Many still ascribe the 2008 spike in oil price to US$147/bbl to speculation and not to the constraint on global oil production, its demand inelasticity and the then high and growing demand for oil. The speculators on the oil futures markets are alleged to have deliberately increased their demand purchases of paper-oil contracts and this demand increased the price of paper-oil accordingly.
The demand-supply-price relationship on the futures markets for oil is justified by the current increase in the price of gold on the world’s markets because investors moved their investments, say in US dollars, to gold to safeguard their portfolios. Attention is also drawn to the fact that very recently, as the US dollar depreciated against the other fungible currencies, central banks around the world bought up US dollars in an attempt to increase the price of the US dollar.
However, the difference between these two examples and the futures market for oil is that the former are physical products whose traded supplies are finite; hence, the traditional supply-demand-price elasticity is a characteristic of the corresponding markets. However, in the futures market nothing physical is sold in the financial transactions. Further, the supply of these paper-oil contracts are infinite and any amount can be bought and sold without affecting the price. Thus, Economics 101 tells us that buying on the futures market should not be able to affect price.
The oil futures markets were first established to provide a hedge for the traders in physical-oil. For example, a supplier of physical-oil, in selling oil to be delivered a month hence, could quote a price of, say, US$70/bbl. This transaction she would hedge on the futures market by buying the same quantity of paper-oil at US$70. If at the end of the month the price of physical-oil was US$75/bbl then the supplier would have lost US$5/bbl on the sale and delivery of oil but would have compensated for this loss on the futures market by a gain of US$5/bbl when the futures contract is marked to US$75/bbl at settlement time.
The futures market would be very illiquid if left to the traders. Hence speculators also bet on prices and their movements on this market. They can make or lose money depending on how good their predictions of the physical price are. The charge, however, is that by large purchases on this market of paper-oil the speculators can manipulate the price of physical-oil at a future date.
In a perfect market all the necessary supply, demand and other information is available to all participants. The physical-oil market is not perfect and information may not be available to the traders, for example, on production bottlenecks, what various global economies will do in the immediate future.
The futures market, open to many besides the traders, is an attempt to inject more channels of information reflecting what the participants think the market future conditions will be. In this way, and, in the very short term the trend of prices on the futures, as an indication of what the actual market conditions are (or could be), can influence the traders in the physical market.
However, if these futures prices are unrealistic, for whatever reasons, with respect to what the other market economic indicators are, then the physical-oil prices agreed to by the traders cannot significantly depart from the these latter indicators of the market fundamentals. Thus, the future market that delivers no oil is marked to physical-oil price delivery at the settlement date to cancel out any aberrations in this market.
One school of thought claims that the expectation of what the economy would do, for example, now that the world is supposed to be emerging from the recession, or, when the global demand for oil was growing rapidly in the face of constrained production, contributes to, or is, speculation. In a dynamic market whose fundamentals are changing, expectations of these changes are surely one of the market fundamentals. For example, if a supplier judges that the demand for oil is increasing she may postpone supply to a later date to increase earnings. This dynamism will also be reflected in the futures market.
Traders can manipulate physical-oil prices if they hoard oil (either restrict production like OPEC, or buy and store away from the market). There is no evidence that the futures markets speculators are indeed hoarding physical oil supplies. Still, the discussion continues-why did the oil prices spike? Studies by the Commodities Futures Trading Commission of the US, using the Granger causality tests, have indicated that the prices of physical-oil and those on the futures markets were highly correlated but elicited no evidence that the latter caused the former.
