For more on this topic, see “The Development of Oil Investment Vehicles.”

This is an issue that will not go away – the idea that investment in commodities can have an important impact on both the levels and the volatility of those commodities, despite a lack of observed connection between commodity prices and commodity investment funds. Recently, the Commodity Futures Trading Commission (CFTC) proposed limits on futures trading by ETFs (Exchange-Traded Funds).

In the spring and summer of 2008 oil prices rose to over $145 barrel, increasing the popularity of commodity investment funds.  Regulators and policymakers, sensing a correlation between the growth in commodity investment funds and oil and other commodity prices, argued that the investment community was driving up commodity prices (and adding to their volatility) and was seriously hampering the development of our commodity markets.

To understand this issue one must first understand that commodity investment funds do not actually buy physical commodities – they buy derivatives like forwards, futures, and options, which have payoffs that are linked to the prices of the commodities.  In other words, they are making bets on the prices of the physical commodities, but they are not actually buying the commodities.

It is certainly the case that flows in and out of commodity funds influence the prices of commodity derivatives. For example, when investors buy more oil futures, the price of oil in the futures market is likely to increase. The relevant question, however, is whether prices in the derivatives markets influence the prices that producers and consumers pay when they purchase the physical commodities. In other words, do bets in the derivatives markets affect the price that we pay for gasoline at the pump?

As a useful analogy, let’s think in terms of a football game and the question of whether or not football betting influences the outcome of the game. We all understand that betting on football cannot influence the outcome of the game unless, of course, the betting market directly or indirectly influences the players. If the players are influenced by the betting market, then yes, of course, the betting can influence the outcome of the game.  This is why we don’t like to see football players gambling on football games or even hanging out with known gamblers.

To complete the analogy, let’s first think about the industrial producers and users of the commodities that are also involved in the derivatives markets. The derivatives markets clearly benefit these participants.  However, since these players are essentially betting on their own games, there are reasons to be concerned about their potential to manipulate prices in the derivatives as well as the spot markets.  However, the individuals and institutions who invest in commodity funds are more akin to the casual sports bettor rather than the actual players.  The question is whether these individuals can influence commodity prices?

Again, the football analogy is useful, and the relevant question is whether the betting odds on a game can influence the players.  If a player sees that his team is a 30 point favorite, then the motivation to practice hard and play hard is bound to be affected.  For similar reasons, the futures price of oil influences decisions to produce and store oil. Specifically, when the futures price is high, there will be more drilling, increasing supply in the future, which in turn lowers the actual prices people pay in the future.  However, when the futures price is high relative to the current spot price, there will also be a greater incentive to store the oil, which will increase the current spot price.

So investment flows into and out of derivatives contracts can in fact influence the prices that people actually pay for the physical commodity.  The question is then, whether the magnitudes of these affects are large – can these flows explain the recent volatility of prices? – and is this good or bad?

The effect of commodity fund flows on drilling choices is difficult to determine.  It’s a bit like asking whether football players are influenced by the point spread – they probably are influenced, but it’s difficult to gauge by how much.  In any event, the affect on drilling choices today will have very little effect on current prices. The potential effect of futures prices on storage is somewhat more straightforward to understand and recent evidence suggests that the combination of derivative prices and storage stabilized rather than destabilized the oil markets.

Indeed, during the run up in oil prices at the beginning of 2008 the spot price for oil was considerably higher than the futures price for delivery in 12 months, providing an incentive to reduce storage.   By taking oil out of storage and putting more supply on the market, the spot price increase was dampened.  Then at the end of 2008 as spot prices for oil were crashing, futures prices stayed above spot prices, creating an incentive to store oil, softening the collapse.

If anything, the volatility in the oil markets over this period of time was caused by a lack of storage capacity that has not grown nearly as fast as the overall oil market.  So if policymakers are serious about dampening volatility, they should encourage the growth in storage capacity.  What does this have to do with derivatives markets?  An active derivatives market makes investments in storage facilities more attractive, because it reduces the risks associated with storing commodities.  Hence, policy initiatives to dampen speculation and hedging in derivatives markets are likely to make storage less attractive, which will in turn, increase rather than decrease the volatility of the actual physical commodity prices.

What do you think? Take the poll (below) and leave a comment to add to our discussion.

  1. Bill Rhea

    My view is that government should do everything within the law to promote the ‘fair market’ (and thus dampen or eliminate manipulation), while at the same time the exchanges should consider policies that dampen rampant speculation to the point where the paper volumes trading in the derivatives market is a multiple of volumes in the physical market. Perhaps for individual trading firms there should be a ‘progressive sliding scale’ for margin requirements such that increasingly larger positions not backed by physical delivery capability have to be matched with increasingly larger margin requirements.

    If the physical market looks to the derivatives market for pricing signals, then perhaps the use of a ‘progressive sliding scale’ will dampen volatility, provide for a more orderly market-place and allow producers to better hedge and plan around their cash flows.

  2. Josh Garrett

    Prof. Titman’s analogy of oil speculation as betting on football is interesting and useful, but has some holes in its logic. Specifically, as hedgers and speculators are buying the same contracts (whether they intend to take on physical oil or not), speculators affect supply of and demand for futures contracts, which directly effects the “game” of oil trading and, in turn, oil prices.

    Read a full response to Mr. Titman’s analysis by contributor Steven Zweig at .

  3. john cope

    Bill Rhea cant be more right about the problem our country is facing. I think the biggest problems on some levels is from wall street.

  4. Roland Sudhof

    The football analogy is interesting but inappropriate in this case. Football is a zero-sum game where one party wins and another party loses. The oil futures markets is not that simple. Ever since the entrance of non-commercial entities into the oil futures market, oil prices have increasingly moved away from fundamentals and now trade more on macroeconomic events than anything else. A large part of this is due to the ideology of “peak oil,” which a speculator (without a strong background in energy) is prone to buy into. Recent research from Rice’s Baker Institute showed that oil prices and the number of non-commercial participants in the oil futures market are strongly correlated.

    Even if there is no “smoking gun,” why leave something so important to our economic wellbeing to be affected by the perceptions of speculators?

  5. Elayne Crain

    Roland, thanks so much for adding your perspective to this discussion. See for Sheridan’s reponse to both of your comments.

  6. Matt Mushalik

    Peak oil is not an ideology as Roland asserts, but physical reality since 2005. Visit my website Spare capacity decreased. It is doubtful whether more storage capacity could have really changed the situation over several years. So peak oil underpinned rising oil prices which made it attractive to expand dealings in oil futures. This was a contribution towards the explosion of derivatives.

  7. Konducta

    @Matt Mushalik: Peak oil may not be a physical reality at all. Some people google “abiotic oil”

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  • About Sheridan

    Sheridan Titman, Professor of Finance at the McCombs School of BusinessSheridan Titman is a professor of finance at The University of Texas at Austin and a research associate of the National Bureau of Economic Research. He was recently elected Vice President of the American Finance Association and is incoming President in 2012. He is also the Executive Director of the Energy Management and Innovation Center (EMIC) at The University of Texas at Austin.

    Learn more about Sheridan's research.

    Read about Sheridan on Wikipedia.

  • About this blog

    This blog’s primary focus will be on energy and this will be, more or less, a learning blog. The blog will offer some of my own views, as well as the views of some of the participants at EMIC. I will also raise questions in the hopes of receiving answers, insights and opinions from our participants. Since my own expertise is in finance, much of the initial focus will be on issues that relate to hedging, financing, derivative markets, and the financial evaluation of alternative energy sources. As my knowledge of these issues expand, I would also like to explore issues that relate more broadly to innovation and the role of public financing in this sector.