Speculation and Oil Prices

Some have argued that at least part of the rise in oil prices over the past two years is due to speculation, rather than fundamental changes in supply and demand. For example, a paper that I just finished reading by Antonio Merino and Alvaro Ortiz (“Explaining the so-called ‘price premium’ in oil markets“) calculated that fundamental changes in supply and demand should only have driven the price of oil to perhaps $35/bbl. during 2004. As the chart below illustrates, oil prices have remained far above that level for the past two years. Merino and Ortiz suggest that the rise in prices above this “fundamental” price level is largely the result of speculative activity in the oil futures markets.

But I have to admit that I’m somewhat puzzled by this whole notion of speculation driving up the spot price of oil. Here’s my question, which I acknowledge may be simply a reflection of my ignorance about how commodities futures markets actually work: how can speculation systematically keep the spot price of oil high? Put another way, are speculative bubbles possible in the oil market in the way that they are possible in other asset markets? I’m not convinced that they are.

Let us tentatively (i.e. I’m open to other definitions) define speculation in the oil markets as the buying of oil futures contracts – specifically, by people who don’t really want to take physical delivery of the oil – with the hope of selling that oil in the spot market at some future date at a higher price. A speculator hopes that when the contract expires (or at some point along the way), he or she will be able to sell the oil committed in the contract for a price greater than the contract price.

Speculative bubbles can and do come up in all kinds of asset markets. But isn’t the ownership of a commodity futures contract different from owning an asset like a stock, because doesn’t that futures contract actually give you a bunch of actual oil at some point down the road? And when that happens, won’t you have to find a buyer for the oil who actually needs to use the physical stuff, if you can’t use it yourself?

I am probably missing something simple here, but it seems like this is a fundamental difference between speculation in a paper asset (like stocks or bonds) and in the futures market of a physical commodity. For speculation in a commodity to actually affect the spot price of that commodity, it seems to me like that speculation needs to actually result in the physical removal of some of that commodity from the market at some point, thus decreasing the actual physical supply of the stuff.

If that’s the case, then the only type of speculation in the oil markets that could actually affect the spot price of oil must take the form of actual physical storage of oil.

If it is indeed the case that speculation that affects the spot price must take the form of the physical storage of oil, this could:

  • explain why inventories of oil worldwide are relatively high right now. I.e. maybe speculation does explain high oil prices, but it’s not speculation in the futures markets, but rather speculation by those with storage capacity, e.g. oil producers, refiners, transporters, etc.;
  • invalidate the econometric technique used by many researchers (e.g. Merino and Ortiz) in which the stock of inventories is taken as a reflection of fundamental supply and demand changes;
  • explain why other researchers who use a different technique (e.g. Pelin Berkmen, Sam Ouliaris, and Hossein Samiei of the IMF) have found that speculation in the futures market has not had a significant effect on the spot price of oil. It’s not that speculation in the futures markets hasn’t happened to affect the spot price over the past two years; it’s that such speculation CAN’T affect the spot price of oil.

I need to think about this more, and as I said, I realize that I’m probably just missing something. I would welcome any additional information about how oil futures contracts work, and how they could actually affect the spot price of oil without physically putting more oil into storage.