Do speculators drive oil prices?

(MoneyWatch) The unprecedented surge in the spot price of crude oil during 2003-08 sparked a heated public debate about the determinants of the price of oil. The popular view was that the surge in the price of oil during 2003-08 couldn't be explained by economic fundamentals. Instead, it was caused by what has been called the "financialization" of oil futures markets, with speculators becoming a major determinant of prices. This interpretation led to calls from politicians to regulate oil futures markets.

The authors of the March 2012 study "The Role of Speculation in Oil Markets: What Have We Learned So Far?" reviewed the academic evidence on this issue. The following is a summary of their findings:

• There's clear evidence of the increased financialization of oil futures markets.
• The existing evidence isn't supportive of an important role of speculation in driving the spot price of oil after 2003.
• There's strong evidence that the co-movement between spot and futures prices reflects common economic fundamentals rather than the financialization of oil futures markets. One study concluded that the price of commodities not traded on futures exchanges rose as much as or more than the price of exchange-traded commodities.
• There have been persistent deviations between oil futures prices and natural gas futures prices that suggest a more important role for supply constraints in individual commodity markets. The recent development of shale gas is a perfect example of the decoupling of prices.
• Not only was the surge in the real price of oil well under way by 2005, but the ability of economic fundamentals -- such as unexpectedly strong demand for crude oil from emerging Asia -- to explain fluctuations in the real price of oil since 2003 didn't depend on how the oil futures market is modeled. This was a robust finding across a wide class of models and methodologies.
• There was no evidence that financial investor flows predicted movements in oil futures prices or price volatility. Rather, such speculative trading was associated with reduced volatility.
• There was no evidence that the positions of hedge funds or other noncommercial investors predicted changes in the futures price. Instead, futures price changes preceded changes in positions. This result is consistent with speculators providing valuable liquidity to the market and with speculators reacting to market conditions, rather than vice versa.
• Two separate studies found that there was no statistically significant relationship between growth in the volume of oil futures contracts on the one hand and oil futures returns, their realized volatility and their implied volatility on the other hand. When a relationship was found at all, it was negative rather than positive.

The authors also noted the important role that speculators play: "The oil futures market cannot function without speculative traders providing liquidity and assisting in the price discovery. The presence of speculators defined as noncommercial traders tells us nothing about whether speculation is excessive. Speculators who end up losing their bets rarely attract public attention."

The bottom line is that while the increased financialization of the energy markets might provide a convenient villain to blame, there's little-to-no evidence that the increased role of speculators drives prices.