In a word, yes.
That isn’t a very satisfactory answer, though, and it’s a bit more complicated than a one-word reply. In short, though, oil futures can be manipulated to the point where prices are affected. Are price fluctuations due to oil futures manipulation, though, or are oil futures purchases and sales driven by price fluctuations? And are there other, primary, driving factors?
In other words, does the oil futures market constitute a major reason why the price of oil goes up and down as it does so frequently?
Here, we’ll examine how the oil futures market is related to price volatility in oil and what that means for the typical investor.
The Oil Futures Market
The oil futures market consists of buyers and sellers connected by two major commodity futures exchanges: NYMEX and the Intercontinental Exchange (ICE). These exchanges feature futures for west Texas Intermediate (WTI) light sweet crude and Brent Crude, respectively. Here, traders all across the globe can participate in gaining direct exposure to oil instead of going through oil-based companies in the stock market.
Those who participate in the market largely fall into two categories of traders: hedgers and speculators.
A hedger is someone who is buying and selling trades to mitigate risk. Oil, like any other commodity, is subject to unforeseen supply and demand issues that are difficult – if not impossible – to predict on a regular basis with confidence. So, in order to hedge against that risk, a supplier of oil may wish to gain some insulation from the price swings inherent to oil and sell a futures contract.
It’s like raising, say, wheat. If you plant wheat and plan to harvest it in the winter, you want to be able to plan ahead. You want to know how much you’ll be able to make so you can invest in new machinery, new chemicals, labor, etc. You don’t want to roll the dice, either, so you offer to sell your wheat to someone in the winter, when it is harvested, for $20 a bushel (I made that number up, by the way).
No matter what the price of wheat does in the winter, you know you will get $20 a bushel – so you can plan your next planting season. If the price of wheat is $15 a bushel in the winter, congratulations- you just earned what amounts to a profit of $5 per bushel. If the price is $22 a bushel, you undersold your wheat by $2 a bushel.
Either way, risk is mitigated.
That is one reason why certain suppliers and buyers of oil participate in the market: to mitigate risk and cut down on uncertainty.
The other category consists of traders who do not supply oil or purchase oil for actual physical delivery. They are in the market to profit from price fluctuations and volatility. These traders are called speculators, and they have a big influence.
Case in point: Only about 2% of oil futures contracts are actually settled through physical delivery. In other words, 98% of trades take place without any intention of actually taking delivery of oil. They exist to profit from price swings.
The question is this: Does this massive buying activity cause price swings?
Speculation and Volatility
This question can be complicated to answer because there are a million and one factors that affect the price of oil. Oil is a notoriously price-sensitive commodity. A ruler dying in the Middle East can cause a spike in oil, if the conditions are right. The wrong, off-the-cuff comment from a central bank president can cause price rises or dips. To put it simply, isolating a few major factors beyond the obvious and vague labels of ‘supply’ and ‘demand’ is difficult.
With that being said, it is clear that speculation does cause a good bit of day-to-day price volatility, even if global supply and demand has more of a impact over the long run.
If the market – and by market, I mean investment firms and other institutional buyers of futures – determines that oil should be higher due to various issues, then buyers will take up positions that will drive the price of oil up. In other words, speculators are betting that the price of oil will rise – and are then taking up positions to make that rise happen.
Remember the movie with Eddie Murphy and Dan Aykroyd, Trading Places? They play two traders who, in an elaborate act of revenge against two orange juice moguls, deliberately sell positions in orange juice futures to help drive down the price of orange juice and ruin their adversaries.
When investors buy a large quantity of futures, that drives up the price for oil delivery in the future, which eventually causes the price of oil itself to rise.
Of course, the same can be said for going the other direction. In fact, the low price of natural gas today is there in part because speculation drove it into the ground. Speculation works both ways. It just so happens that oil speculators are causing the price of oil to go up, in part, because natural supply and demand constraints are trending that direction.
The average investor needs to be aware of the presence of speculation in oil futures markets and other commodity markets and understand that not all price movements will be caused by tangible events or supply and demand constraints.
For the most part, though, speculators operate based on the same supply and demand issues as hedgers and other market participants. If oil were heavily abundant and significantly outstripped demand for the foreseeable future, no amount of speculative buying could drive up the price of oil. That is why it is not nearly as simple as saying speculation always impacts price, or even is always a major driver of price.