The Commodity Futures Trading Commission (CFTC), which regulates speculative trading in energy commodities, has found no evidence that prices are not being set by the economic fundamentals of supply and demand. Others, however, believe that changes in the fundamentals do not justify recent increases in energy prices, and seek the cause for soaring prices in the futures and derivatives markets, which are used by financial speculators as well as producers and commercial users of energy commodities. Hedgers—producers or commercial users of commodities—trade in futures to offset price risk. They can use the markets to lock in today's price for transactions that will occur in the future, shielding their businesses from unfavorable price changes. Most trading, however, is done by speculators seeking to profit by forecasting price trends. Together, the trading decisions of hedgers and speculators determine commodity prices: there is no better mechanism available for determining prices that will clear markets and ensure efficient allocation of resources than a competitive market where hedgers and speculators pool information and trade on their expectations of future prices. In other words, there is no reason why speculation in and of itself should cause prices to be artificially high. Theory says increased speculation should produce more efficient pricing. In practice, however, some observers, including oil company CEOs, OPEC ministers, and investment bank analysts, now speak of a "speculative premium" in the price of oil. How could the price discovery function of the energy derivatives market have broken? Several explanations are possible. First, the market could be manipulated. Eventually, prices return to fundamental levels, often with a sudden plunge. However, there is no sure method for determining what the true price is; the only observable price is the one the market generates. Other bills, including H.R. The question of whether current prices are justified by fundamental factors of supply and demand, or whether irrational exuberance has created a bubble in energy prices (similar to what was observed in dot-com stocks in the late 1990s), is beyond the scope of this report. However, testimony presented to Congress has identified a recent trend in financial markets that some argue may be putting upward pressure on prices: decisions by institutional investors, such as pension funds, foundations, or endowments, to allocate a part of their portfolio to commodities. While the decision of an individual pension fund to put 3%-4% of its portfolio in commodities may appear entirely rational, some observers argue that the aggregate impact of institutional index trading has been to overwhelm the commodity markets, because of the disproportion between the amount of money held by pension funds, foundations, and other institutions and the amounts that have traditionally been traded in the energy futures market. Hedgers, those who use the futures markets to offset price risk arising from their dealings in the underlying commodity, are generally exempt from position limits. 6604 and S. 3268 , two bills that were brought to the floor in their respective chambers in July 2008 but failed on procedural votes.
While most observers recognize that the fundamentals of supply and demand have contributed to record energy prices in 2008, many also believe that the price of oil and other commodities includes a "speculative premium." In other words, speculators who seek to profit by forecasting price trends are blamed for driving prices higher than is justified by fundamentals.
In theory, this should not happen. Speculation is not a new phenomenon in futures markets—the futures exchanges are essentially associations of professional speculators. There are two benefits that arise from speculation and distinguish it from mere gambling: first, speculators create a market where hedgers—producers or commercial users of commodities—can offset price risk. Hedgers can use the markets to lock in today's price for transactions that will occur in the future, shielding their businesses from unfavorable price changes. Second, a competitive market where hedgers and speculators pool their information and trade on their expectations of future prices is the best available mechanism to determine prices that will clear markets and ensure efficient allocation of resources.
If one assumes that current prices are too high, that means that the market is not performing its price discovery function well. There are several possible explanations for why this might happen. First, there could be manipulation: are there traders in the market—oil companies or hedge funds, perhaps—with so much market power that they can dictate prices? The federal regulator, the Commodity Futures Trading Commission (CFTC), monitors markets and has not found evidence that anyone is manipulating prices. The CFTC has announced that investigations are in progress, but generally manipulations in commodities markets cause short-lived price spikes, not the kind of multi-year bull market that has been observed in oil prices since 2002.
Absent manipulation, the futures markets could set prices too high if a speculative bubble were underway, similar to what happened during the dot-com stock episode. If traders believe that the current price is too low, and take positions accordingly, the price will rise. Eventually, however, prices should return to fundamental values, perhaps with a sharp correction.
One area of concern is the increased participation in commodity markets of institutional investors, such as pension funds, foundations, and endowments. Many institutions have chosen to allocate a small part of their portfolio to commodities, often in the form of an investment or contract that tracks a published commodity price index, hoping to increase their returns and diversify portfolio risk. While these decisions may be rational from each individual institution's perspective, the collective result is said to be an inflow of money out of proportion to the amounts traditionally traded in commodities, with the effect of driving prices artificially high.
This report summarizes the numerous legislative proposals for controlling excessive speculation, including H.R. 6604 and S. 3268, which received floor action in their respective chambers in July 2008. It will be updated as events warrant.