On July 7, the CFTC (US Commodities and Futures Trade Commission) put forward a proposal to limit speculative trading of oil and natural gas. Specifically, the CFTC proposed to: 1) impose limits on trading and positions and 2) enhance the weekly Commitment of Traders (COT) reports to better inform the public about the positions of different traders. The plan immediately affected crude prices even before a scheduled summer hearing (and certainly before any implementation). The price of crude oil dropped below $60/bbl last week, perhaps indicating that policy may have clearer and more significant influence on price levels compared to the not-so-clear role of speculators in the price setting scene.

CFTC’s initiative is part of the current administration’s effort to create more transparent and accountable trading of commodities, and correct for serious imbalances such as the surge and plummet of crude prices over the past year. Will rigorous regulation on speculation lessen price volatility? Or, are there multiple reasons for this instability, among which are the fundamentals of supply and demand?

A few insights are offered by IEA’s 2009 MTOMR report:

When both the supply and demand functions are inelastic, a small change in demand can alter the price to a great extent. The 55 percent price jump corresponding to a 1 percent change in demand between January and July of 2008 implies a price elasticity of supply of 0.0227, which is close to the estimated figures of 0.2 and 0.5 predicted in previous IEA studies. Projections of prices based on the fundamentals find the price hike reasonably close to estimates, as was evident in the 75 percent drop in prices earlier this year. The prediction would suggest an even greater price drop of 90 percent corresponding to a 5 percent change in demand.

Changes in OPEC’s spare capacity reflect the fundamentals. Production increased and caused spare capacity to fall from a steady 2.3mb/d to 1.5mb/d last year. Concurrently, prices made their way from $35/bbl to $147/bbl until the effect on income (which was also intensified by the global recession) began to trigger a weaker demand, which motivated OPEC to increase its spare capacity. The movement of the spare capacity can be traced in the following figure:

Source: IEA 2009 Medium-Term Oil Market Report

CFTC’s December report and IMF’s October report in 2008 both establish statistical results indicating no correlation between speculative activities and spot prices. During CFTC’s summer hearing, we should expect to see challenges to new regulation which refer to its own report as evidence that speculation does not influence spot prices as claimed. The graph below follows CFTC’s line of reasoning to show no correlation between speculating activities and spot prices.

Source: IEA 2009 Medium-Term Oil Market Report

The impact of speculation on price is acknowledged but essentially limited by physical trade of crude oil. Buyers and sellers actually bargain and complete purchases at discounted prices depending on their respective bargaining abilities. The following graph shows the reach of speculators, which lies on the vertical section where supply and demand meet. Their impact is short-lived because over time, fundamentals would achieve a new equilibrium regardless of elasticity.

Source: IEA 2009 Medium-Term Oil Market Report

Identifying and classifying speculators may be one of the hardest tasks for CFTC in its mission to make the trading scene more transparent. In addition to the non-commercial dealers (index funds, hedge funds, swap dealers, etc) who are not interested in the physical commodity, commercial traders (oil companies, refiners, etc) are also interested in taking part in speculation based on their views of the market. Assuming CFTC is capable of separating out these players and regulating them all, the agency must carefully weigh the costs and benefits of the current system and any changes to it. New regulation may mean changing the pricing mechanism and reducing cash flow in the market.

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