Speculative Oil

Anna Kruglova
Massachusetts Institute of Technology

The paper contributes to the newly emerging literature that seeks to develop new frameworks for the dynamics of prices in financial markets for crude oil. The need to develop these new frameworks is driven by the fundamental structural changes that financial markets for crude oil have been experiencing during the last decade due to the influx of financial investors, namely banks, that seek to take exposures to crude oil, as a “new” asset class. As a result, the previous long-standing framework predicated on a premise that producers are the main drivers of energy prices, the so-called “hedging pressure” theory has been shown to be less and less consistent with the empirical regularities present in the oil prices. For example, the rapid increase followed by a decrease in crude oil prices during 2008-20009 is very hard to explain using the standard hedging pressure theory. The hedging pressure theory is based on an idea proposed by Keynes (1923) and Hicks (1939) and formalized by Hirshleifer (1990) and others that commodity futures prices reflect the desire of the “hedgers” (those with a natural long exposure to a physical commodity) to transfer some amount of their price risk to the “speculators” (those with the money to play); in other words, hedgers are willing to pay a risk premium to the speculators in return for insurance against commodity price risk. However, the traditional hedgers in the crude oil market such as producers and refineries typically enter into long-term contracts and use over-the-counter swaps to hedge their price risks. They do not come to the market every minute of every day. In fact, the price of crude oil reflects the last needed barrel. We hypothesize that with the influx of financial investors, the last needed barrel is traded in the market not between a hedger and a speculator, but between two speculators: a commodity trader and a bank or vice versa. We plan to use an extremely detailed database from Datamyne, a top global international trade data company, which includes granular information on all shipments of seaborne crude oil into the United States during 2007-2012, to determine who holds the crude oil that supports the determination of prices in financial markets. We call it speculative crude oil. We then plan to examine the industry structure of trading in speculative crude oil to see how concentrated it is. It is known that due to strategic interaction among traders, prices in a concentrated oligopolistic industry can deviate from competitive levels.

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