Much-reviled speculators a crucial part of market system

Traders work the floor of the New York Mercantile Exchange.

Speculators have been blamed for bringing volatility to the crude oil market in their quest for the quick dollar. But their supporters say they are a crucial part of the market system, and provide much in the way of insight to other investors. Chris Stanton reports September 22 last year began like any other day on the floor of the New York Mercantile Exchange. Traders dressed in colourful jackets took orders and, using complex hand signals, placed others to buy and sell lots of 1,000 barrels of light, sweet crude oil for delivery in October.

The worsening state of the global economy was becoming increasingly clear and many dealers in the crude pit were preoccupied with how the crisis would affect demand for their commodity. But in the afternoon, many of these oil market veterans watched helplessly as prices steadily climbed, registering a jump of more than $16 in the span of a few hours, the largest daily gain in history. The price movement had almost nothing to do with oil supply or demand. In fact, it was a classic trader's manoeuvre called the "short squeeze".

When commodities speculators want to bet that prices will fall, they sell short; that is, they borrow futures contracts from another trader and immediately sell them off. If all goes well, they watch the price fall, then buy back the contracts at the lower price for their return to the lender. But September 22 happened to be the monthly deadline for the October contract's expiry, meaning speculators had to buy back the contracts at any price or face the prospect of delivering crude oil to their prospective customers.

The sellers knew this and when crude price ticked upwards, they held on to the contracts through the afternoon, waiting until minutes before the expiry to sell. Coming at a time when Wall Street investors were already under attack, the short squeeze sparked outrage in Washington. Oil prices were being manipulated by giant investment banks and hedge funds, Congressmen thundered, and customers as diverse as haulage companies, airlines and normal drivers were stuck paying the cost.

When given a hearing, the speculators fired back. Bankers cast their critics as ignorant populists who fail to understand how today's complex financial instruments help reduce the unpredictability of energy prices. The problem of oil price volatility will not be resolved with greater regulation, they said, but through greater participation from investors. As the Commodities and Futures Trading Commission (CFTC), the US government regulator, considers slapping new limits on oil market speculators to reduce volatility, it will need to weigh concerns about the outsized influence of Wall Street speculators against the demonstrated good they offer markets.

Bart Stupak, the Democratic congressman from Michigan, told a CFTC hearing last month that between 2000 and last year, the share of the oil futures market held by traditional commercial traders, such as airlines and refineries, dropped to 29 per cent from 63 per cent. The speculators' share, meanwhile, jumped to 71 per cent from 37 per cent. "If the dollars in swaps and related futures positions equals votes in the market place, the banks and hedge funds are determining prices, and physical hedgers have become small players in the process," Mr Stupak said.

"The driving factor contributing to an increase in the price of oil this year was the surge of funding from index investors back into the oil markets." The comments added to calls from European leaders and oil producers, including the UAE and OPEC, that greater regulation of commodities markets was needed to reduce the volatility of oil, the world's most important commodity. An oil futures contract is a promise that a seller will offer a set quantity of oil at a set price at a set date. Futures contracts allow major commercial traders to lock in guaranteed prices, giving them a basis on which to make investment decisions.

Futures also allow these firms to "hedge" or make bets on prices that insure them against the potentially devastating effect of a big swing in prices. A speculator is anyone who buys the future to make a profit and sells it before its expiry, without any intention of using the physical quantity of oil the contract represents. The argument put forward by Wall Street's critics is simple, which partly explains its political appeal, experts say. The run-up in oil prices between 2003 and last year coincided with a huge inflow from outside investors looking to turn a profit on commodities. The new types of investment vehicles and higher demand for commodities pushed up the value of futures contracts.

But proving that one caused the other is not quite as easy as Mr Stupak suggested. At the same time that investors were pouring money into futures, the global oil market was experiencing seismic changes. Oil demand in East Asia, led by rapid economic growth in China, shot up much faster than expected, and experts pushed up long-term forecasts of how much oil the world would eventually need. At the same time, the "peak oil" theory regained popularity as academics pointed to stagnating production growth in some countries as evidence that the world was set to undergo an oil supply shortage.

The argument that speculators caused the price peak last year could just as easily be turned around, to suggest that the peak was the cause of the investment, says Dalton Garis, an assistant professor of economics and market behaviour at the Petroleum Institute in Abu Dhabi. "I could make an argument for causation moving in the other direction: because prices were going up people had to hedge," Mr Garis says. "It wasn't the speculating that made the oil go up, it was the oil going up that made people want to speculate."

Wall Street executives who testified last week argued that the price peak last year, and oil's gains this year, could be explained by concerns about future demand and supply, and critics had failed to offer robust evidence of a causal link. Speculators have been reviled throughout history but economists and commodity traders all agree they are a necessary force in the market, as they are often the only ones willing to take the risk of buying price hedges and making a bet on prices.

Their moves send a signal to buyers and sellers about the real value of a given commodity. If the market values oil delivered in September at about $70, for example, but a speculator believes the world economy will fail to recover, he may short sell the futures contract. If pessimism grows, more speculators will place short bets until commercial traders take notice and buy contracts at lower prices.

"If one were to remove speculators from the commodity futures market, one would simply force the market to function with less informed views, degrading the price discovery mechanism," says Craig Donohue, the chief executive of the CME Group, which owns a number of big exchanges including the New York Mercantile. But the debate in today's oil market is complicated by the diverse set of outside investors that include hedge funds, swaps dealers and commodity index funds, or exchange-traded funds that passively track the movement in oil prices.

Commodity index funds, held by a number of individual investors, are under fire precisely because they mimic the moves of the market. The concern is that the funds, which control blocks of contracts and make buying and selling decisions largely on the basis of computer programs, could become predictable in their movements. Other traders, including big speculators such as hedge funds, can and do bet on the movements of these funds rather than the actual market, critics say, increasing the instability of oil prices.

Together, index funds and large speculators could cause a run-up in prices or a sudden, unwarranted dip. But the burden will now be on critics to justify their allegations and discern benign speculators from more malignant investors. "In places in the world where you don't have vibrant futures markets you have huge boom and bust cycles," Mr Garis says. "Study after study has shown that futures studies don't destabilise prices, they stabilise them."