Others, however, doubt that supply and demand conditions justified an 80% price plunge and argue that financial speculators had created artificially high prices. Economists and market regulators have not reached a consensus as to the causes of oil price movements in recent years. One econometric analysis that incorporated oil supply and energy demand effects concluded that speculation did not explain increases in oil prices in the 2003-2008 period, although the study suggested that speculation may have played some role in previous oil price spikes. This report provides background on futures and options markets for crude oil and presents data analysis of a possible relationship between market activities of speculative traders and oil prices. The data presented in this report cannot explain causes of oil price movements, but are intended to provide a context for evaluating arguments about the impact of speculation. Conversely, a short contract requires the holder to sell at today's price, and gains value if prices fall, because the holder may sell at above the market price. For example, a long contract in effect provides insurance to an oil refinery against an increase in the price of crude oil; if prices rise, the firm will pay more for oil on the physical (or "spot") market, but appreciation in the futures position offsets the price increase. Most trading on the futures exchanges is short-term. The Commitments of Traders (COT) report published by the Commodity Futures Trading Commission (CFTC) shows the open interest in futures and options on futures, broken down by several classes of market participant, distinguishing between commercial hedgers and speculators. Other Reportables. These may be hedgers or speculators. While the total level of open interest appears to be more stable than the price of oil, the aggregate figures mask significant fluctuations in the size of positions held by different classes of traders. Is the relationship the same for different classes of traders? While changes in long and short positions of swap dealers and producer/merchant hedgers are not correlated with price changes when considered individually, controlling for changes in short positions does produce positive correlations between long positions and prices for swap dealers and producer/merchants, as well as for money managers. These statistical relationships are discussed further in the Appendix . To use the terminology of a classic study on hedging and speculation, are money managers driving the price of oil, or are they hitchhikers along for the ride? An alternative explanation is that money managers do trade on fundamental information and that they are more adept than others at identifying information that is going to move prices. If money managers are consistent in their ability to identify new and relevant information that will affect prices (and trade on that information before others do), one result would be the observed correlation. Money managers might also profit by following price trends. Other market participants may have longer investment time horizons or be less sensitive to price changes. Trading with this time horizon would be captured by the weekly COT reports, and may be more typical of money managers than other traders in oil futures and options. Money managers may follow prices in other ways. Certain hedge funds trading in oil markets might thus bootstrap information gleaned from trades of specialist traders who lack the financial resources to take full advantage of their informational advantages. Some contend that hedge funds and other sophisticated traders have used advantages in trade execution to benefit from slow-footed rivals. That is, when prices are rising, or expected to rise, long hedgers such as airlines or utilities would appear to have greater incentives to hedge the risk of further price rises, while short hedgers, such as oil companies, might be expected to reduce their hedging position to reap the full benefits of higher prices.
Dramatic swings in crude oil prices have led Congress to examine the functioning of the markets where prices are set. A particular concern is that financial speculators may at times drive prices above the level justified by supply and demand. Most oil speculators produce no commercial quantities of oil and take no deliveries; rather, they trade financial contracts whose value is linked to the price of oil. These derivative contracts—futures, options, and swaps—allow speculators to profit if they can forecast price trends or exploit new arbitrage opportunities. Derivatives also permit oil companies, airlines, utilities, and other energy-consuming or energy-producing firms to reduce or "hedge" price risk by locking in today's price for transactions that will occur in the future. Hedgers and speculators trade on regulated futures exchanges in a continuous auction market. Prices set there serve as benchmarks for many physical oil transactions.
Some contend that oil speculators do not always trade on fundamental information related to supply and demand, but are nonetheless able to drive up prices by flooding the market with cash and overwhelming the influence of commercial hedgers who actually deal in physical oil. On the other hand, most empirical studies suggest that speculation does not generally increase price volatility, although the occasional emergence of speculative "bubbles," when market prices may diverge significantly from fundamental values, is well known. Neither economists nor regulators have reached a consensus as to the causes of oil price movements in recent years—some point to the fundamentals (where both demand and supply are inelastic in the short run, and questions exist about the capacity to meet growing global demand in the long run), while others focus on financial markets. Both are possible sources of price volatility.
This report examines the relationship between the price of oil and the positions of various classes of traders in crude oil futures and options. Position data come from the Commitments of Traders report, published weekly by the Commodity Futures Trading Commission (CFTC). A statistically significant correlation is evident between changes in positions held by "money managers" (a category of speculators that includes hedge funds) and the price of oil. In other words, during weeks when money managers have been net buyers of oil futures and options (or increased the size of their long positions), the price has tended to rise. Price falls, conversely, have tended to coincide with reductions in money managers' long positions. This statistical relationship is weaker for other classes of speculators and for commercial hedgers.
There are several possible explanations for why money managers' trades might be more closely linked to prices. Money managers might identify information that will affect prices (and trade on that information) more quickly or accurately than other market participants. Other traders might copy the trades of certain hedge funds viewed as market leaders, driving prices further in the same direction. In this way, money managers' trades could move the price, even though their positions account for a relatively small share of the total market.
Causation could also run in the opposite direction—perhaps on average money managers chase price trends rather than set them. Other traders whose positions appear in the Commitments of Traders data, such as commercial hedgers or swap dealers, may be less price-sensitive than hedge funds and react more slowly to price changes. Data presented in this report cannot explain causes of oil price movements, but are intended to provide a context for evaluating arguments about the impact of speculation. This report will be updated as events warrant.