Parsing the Price of Oil

Published on: 11/27/2012
Posted on: 11/27/2012
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In new research, a novel perspective is offered to decipher the root causes of speculation and why certain commodity markets behave differently. The research by SMU Cox's James Smith, Chair in Oil and Gas Management, with co-author Rex Thompson reveals the fundamentals behind oil prices and markets, with implications for all types of commodity markets. The idea that excessive speculation drove the oil price spike of 2004-2008 still resounds, in spite of evidence to the contrary.

The Meaning Behind the Price of Oil

The idea that excessive speculation drove the oil price spike of 2004-2008 still resounds, in spite of evidence to the contrary. While it is true that financial traders and the "managed money" of hedge funds, pension funds and commodity index funds greatly increased their holdings of crude oil futures contracts, which represented an influx of new money, during the price run up — expectations regarding crude oil market fundamentals still mattered most. And those expectations are revealed in spot prices, the price paid in the physical market, not the futures market. In new research SMU Cox's James Smith, Cary M. Maguire Chair in Oil and Gas Management, with co-author Finance Professor Rex Thompson offer a new perspective to decipher the root causes of speculation and why certain commodity markets behave differently.

A recent Wall Street Journal article discusses how the U.S. and advanced economies set the pace for oil demand growth for decades until the turn of the 21st century. Because of burgeoning Chinese demand and other growth areas during 2000-2009, prices were pushed up and supply did not keep up with demand. Smith highlights in earlier research that high oil prices resulted from OPEC capacity being low. While oil demand in the advanced economies may now have peaked, the continued growth in demand from developing economies can only be met by increased production from new and unconventional supplies—or by higher prices.   

Importantly, this paper considers how well the spot markets reveal information in various commodity markets, which can reduce speculation in futures commodities markets by aligning traders’ expectations regarding future market conditions.  Smith explains that to consume wheat, a buyer purchases it from the spot market, the physical market. Different stakeholders have differing expectations as to how the crop will turn out at year-end. Will export demand from Latin America or China be high? Smith relays, "Those expectations tend to get revealed in the spot market. If the supply is expected to be short, buyers will bid up price to grab a bigger share of inventory, which is increasing in value.

"To the extent that the market works well," Smith continues, "everybody reads this information from those spot prices, which helps to align expectations. While there may be uncertainty with export demand or the crop yield, trading in the spot market helps participants acquire the same information and look to the future with the same expectations. If that is true, we wouldn't see any speculative trading in the futures market because all parties would believe the same thing — you wouldn't be able to find a counterparty to take the opposite side of your bet on the direction of a future price change."

It's the Commodity

There are characteristics in common to most all commodity markets. True, a commodity must be stored and transported, but beyond that the nature of the commodity and its market's structure also play a role in spot price and futures, factors like how information is available, gathered and disseminated to predict future conditions. For example, natural gas is harder to store than gold. Some commodities have futures markets and others do not, like rare earths.

To become informed, traders and their firms spend considerable sums of money. Specialists exist in global oil markets and others, investing in information to project what lies ahead. Many participants don't have that information, but to some extent that private information is revealed in the spot price anyway. The informed trader reveals his knowledge in his price offered, and by extension to the general market.  The extent of revelation, and the degree to which expectations are aligned, depends on fundamental characteristics of the commodity and market in question.

In the spot market, even if the market is at equilibrium, and you are satisfied with your positions, differing beliefs about the future price will lead to speculation in the futures market. Whether such differences in beliefs will exist, and whether they will be large or small, will vary from one commodity to another, as well as across time for each individual commodity.  The implication is that the scope of speculative trading will also vary across commodities and across time—all depending on fundamental characteristics of the commodities in question. 

Price of oil

The price of oil reveals considerable information.  Smith suggests, "This price tells us what smart money thinks will happen with Iran next year as we approach the redline in their nuclear program, for example. If we were to provoke Iran, to the extent they would shut down the Persian Gulf, it would be a travesty for world oil markets. We don't know the probability. But the likelihood of that type of event is already rolled into the price of oil today. Price serves as an early warning detection system on supply side disruptions but also on the demand side."  For example, will the slowing Chinese economy pick up again? "When expectations regarding Chinese demand decrease, it creates a large excess inventory of oil to be absorbed, which takes pressure off of the market, " says Smith. On the other hand, "if market participants believe the storable commodity of oil is going to be more valuable next year, and the smart money is aware of that, they will bid up the price."

In some commodities, spot prices may be sufficient to achieve full revelation of private information and perfect alignment of expectations. Smith qualifies, "In some commodities market, where storage is easy and there is little volatility in demand, there is no need for an extra super-structure like the futures market." You can buy it; store it, period. The market brings people together to help them resolve each other's behavior. "The act of trading may affect each other's positions," explains Smith. "It helps bring expectations together which is a good thing because we need to be playing out of same deck if we are to have a well-organized economy."

When asked whether oil is a commodity in which there are larger gaps in belief or expectations versus, say wheat, Smith suggests: "We need to do more empirical work to determine this. Oil is cheaper to store than natural gas and that is a factor that helps to bring beliefs together. On the other hand, the demand for oil is very inelastic. We will drive our car in spite of price variations. But demand for natural gas is more elastic because power plants can switch off to coal. Inelasticity magnifies differences in expectations. But there are also many other fundamental attributes, like the volatility of demand shocks, that impact the ability of the spot market to align our expectations. We need to do a more systematic data analysis to see the net impact of all these factors, and that ongoing course of research is now underway."

In conclusion, the research suggests that if governments wish to reduce speculative trading in futures markets, they should focus on the fundamental factors that tend to sustain differences in beliefs, which act as the catalyst for speculation. By offering better information on the fundamentals of the underlying spot market — such as increasing the scope, quality and transparency of data as has occurred in food market transparency initiatives — the playing field will be more level. Current tactics to suppress speculation through broader restrictions on trading are not proving fruitful or effective.

The discussion paper "The Informational Role of Spot Prices and Inventories" by SMU Cox School of Business' James Smith, Cary M. Maguire Chair in Oil and Gas Management, and Finance Professor Rex Thompson was recently published.

Also see Dr. Smith's presentation and video related to this material at Resources for the Future, where he recently spent time on sabbatical.

Written by Jennifer Warren.

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