Bassam Fattouh & Lavan Mahadeva
In the last decade, purely financial players with no interest in the physical commodity, such as hedge funds, pension funds, insurance companies and retail investors, have become more prominent in oil futures and derivatives markets. In parallel, there has been an explosion in the variety of instruments that permit speculation in oil, such as futures, options, index funds, and exchange-traded funds. This massive expansion of the financial layer of oil has been called the financialisation of the oil markets. Has this affected the price of oil? And does it matter?
Figure 1 plots one measure of financialisation. The net long positions of non-commercial traders in oil futures as compiled by the Commodity and Futures Trading Commission have increased tremendously, especially since 2003. Also, although the data is noisy, a brief slowdown in the second half of 2008 is discernible. The chart shows that the real West Texas Intermediate oil price has followed a similar pattern; it has also risen on average since 2003, and also experienced a temporary fall in late 2008.
Motivated by correspondences of this type, some have concluded that greater financial participation has changed oil-price behaviour (Masters 2008). There have even been calls for policy intervention to limit financial participation in oil per se (UNCTAD 2012). However, as Scott Irwin pointed out early on in this debate, correlation is not causation (Irwin 2008). Indeed, the familiar culprits of supply and demand forces could have been responsible for the post 2003 data on oil prices and financial participation (Fattouh et al. 2012 and Kilian, 2012).
The first conceptual hurdle to overcome is to define what is meant by speculation and financialisation. A typical approach to answer this question is to define destabilising speculation as whatever is left over after fundamental forces have been accounted for (Lombardi and Van Robays 2011).
But speculation is the economic response mechanism to a large variety of underlying uncertain changes, some of which could be down to current and/or anticipated demand and supply prospects and some of which could be down to financial layer shifts. Anyone who decides between buying a small car or a petrol guzzler is effectively speculating in oil, and it is surely not a concern that they have a view on the future price of energy. Similarly, the accumulation of physical inventory in anticipation of future changes (providing the market is not being squeezed) is a market solution to