existence of a futures market makes easier to become an speculator (a smaller expected price rise is needed to make speculation profitable). So I remain unconvinced about your a priori statement that curbing futures would push prices up rather than down.

    In fact, I have always understood the theoretical literature on speculation as saying that speculation can help to anchor prices to fundamentals or can give rise to bubbles depending on specific, context-related, conditions.

    I was unaware of the existence of controlled experiments on this, so thanks for the references! They will make interesting reading.

  2. Does anyone actually need to hoard? Or leave the oil in the ground for when the price shoots up? Seems to me the possibility that the members of OPEC are simply doing their thing and there's a mutual benefit to speculating and ... "hoarding."

  3. Anonymous5:29 AM

    "Does anyone actually need to...leave the oil in the ground for when the price shoots up?"

    this already seems to be happening. see jim hamilton's 2008 paper "understanding oil prices".

  4. Seconding gallinacrema here - 'hoarding' oil is costly, except by leaving it in the ground.

  5. Futures trading reduces the volatility of prices, not bubbles per se. Bubbles are simply a symptom of a high standard deviation in perceived value.

    Take a look at onion prices, where futures trading has been banned since 1958. The price of onions swings wildly, "bubbling" over an over again.

  6. Standard deviation in onion prices is 61% and 8.7% in oil.

  7. Noah -

    You are assuming two realms, one with and one without futures markets.

    But "with" is not a single realm. There are significant differences due to the presence, robustness and enforcement protocols of regulation.

    On another dimension, there is the quantity of money involved in futures market and related derivative activities. Beyond whatever is necessary to keep the market liquid and efficient, what is the effect of additional large quantities of money? Isn't that, rather than the market itself that enables bubbles?

    I'm not going to suggest that "real-world markets are so different that exactly the opposite thing happens when you allow futures markets in the real world." But I do think that phrasing it that way is simplistic.

    There's a big difference between allowing futures markets, which serve a useful function for actual suppliers and business people, and allowing a population of essentially rent-seeking speculators who are in it to make a quick buck.

    The market value of obscure financial instruments is at a large multiple of global GDP, while "Thanks to financial innovation, the stock of financial assets – much of it in the form of derivative financial instruments, has grown three times faster than global GDP since 1980."

    (Footnote 5 at