Hilary Till, research associate with the EDHEC-Risk Institute, discusses the latest EDHEC-Risk position paper on the issue of whether there is excessive speculation in the US oil futures markets, the transparency of global oil markets and changes in the commodities markets. In this interview, she also discusses how her research on the oil derivatives markets could have broader applicability within over-the-counter financial derivatives markets.

Q: You have recently written an EDHEC-Risk Position Paper entitled ‘Has There Been Excessive Speculation in the US Oil Futures Markets?’. This is a follow-up to research that you carried out in 2008, but is based on new data released by the Commodity Futures Trading Commission in the US. Could you tell us about this new data?

A: Yes, on October 20th, 2009 the CFTC released three years of enhanced market-participant data for 22 commodity futures markets in its new “Disaggregated Commitments of Traders” (DCOT) report. As noted in the new EDHEC-Risk position paper, this is a welcome announcement of additional transparency into the workings of the US commodity futures markets. This new data is important because we can now evaluate whether the balance of outright position-taking in the US exchange-traded oil derivatives markets has been excessive relative to hedging demand during the past three years.

Using this new data and with some notable caveats, one can conclude that speculative position-taking in the US oil futures markets does not appear excessive when compared to the scale of commercial hedging over the past three years. As noted in the paper, though, we have to be very careful on how strongly we state this conclusion. For example, we do not examine whether there was excessive speculation in the oil markets in other venues besides the US oil futures markets.

Q: How difficult is it to distinguish between speculative position-taking and regular commercial hedging?

A: This is the key issue. Prior to the release of the DCOT report, it was difficult to disaggregate the position-taking due to true commercial hedgers versus traditionally defined speculators. The existing Commitment of Traders (COT) report had used some categorizations that rendered their meaning ambiguous. Specifically, the meaning of the traditional COT categories became ambiguous when swap dealers, who were providing commodity-index exposure to investors, became classified as “commercials.” In a broad sense, when swap dealers hedge the exposure of their swaps with positions in futures markets, this is indeed hedging. But it is not hedging in the traditional sense of the word.
Therefore, it became difficult, strictly speaking, to understand the balance between (physical) commercial hedging participation in the futures markets versus participation by those not involved in the handling of the physical commodity. The new DCOT report largely solves this problem by clearly disaggregating position-taking by those who handle the physical commodity versus those who do not. This means that we can readily determine the balance of commercial hedging versus speculation, which we do in the new EDHEC-Risk position paper.

More recently, the CFTC announced on December 4th that the agency will be including disaggregated data on all U.S. physical commodity markets, and not just the initial 22, in the weekly DCOT report. The agency also announced that it will soon provide three years of disaggregated data on all remaining physical commodity markets, too. This new data will provide researchers with a wealth of data for evaluating the speculative impact on all US commodity markets.

Q: Can you briefly describe the metric that you used in evaluating the level of hedging-vs.-speculation in the oil futures markets?

A: The first step in evaluating whether there has been excessive speculation in the oil derivatives markets is to define what this phrase actually means. The eminent economist, Holbrook Working, provided a methodology in 1960 that we can use in our current work. In order to measure the adequacy (or excessiveness) of speculation, Working devised the Speculative “T” index. This ratio is calculated by measuring the amount by which speculation exceeds commercial hedging needs, divided by commercial open interest. A value of somewhat greater than 1 is acceptable for the T index since technically an excess of speculation is economically necessary for a well-functioning market. But how much greater than 1 is acceptable?

One can examine historical research, which uses data since 1947, to find out what levels of the T index were considered tolerable in the agricultural futures markets. The levels ranged from 1.155 to 1.68, according to research from the University of Illinois at Urbana-Champaign. Can we calculate the T index for the oil futures markets? The answer is yes; and significantly, we are only able to do so now because of the release of the new CFTC data. Fig.1 shows the calculation of the T index for the NYMEX WTI oil futures contract from 6/13/06 to 10/20/09.

From examining the chart, we can say that as long as one includes options positions, the T indices were not excessive, provided that it is acceptable to reference the historical agricultural futures markets as a guide to the adequacy (or excessiveness) of speculation. We do need to note, though, that if we exclude the option positions in the NYMEX oil data, then the futures-only data would potentially show excessive speculation in the US oil futures markets. That said, we regard the futures-and-options data to be more comprehensive since speculative participants obtain exposure to the oil markets through both sets of instruments.

Q: Do you feel that there is generally more transparency now in the global oil markets?

A: Arguably, no. Many facets of the world oil markets remain too opaque, including future productive capacity estimates from important suppliers, inventory statistics from important non-OECD consumers, and summary position data from over-the-counter (non-exchange-traded) derivatives participants.

Q: The physical commodity markets are niche markets from the point-of-view of institutional investors. Does your work have wider applicability?

A: I think so, and here is why. The idea behind the Speculative T index is admittedly simple: that commodity markets exist for the commercial purpose of hedging, and therefore, speculation needs to be evaluated in terms of how it facilitates commercial hedging. I think that it is useful to reexamine the basics of the derivatives markets, as we contemplate the largest change in financial regulation since the Great Depression. Arguably, one could extend the T index concept to financial derivatives contracts, if there becomes greater mandated transparency in the over-the-counter derivatives markets. For example, let’s take credit default swaps (CDS). In viewing the events of 2008, there have been legitimate questions about the ability to enter into CDS on corporate names, when an investor has no economic exposure to that name. Some have even compared such activity as buying fire insurance on a neighbor’s home. The incentives do not look good. What amount of this activity would be considered “excessive”? If a first principle is that derivatives markets need to serve an economic or social purpose, or otherwise they would be seen (and regulated) as gaming activities, how should one proceed in evaluating the level of position-taking in CDS?

Returning to Holbrook Working, one might consider that the primary purpose of both exchange-traded and over-the-counter derivatives markets should be for facilitating hedging and risk management. In that case, one would want to see reports like the Commitments of Traders reports created for the over-the-counter credit-derivatives markets. What amount of credit-derivatives positions have been undertaken by those who have economic exposures to various credits, and whom we will call “commercials” or “hedgers”; and what amount of credit-derivatives positions have been undertaken by those who have no economic exposure to various credits, and whom we will call “non-commercials” or “speculators”? With this information, one could construct T indices, which would show the amount of excess speculation over the margin needed to offset commercial hedging needs in the credit markets. One could evaluate whether the levels of the T indices objectively showed if these particular markets were serving other than hedging needs.

Essentially, a strong case can be made that the CDS markets should be placed within the framework of that which already exists for exchange-traded products, in order to help avoid future disastrous scenarios, as occurred in 2007-2008. As a final note on historical concepts, the framework of the Commodity Exchange Act of 1936 was very well-thought-out and should be revisited in the current debates around derivatives regulation.

Q: What are the major changes that have you seen in the commodities markets in the last several years?

A: A significant change in the commodity markets is how closely correlated all commodities seem to be with other risk assets now. I first noticed this is in May-June 2006 during a global de-risking that hit all risky assets, whether it was the Nasdaq, Brazilian stock markets or individual commodity markets. Another theme has been that up until 2005, one could trade commodities based on US-centric themes. Unfortunately, for those traders and investors who built up a wealth of US-based experience in the commodity markets, many of their strategies became obsolete after 2005, with the predominance of idiosyncratic Chinese factors becoming much more important.

One issue that has become more important over the past year is reconciling the use of commodity-futures positions as a hedge against the potential of further dollar depreciation. The potential demand for this sort of hedge could be greater than the size of the commodity futures markets. And it may be that the best answer is for institutional investors to use the currency forward and futures markets for this hedging goal rather than the much smaller commodity futures markets.

For the past 25 years, one has not had to defend the economic and social usefulness of commodity futures trading. But this has changed in the past year and a half, after the explosive dislocations in both the financial and commodity markets. From a broad historical view, though, this is all to be expected. In a 1970 article by Holbrook Working, one can read about how fragile the existence of commodity futures trading has been in the United States since the late nineteenth century.

As noted in the October 2008 EDHEC-Risk position paper, “The Oil Markets: Let the Data Speak for Itself,” one hopes that public policy regarding commodity futures markets in the US and in other financial centers will continue to be based on the careful examination of empirical data.

Therefore, for statisticians, economists, and market participants, the CFTC’s launch of more detailed data on oil-market participation is excellent news. The public release of this detailed market-participant data shows that the CFTC is continuing in its decades-long tradition of providing policy-makers and academics with empirical data that (one hopes) can be used to make sound decisions on the regulation of US futures markets.

Hilary Till is a Research Associate at the EDHEC-Risk Institute (Nice, France). She is also the co-founder and portfolio manager of Premia Capital Management. Her recent EDHEC-Risk position paper is entitled ‘Has There Been Excessive Speculation in the US Oil Futures Markets? What Can We (Carefully) Conclude from New CFTC Data?’ is available at: http://docs.edhec-risk.com/mrk/000000/Press/EDHEC-Risk_Position_Paper_Speculation_US_Oil_Futures.pdf.