Over the past decade or so a silent war has waged between sometimes obscure, and sometimes not so obscure, parties. The war is over what has caused the run-up, since 2003, of oil prices. I’d actually been fairly interested in this for quite some time but I’d never got around to doing a proper survey of the literature. Well, now I have and the results are somewhat surprising. In what follows I will just pull out what I think to be some of the more interesting results of this survey.
Okay, so who is saying what? Well, those who claim that speculation is a big deal in the markets generally say that a massive influx of speculative capital into the futures markets is leading to a run-up in futures prices. This run-up in futures prices is then leading producers to pull back on production because they expect the price of their oil to rise in the near future. This then turns out to be something of a self-fulfilling prophecy and what we get is a spiral of profit for bullish futures speculators and hoarding oil companies.
(There is actually an alternative theory to this among those who think that speculation is driving the price. This is the one put forward by Izabella Kaminska and Chris Cook. They reckon that oil, together with other commodities, are being used as a sort of inflation hedge. I won’t get into this interesting theory too much here because I’m more interested in a “who said what when” sort of story here, but needless to say the effects are the same as the above story, but the motivations and the contracts used are a bit different.)
Well, that’s what people are saying but who are these people? Actually, we’ve got some pretty surprising characters who turn up here. We have a few hedge fund managers. One of whom is Mike Masters who famously testified to the Senate in 2008. I had already been aware of Masters and his report for quite some time before I started digging into the literature and I’d long known that he was seen as a bit of a pariah by the rest of the finance industry who often paint him as a dirty market manipulator.
There are some academic types who push the speculative line too. But what’s really surprising is that some big names are also card-carrying members of the “speculation” club. First of all, we have two economists called Luciana Juvenal and Ivan Petrella at the St. Louis Fed who, in a 2012 paper entitled Speculation in the Oil Market write that:
As before, global demand shocks are the most important driver of oil prices, accounting for up to 45% of oil price fluctuations. Speculative shocks are the second most important driver, explaining up to 13% of oil price movements. The oil inventory demand shock is particularly important on impact (13%) but decreases to 4% at longer horizons. The oil supply shock is the least relevant driver, explaining less than 9% of the variation in oil prices at all horizons… The speculative shock affects the incentives faced by producers, who lower oil production in anticipation of perceived increases in the price of oil. Therefore, it is expected that speculative shocks play a role as a driver of oil production. In fact, they explain around 20% of oil production fluctuations. The large effect of speculative shocks on oil production can be attributed to the fact that the speculative shock resembles a managed supply shock in the presence of higher expected prices. (pp22)
13% of price fluctuations and 20% of production fluctuations are caused by speculation? Well, that ought to ruffle a few feathers within the Fed, right? Wrong. Because their inspiration comes from a pretty senior figure within the Fed. You might know him. His name is Ben Bernanke. In a 2004 speech Bernanke said that:
(…) speculative traders who expect oil to be in increasingly short supply and oil prices to rise in the future can back their hunches with their money by purchasing oil futures contracts on the commodity exchange. Oil futures contracts represent claims to oil to be delivered at a specified price and at a specified date and location in the future. If the price of oil rises as the traders expect more precisely, if the future oil price rises above the price specified in the contract they will be able to re-sell their claims to oil at a profit. If many speculators share the view that oil shortages will worsen and prices will rise, then their demand for oil futures will be high and, consequently, the price of oil for future delivery will rise. Higher oil futures prices in turn affect the incentives faced by oil producers. Seeing the high price of oil for future delivery, oil producers will hold oil back from today’s market, adding it to inventory for anticipated future sale. This reduction in the amount of oil available for current use will in turn cause today’s price of oil to rise, an increase that can be interpreted as the speculative premium in the oil price.
Interesting, right? Before I started looking into this I thought that this was an argument coming only from a few left-leaning economists — mostly Post-Keynesians — a few renegade hedge fund managers and a couple of policy wonks at the Commodities Futures Trading Commission. Not so. It would seem that the man with the beard is on board too — although he certainly hasn’t been shouting this view from the rooftops since he took over the reigns.
Honestly, I didn’t think much of the St. Louis Fed report — which is an econometric study plagued with all the problems that all econometric studies are plagued with — but its fascinating to see that central bank economists and, indeed, central bankers are espousing a causal theory that is deeply heterodox. Okay, so they don’t seem to realise the theoretical implications of what they’re saying. But they’re still saying it nonetheless.
Another report worth note in the “speculation” camp is a thorough report prepared by the Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs and presented to the Senate in 2006. I thought much more highly of this report than the St. Louis Fed study as it takes a far more intuitive and no-nonsense approach than the clunky econometrics of the Fed study. Again, the causal mechanism argued is the same. As to summarising the report, I will just leave the reader with the following graph — one which should be examined while keeping in mind that crude oil had gone from about $30 a barrel in 2003 to about $70 a barrel in the period covered in this graph:
Pretty striking, no?
Okay, so who are the opposition? Well, it seems to me that its mainly academic neoclassicals. A good characteristic example is a 2012 paper entitled The Role of Speculation in the Oil Markets: What Have We Learned So Far? by the economists Bassam Fatouh, Lutz Kilian and Lavan Mahadava. The authors survey a good deal of the other arguments and pick away at them in what strikes me as a somewhat unconvincing display — you know the drill: pick at minutiae that don’t strike the reader as important while throwing around a few casual “yes sure, buts…” every now and again. They do make one interesting point though (note that they refer to the speculative hypothesis as the “Masters hypothesis” after Mike Masters):
It had been academics that were reluctant to embrace Masters’ hypothesis rather than policymakers. In fact, the prevailing orthodoxy among policymakers had been precisely the position [that speculators are playing a role].
This is an interesting observation and strikes me as being quite true. The arguments against the speculative hypothesis tend to come in highly abstract form — usually dodgy “black box” econometrics studies — while the arguments for the speculative hypothesis tend to be quite clear and presented by practical sorts of people who actually work in these markets day-to-day. There are exceptions to this — there are dodgy “black box” studies on the speculative side and many “pragmatic” tinkerers working in the financial industry who are convinced Chinese demand is driving price — but as far as the main battle-lines are drawn I don’t think that Fatough, Kilian and Mahadava’s characterisation is inaccurate.
Am I going to resolve this dispute right this moment? No, that’s not the intention — although my biases are probably by now clear. However, I do want to raise two important points. First of all, the oil price debacle has led some very mainstream figures to make some very heterodox arguments — ones which, I would argue, have massive implications for how we should theorise not just financial markets but all markets. Secondly, the manner of argumentation by both sides is fascinating. The speculative crowd remind me of the Post-Keynesians during the monetarist debates, who picked over institutional details to figure out how the money system actually worked. While the anti-speculative crowd remind me of the monetarists, with their big clunky regressions and their lags trying to show the “real causes” using a mass of data thrown in a blender. Food for thought, if nothing else.
And with that, I’ll leave folks with Masters himself… of the infamous and ominous-sounding “Masters hypothesis” (see if you spot the journalistic stitch-up towards the end by the financial channel Bloomberg news which, if you know how these things work, you will recognise as an editorial decision and not the decision of the journalist who does her job properly):
Update: Since writing this post I have come to realise that the chart presented to the Senate Subcommittee shown above is actually quite misleading. I have since discussed and corrected this here.