When oil prices were spiking in 2008 and some commentators were predicting prices of $200 a barrel, many pundits and politicians turned to blame speculators and hedge funds for pushing prices upwards. That period of high prices passed and speculators avoided any tough new regulations in part due to mix empirical evidence surrounding the causes of price volatility. Now though, the opposite case is being made; hedge funds shorting oil may be behind recent volatility and the current low price of oil. Related: U.S. Failing To Harness Hydro Power Potential
Given the benefits to consumers from low oil prices, there is little talk of new regulation to prevent hedge fund shorting, but it is unclear if regulation would do much good in any event. While there is a correlation between hedge fund positions and oil prices, it is unclear if hedge funds are causing moves in the price of oil, or if oil markets are simply responding to a third set of unobserved causal factors.
At a basic level, oil prices are based on the intersection of supply and demand. On the supply side are producers from OPEC to U.S frackers. The demand side is a little more complicated. Of course consumers and businesses fall into the demand category, but it could be that hedge funds also play a role here. If hedge funds and other investors buy up oil in anticipation of a future recovery in prices, then they might be able to help prop up the price of oil or even drive the price of oil higher. That was the case often made in 2007 and 2008.
There is definitely some evidence that is going on today. When investors buy and store oil, they will eventually have to sell it, which moves them to the supply side of the price equation. As a result, theoretically investors should help to limit volatility in oil markets by buying in anticipation of future higher prices and selling in anticipation of future lower prices. As each type of trade is unwound, it acts as a stabilizer for the market and should help to cushion price changes. This is true even when hedge funds and others short oil since eventually they have to buy to cover those short positions.
Still the bigger issue is whether hedge funds and other investors are large enough to materially move the overall oil market, which is one of the largest and most liquid of all markets globally. While the hedge fund industry as a whole manages roughly $2.7 trillion in assets, managed futures or commodity trading advisors (CTA) only manage around $330 billion according to Barclays. For comparison purposes, the overall oil market trades about 96-97 million barrels of oil per day. At an average price per barrel of around $50, that implies a total value of all oil traded of roughly $4.8 billion per day. Related: Saudi Cash Crisis Intensifies As Interbank Rates Soar
Obviously CTA firms could be influencing the price of oil given their level of assets and the level of the traded market size in oil, at least in the short term. CTA firms could represent an additional 10 percent of demand in the market on days when the price of oil appears too low or 10 percent supply on days when it appears too high. That would be feasible and require about $500 million in capital versus total CTA AUM of $330B. Still over the course of a year, total oil trades come to more than $1.25 trillion in value which dwarfs CTA assets and represents a sizeable piece of the overall hedge fund industry.
So what is the moral of this story? It is unclear if CTA firms are having a sizeable impact on the oil industry, but they could be in the short term. Over the medium and long term, the oil markets are far too large to be consistently influenced by hedge funds or other investors especially since at any given point investors are likely to be taking opposite sides of the same trade.
By Michael McDonald of Oilprice.com
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