In defence of speculators

March 26, 2010 | 00:00

In defence of speculators

Speculators (those who trade in “paper barrels”) have been blamed by politicians and energy companies for causing extreme price volatility in the oil market, and for the record high prices we saw in 2007-2008. Governments, led by the Commodity Futures Trading Commission (CTFC) in the US, are now planning to take measures to limit “speculation” in oil futures.

This may seem to be a logical approach. After all, political leaders are expected to avoid price explosions, especially in commodities. The people need to be protected! So, the speculators get the blame. The word “speculator” itself has a negative connotation and is often explained in a negative sense.

The reality is rather different. Speculation is in fact a sophisticated and quite useful tool. Market specialists make thorough analyses of a seemingly infinite number of factors that influence prices. They devise very complex trading strategies, making use of correlation coefficients between prices of different commodities and/or markets. By doing so, and engaging in (a lot of) transactions, they bring more liquidity to markets and make markets more efficient. In other words, speculators help to make markets “mature”. This is often overlooked by the critics.

These days many trading firms support their transactions with computer models. Computerised trading means that trades are initiated based on the software (algorithms) implemented in their systems. High-frequency trading is the most advanced form of computerised trading. Most of the time, the computer models help to limit the volatility of prices, within certain price ranges.

However, sometimes the opposite happens. When prices move beyond the preset boundaries, stop-loss limits may be triggered, leading to the liquidation of portfolios. This may have a snowball effect in the market, since other traders may then also have to liquidate their positions as prices move out of their preset trading ranges. In this case the volatility will increase. Admittedly, this is a negative effect, but the critics tend to focus only on this negative side; they never mention the positive effects that speculation has. Politicians don’t complain when speculators drive down prices! After all, speculators trade both on the upside and on the downside of markets.

The peak-price of $147 per barrel WTI crude that was reached in 2008 may, in fact, have been caused by speculators who were trying to drive down prices. Yes, I know that sounds completely counterintuitive, but it is true nonetheless. How could this happen? When prices went from $80 to $90 a barrel, then to $100 and more, speculators came into the markets and initiated short positions. In other words, they sold futures short, speculating on lower future price levels. However, as the price moved up further they started to feel uncomfortable. At a certain point, the traders’ risk managers woke up and started to ask questions. When the potential losses became too big, because prices went on going up,
Author and former “market maker” Jerry de Leeuw, currently owner of the Amsterdam-based financial consulting and training company Mercurious (www.mercurious.nl), explains how traders look at – and influence – the energy world.
the speculators were forced to close down their open (short) positions. In other words, they started buying, which led to even higher prices. Then other speculators with similar short positions also had to close down their portfolio. Such a snowball effect is called a short squeeze, and usually leads to incredibly steep price peaks.

It should also be remembered that many of the traders who were active were not speculators at all. In other words, they weren’t financials, such as investment banks, hedge funds or trading firms, but large energy users who should have hedged their physical needs, but had failed to do so, because they were not used to extreme price developments. After all, the price of oil had been fairly stable over the previous decade. Many large oil consumers had not expected prices to become that high. Many did not even have an energy purchase policy in place. So when prices moved up beyond $120, they had to close down their positions – they had to buy, which contributed to the record high prices.
 
Regulation of markets may be helpful to some extent, but it would be foolish to try to ban speculation altogether. If you want to have free markets, you have to accept how markets work. If you don’t want free markets, you have to ask yourself, what kind of market structure do you want? So, the question is not so much whether we should abolish speculation, but whether we should abolish the market or not.

 

For earlier articles on this subject see our interview with Noé van Hulst, Secretary General of the International Energy Forum, and France declares war on oil speculators)

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