Have Index Funds Increased the Oil Price?

"The large increase in the oil price will continue to provoke debate about the character of the oil market and the potential for price manipulation."

There has been a great debate raging in Washington during recent weeks about the role of speculators in driving up the prices of oil, corn, wheat and other commodities. It has been alleged that the rise of hedge funds and commodity index funds has created a large new flow of money into the markets and driven up prices. At one Congressional hearing, hedge fund manager Michael Masters pointed out that the assets of commodity index funds have risen from $13 billion in late 2003 to $260 billion during March, 2008. He then explained that the commodity funds have increased their holdings of oil contracts by 848 million barrels since 2003 compared to growth in Chinese demand of 920 million barrels during the same period. He also criticized the CFTC for not effectively distinguishing between commercial traders and non-commercial traders in regulating the market. He said, “The CFTC has granted Wall Street banks an exemption from speculative position limits when these banks hedge over the counter swap transactions. This has effectively opened a loophole for unlimited speculation. When index speculators enter into commodity index swaps, which 85-90% of them do, they face no speculative limits.’ ”˜The really shocking thing about the swaps loop hole is that speculators of all stripes can use access to the futures markets. So if a hedge fund wants a $500 million position in wheat, which is way beyond position limits, they can enter into a swap with a Wall Street bank and then the bank buys $500 million worth of wheat futures.’ ‘In the CFTC’s classification scheme all speculators accessing the futures market through the swaps loophole are categorized as “Commercial” rather than “non-commercial”. The result is a gross distortion in data that effectively hides the full impact of index speculation.” At another hearing, Michael Greenberger, a law school professor and former CFTC director, criticized the CFTC for not having any effective regulatory monitoring or control over the ICE exchange in London. He believes that speculative funds have used the London market to evade restrictions which exist in the US market. The CFTC has responded to these attacks by contending that markets are functioning adequately and that the role of hedge funds or index funds has been exaggerated. The chief economist of the CFTC, Jeffrey Harris, gave a detailed testimony to Congress outlining the major trends the agency sees in the oil markets. He said,

“First we see large increases in the use of futures contracts by both commercial and non-commercial interests. Growth across these groups has been largely parallel, however, with the non-commercial share of total open interest increasing only marginally from 34% to 35% over the past three years. It is important to understand that the majority of non-commercial positions are in spreads. That is, taking a long position in one contract and a short position in another. This is important because any upward pressure on price due to those long positions is almost surely offset by downward pressure from the short side of those spreads.’ ”˜Second, much of the growth in open interest contracts is concentrated in futures contracts that expire after twelve months. Whereas contracts beyond one year were rare in 2000, we are now seeing significant interest in contracts which expire out to five years and beyond. In fact, contracts extending beyond eight years are now available on NYMEX.’ ‘Our charts also highlight the fact that commercial traders generally take short positions to hedge and rely on non-commercial traders to take the opposite side of their trades. Thus, much of the growth in non-commercial positions appears to be related to meeting the needs of commercial hedgers and speculators together in the futures markets.’ ‘The third major trend during the past few years in crude oil markets is that swap dealers now hold significantly larger positions in crude oil futures. These dealers, who sell over the counter swaps to their customers (such as pension funds buying commodity index funds or airlines seeking to hedge jet fuel costs) turn around and hedge their price exposure with long futures positions in crude oil and other commodities. This development has expanded the ranks of commercial traders. Traditional commercial traders predominantly hedge long cash positions using short futures contracts. Conversely, swap dealers (also classified as commercial traders) frequently hedge short swap positions with long futures contracts.” Harris then went onto to say that the activities of non-commercial traders had not produced major increases in the price of oil. Harris stated, “Our studies consistently find that when new information comes to the market and prices respond, it is the commercial traders (such as oil companies, utilities, airlines, etc.) who react first by adjusting the futures positions. When these commercial traders adjust their futures positions, it is speculators who are most often on the other side of the trade.”

In a subsequent research report, Harris provided detailed information about how the character of the oil markets has changed since 2000. The most significant development has been a sharp increase in the value of long-term contracts. Between 2000 and 2006, the value of short-term contracts (under three months), held by commercial traders increased by 154% compared to 118% for non-commercial traders. The value of contracts with a life span of 3-36 months, by contrast, increased by 155% for non-commercial traders and only 6% for commercial traders. In contracts extending beyond 3 years, the non-commercial traders also increased their positions by 771% compared to 186% for commercial traders. The CFTC data which Harris cited is complex. The numbers for non-commercial traders include hedge funds and other managed money but does not include swap dealers. Based on the long standing classification of swap dealers as hedgers (They hedge OTC exposures with futures), the CFTC has classified them as commercial traders. Most index funds execute via swap dealers, so they would be captured primarily by the swap dealer positions. Congressional staff have rearranged the CFTC data to include non-commercial traders with swap dealers. When these two numbers are combined, the staff estimates that speculator positions have increased from 37% of open interest long positions in 2000 to 71% recently. James Newsome, president of the New York Mercantile Exchange, testified before Congress on June 23rd. He reinforced testimony by Harris and rejected the suggestions by congressional staff that speculators accounted for 71% of the market. He asserted the following: Many believe that speculators, particularly index funds and other large institutional investors in our markets are responsible for the high price of crude oil. However, data analysis conducted by our Research Department confirms that the percentage of open interest in NYMEX Crude Oil futures held by non-commercial participants relative to commercial participants actually decreased over the last year even at the same time that prices were increasing. In addition, non-commercials are relatively balanced between long (buy) and short (sell) open positions for NYMEX crude oil futures. Thus, non-commercial participants are not providing disproportionate pressure on the long ( buy) side of the crude oil futures market. We also reviewed the percentage of open interest in the NYMEX Crude Oil futures contract held by non-commercial longs and shorts relative to that held by commercial longs and shorts from 2006 to the present. Commercial longs and shorts consistently have comprised between 60 and 70% of all open interest. We have seen various representations made relative to participation by speculators in our markets that directly contradict our data. One such representation claims that 70% of our crude oil market is made up of speculators. That analysis incorrectly assumes that all swap dealers are non-commercials and that all of their customers who would be on the opposite side of any energy swaps that they might execute would also all be non-commercials. We know that this is simply not the case. However, this confusion clearly highlights the need for the CFTC large trader data to delineate for energy futures the degree of participation by non-commercials in the same manner that such data are now being delineated for agricultural contracts.

NYMEX also maintains a program that allows for certain market participants to apply for targeted exemptions from the position limits in place on expiring contracts. However, such hedge exemptions are granted on a case-by-case basis following adequate demonstration of bona fide hedging activity involving the underlying physical cash commodity or involving related swap agreements. A company is not given an open-ended exemption, and the exemption does not allow unlimited positions. Instead, the extent of the hedge exemption is no more than what can be clearly documented in the company’s active exposure (as defined by the CFTC) to the risk of price changes in the applicable product. In a number of instances, hedge applications are either reduced in number or are denied because of staff’s overriding focus on maintaining the overall integrity of our markets. In an interview with the Financial Times last week, the oil analyst Paul Horsnell at Barclays Bank also appeared to agree with the CFTC testimony. When asked about the role of speculators in driving up oil prices, he said, “This year has seen more speculative money exit than enter the oil market. Currently, the scale of long (net buyers) by non-commercial oil market participants is roughly the same as it was last July, when prices were 65% lower. So we do not think that speculative flows have played any significant role.” The CFTC has taken the congressional criticism very seriously. It announced this week that it is imposing new rules on the ICE market in London. The CFTC will now require that trades placed on the ICE futures market adhere to the same position limits and reporting standards as trades in the US. The new rules apply to West Texas Intermediate crude oil contract, which is linked to the NYMEX contract. The new rules will take effect in 120 days. The CFTC has also promised to conduct further studies on the role of index funds and other transactions being conducted through swap dealers.

The large increase in the oil price will continue to provoke debate about the character of the oil market and the potential for price manipulation. The data which is available indicates that the market has expanded significantly during the past eight years but there does not appear to be a major imbalance between commercial and non-commercial traders. They instead appear to be playing a complementary role by helping to offset each other’s trades. The non-commercial traders also appear more willing to short the market and thus help to restrain prices. If Congress attempts to restrict the non-commercial traders with tighter limits on margin debt, there is a risk they could drive oil prices higher by reducing the magnitude of short selling. The oil price has surprised practically all analysts by rising sharply this year. The decline now occurring in US gasoline consumption and the decision of many developing countries to hike oil prices during the past month should ultimately help to restrain prices if there are no new geopolitical shocks in the Middle East. But as a result of the magnitude of this year’s price shock, investors will remain apprehensive until they actually see a major price correction in the oil market.

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