Speculative rise

Globally there are very few resources that can affect the world economy like the price of oil does. Currently oil is one of the most important sources of primary energy in the world, accounting for about 33% of the total. Oil availability and prices affect the global output capacity, economic growth and inflation, and oil price fluctuations have significant macroeconomic repercussions.

During the eighties and nineties the global oil prices remained low and stable in nominal and real terms. However, international price of crude oil, since the beginning of the 21st century, has seen a rising trend before it nose-dived in 2008. Between 2002 and 2005, crude price rose steadily, and doubled from almost $20 per barrel to $40 by early 2005and then sky-rocketed to touch almost $140/barrel in July 2008 before falling to almost $40/barrel towards the end of 2008. Since then the oil prices have picked up again.

A growing body of literature blames rising financialisation of the oil market for the price volatility. Market players' expectations, specially about future market fundamentals, have been largely deciding prices, more than the current fundamentals. The recovery of oil price in end December of 2008, despite poor market fundamentals, testifies the same. Also, demand and supply between the second quarters of 2007 and 2008, show that while demand grew by 0.8 million to 1.2 million barrels per day, global oil supplies rose between 1.4 and 1.6 million bpd; more than change in demand, still enormous run-up in prices was observed. This, too, pointed to the role of speculation.

In the oil futures market financial activity can be both stabilising and destabilising. The stabilising financial activity agents bring their information sets and expectations on future fundamentals into the pricing mechanism, thereby contributing to price discovery and market liquidity. Then, there are agents with positions independent of expectations, who allocate a part of their portfolio to oil for hedging stock market risks, as oil futures are mostly negatively correlated with stock indices. New commodity index instruments, too, allowed investors to enter on the long side of the crude oil futures, independent on fundamentals.

The US Commodity Futures Trading Commission (CFTC) commodity index-related instruments purchased by institutional investors had increased from an estimated $15 billion in 2003 to at least $200 billion in mid-2008. Though they followed a passive trading strategy, yet financial funds may have distorted price formation.

Price increases in the last two years have some experts fearing another bubble in the making. Some studies have shown global oil price volatility ranges between 5 and 20%. While speculators are needed in the futures market to create sufficient liquidity for commercial purposes, global policy makers are for curbing excessive speculation that distort markets. But determining the speculative limits is a challenge.

Regulatory measures should aim at enhancing confidence in the good functioning of the market. This can be achieved by increasing transparency and the level of available information on futures trading.

Also, suspicious behaviour (e.g. traders requesting permission to invest above their speculative position limits) should be investigated closely. Since the financial crisis hit the global economy, there has been increased call for better regulation of the oil market. Opec and others had called for greater controls on energy markets--particularly on futures trading. The G20 is considering new rules to address volatile commodity markets.

A US financial reform law enacted in July 2010 gave the CFTC more power to regulate the futures market, and make it more transparent. Better international dialogue, negotiation and concerted actions are paramount to addressing these challenges. But the larger question that will remain is whether such measures can be implemented at a global scale and will it adequately reduce oil price volatility.

Tags: power sector, Commodity Futures Trading Commission (CFTC), oil price, Oil export and import