Are futures markets a friend or foe of consumers? To hear the political class tell it during this season of soaring gasoline prices, they are clearly an enemy of nearly all mankind, a playpen for wild speculative orgies where nothing is produced — except higher fuel prices — and no services are rendered except to those who profit from the resulting price volatility.
Economists, however, argue that futures markets serve two essential functions. First, they allow us to learn about the future prices of commodities given the best information available to the market. This price discovery is helpful to consumers and investors because it assists them in deciding whether certain expenditures or investments today make sense. Second, the existence of futures markets allows people to buy insurance against price increases (or declines). Given the volatility of oil prices, the ability to purchase certainty is very useful. Allowing risk to trade from those who don’t want to bear it to those who do enhances efficiency.
But regardless of the benefits, are there costs? Do oil futures markets result in higher and more volatile consumer prices? A number of sophisticated econometric tests of that proposition have been undertaken by economists, and their answer is no.
Now it’s certainly true that the price of a futures contract is established by the supply of, and demand for, those contracts — just like everything else. So as oil economist Philip Verleger points out, “forward prices will rise relative to cash prices if a large number of buyers of forward contracts enter the market.” And that’s exactly what we’ve seen, as the advocates of futures market regulation so dearly love to point out. Verleger, in fact, agrees that the commodity index funds that invaded the oil futures markets with tens of billions of dollars have, since 2004, single-handedly turned the market from its normal state of “backwardation” (where futures prices are lower than present physical prices) to “contango” (where futures prices are higher than present physical prices).
If the flow of money into futures markets, however, were driving physical (that is, real) crude oil prices paid by consumers, one would at least expect to find some relationship between the dollars being parked in futures markets and retail prices. But Verleger has been tracking daily dollar flows in the principal futures markets for West Texas crude since January 2005 and finds that, while cash has been injected steadily into those markets, there has been no surge of dollars into those markets over the past few months.
In an earlier test Verleger examined the flow of money invested in the two principle commodity index funds (managed by Goldman Sachs and JPMorgan Chase) from January 2006 through June 2009 and found no correlation between the flow of money from these sources into the futures market and the price of West Texas crude. It’s therefore hard to argue that trading volume alone has anything to do with the recent run-up of gasoline prices.
The suspicion that it’s not trading volume per se that drives physical prices, but the number of speculators betting that prices will rise was tested by economist Craig Pirrong of the University of Houston. He examined the relationship between changes in the net position of speculators and physical oil prices between January 2006 and July 2008, and found that, even if we assume correlation equals causation, speculative behavior could only account for a 2.56% increase in oil prices during a time in which prices actually increased by more than 123%.
None of this is to say that futures markets can’t in theory determine retail (physical) prices. University of Michigan economists Lutz Kilian and Dan Murphy, for instance, conclude that speculation in futures markets did play a significant role in the oil price increases experienced in 1979 and 1990 (and, for that matter, in the price declines in 1986 and 2008). But their econometric investigation finds no evidence that this was a factor in the price run-up from 2002 to 2008.
What of the charge that speculators trigger wild price gyrations that wouldn’t occur if futures markets did not exist? Let’s first consider those traders who rapidly incorporate new information about present and future supply and demand. They are simply messengers about evolving market conditions and any subsequent price changes are the result of this new information and not their trading behavior per se.
What is the effect of scalpers (who seek to profit from their read of market momentum by buying and selling the same contract within seconds) and day traders (who hope to cash in on short-term market trends and can induce herding behavior and overreaction to the news of the day) on the futures market? Do these “noise” traders — who are unconcerned about market fundamentals — make futures markets more volatile by introducing pricing errors that require subsequent correction? French Economists Delphine Lautier and Fabrice Riva recently examined light sweet crude oil futures contracts on the NMEX from January 1989 through June 2005 and concluded, “yes.”
The more important question, however, is whether noise trading makes actual (physical) crude oil prices (rather than crude futures prices) more volatile. Superficially, it might appear so; oil prices have become more volatile since the advent of oil futures markets in the early 1980s. But economists Christiane Baumeister and Gert Peersman of Ghent University conclude that the increase in volatility is the result of a decline in global spare oil production capacity, something that can be directly laid at the feet of OPEC.
Moreover, it was the arrival of this greater price volatility that helped increase investment in futures markets by offering a means by which commercial interests could buy insurance against price volatility. In other words, the volatility created the futures market, not the other way around.
Questions of cause and effect aside, economists Robert Kolb and James Overdahl reviewed the literature to ascertain whether physical prices exhibited more or less volatility after futures markets were introduced. They found 26 published studies examining various agricultural, energy, and financial markets but noted that only two of those studies (pertaining to cattle and mortgages) found that prices were more volatile after futures markets were established. Fourteen studies, on the other hand, found that cash market volatility decreased after futures markets were introduced (the remainder found no effect).
The upshot is that futures markets — and the speculation that occurs therein — provide a public service. Regulating, restricting, or eliminating those markets would not bring prices down or make them more predictable. All it would do is prevent these agents for social good from doing their job, which is to tell us the truth — as best they see — about the future cost of crude and to offer a means by which we can insure ourselves against the impact of increasing or declining crude oil prices.
So the next time you see an oil speculator — the fellow without whom these markets could not work — pat him on the back and buy him a well-earned cup of coffee (or cocktail, if you prefer). He is your friend, and should be treated like one.