The US Commodity Futures Trading Commission (CFTC) in mid-July reclassified a futures trader as “large noncommercial” (speculator-investor) from its former designation as “large commercial.”
Much of the general media coverage that followed implied that the action provides evidence that speculators have been the driving force behind rising crude oil prices. A careful examination of the CFTC data rejects such a conclusion.
It is particularly troubling that such inaccurate coverage permeates the media at a time of serious congressional debate regarding the role of speculators in these markets, especially when the reclassified trader actually may have been providing risk mitigation and liquidity service to the market via relatively low risk strategies.
The effects of the reclassification can be seen in CFTC comparative data for the week of July15, 2008. Detailed tables available from CFTC show that the reclassification entails shifting only one firm to large noncommercial status. Media reports identified the firm involved as Vitol, a Swiss oil trader.1
The fact that only one firm is involved in the reclassification may be discerned from the CFTC tables showing change in the number of traders by only one under the headings of commercial long, commercial short, noncommercial long, and noncommercial spreading. This pattern of restructuring of the trades, especially the spreading component, does not support the conclusion that the shift implied a role for noncommercial traders in general in the upward movement of crude oil prices.
The shift in open interest from commercials to noncommercials falls almost entirely into the category of noncommercial spread trading. The spread trading reported in the CFTC data are predominantly calendar spreading, where a trader simultaneously holds a long (short) in a near month contract and a short (long) in a more distant maturity contract. Consequently, this shift in large trader classification does not shift the weight of longs vs. shorts attributable to noncommercials vs. commercials. The commercials are generally still net short in this market, and the shortfall of hedging services for short commercial traders remains satisfied by the noncommercials.
The recent argument has been that speculators have been long—excessively so—resulting in the upward move in prices. Moreover, recent claims contend that CFTC incorrectly classified traders, masking the role of speculators. The reclassification seems to have been interpreted as a lifting of this mask. However, an examination of the data shows that the reclassified firm had long positions of 150,716 contracts and simultaneously held short positions of 146,856 contracts (see table). This means that there were 146,856 contracts involved in calendar spread positions and that the firm was net long position by just 3,860 contracts.2 These values are for futures contracts only, and the net long positions of this one firm amounted to just 0.3% (roughly a third of 1%) of the total open interest for the reported week.
The story is even more interesting when examining the combined futures and options positions. When including the delta-adjusted options equivalents to the futures-only data, the reclassified firm had 326,648 long positions and 330,741 short positions. This means that the firm actually was net short in the market by 4,093 contracts.
The claim that speculators accounted for as much as 81% of the market is not supported by the CFTC data.3 Before the reclassification, the long positions for commercial traders accounted for 61.1% of total open interest, and the short positions accounted for 62%. After the reclassification, long commercial positions accounted for 49.8% of open interest, and commercial shorts were 51.1%.
These shares are for the futures-only data. Combined futures and options data show that before the reclassification, commercial long positions were 56.6%, and shorts were 59.6%. After the reclassification these shares fell to 45.6% and 48.4%, respectively. In no case, however, is there room for noncommercials-speculators to account for 81% of the market.
The general media’s reporting of these issues implies that speculators are, in effect, uniquely long in these markets, thus driving price in only one direction, upward. This is a misrepresentation, or misunderstanding, of the nature of the trading positions in this market. Both commercials and noncommercials maintain considerable long and short positions. The commercials, usually seen as using the futures markets to hedge market price risk, tend to be net short; that is, tending to sell more futures contracts than they buy. For the market to balance, and to balance at the lowest risk mitigation cost, the net short positions of the commercials must be offset by net long positions by the noncommercials.
Nevertheless, it is not quite as simple as it sounds. The spreading positions by noncommercials also must be analyzed. This is because they represent quite different risk characteristics and because this type of trading dominates the activity of the noncommercials in this market. Spreading also enhances market liquidity simply by providing more opportunities for hedgers to enter and exit the market freely.
As noted, calendar spread positions represent a given trader simultaneously holding long and short positions in the same commodity but with different maturities. The returns on these spread positions are determined by changes in the slope of the forward curve in these futures prices.4 As such, the volatility of the spreads returns is expected to be much less than if the trader took a straight long or straight short position. One interpretation of noncommercial use of spreads trading is that they accept exposure to this asset class in their diversified portfolios, thus providing risk mitigation and market liquidity service—but with minimized risk. Such action is not indicative of the risk seeking preferences often attributed to this class of trader.
Spread trading by noncommercials dominates straight trading by this class of trader; therefore, constraining their activity could significantly reduce the availability of risk mitigation and market liquidity services for commercials-hedgers. Because of reduced competition, this likely will increase the cost of the services that do survive.
The dominance of spread trading reported for futures only may be observed in the table, where the 369,766 spread positions clearly exceed the noncommercial’s (after the reclassification) 210,013 long positions and 187,631 short positions. For the futures and options combined, the 1,269,679 spread positions dwarf the 238,130 long positions and 150,870 short positions.
Note, too, that although dominating noncommercial activity, there are fewer of these noncommercial spread positions than there are of the long and short positions held by commercial traders in either data set. Commercial traders, under the futures-only grouping, held 670,135 long and 686,747 short positions, and for the futures and options combined they held 1,356,837 long and 1,440,782 short positions.5
The spreading activity offers potentially more risk mitigation service for hedgers-commercials than would be the case if the same number of noncommercials invested in straight longs or shorts. This follows from the nature of futures contracts and spreads. As with any transaction, a sale must be offset with a purchase. For futures, this translates as every long in a maturity must be offset by a short in the same maturity. Since spreads involve longs and shorts in different maturities for a given trader, each side (maturity) of a spread transaction opens the opportunity for a hedger (exposed at one of the maturities and in a particular direction) to be in the opposite position. Thus, in the extreme, noncommercial spread positions may provide twice the hedging opportunities as straight long and straight short futures positions.
The trading activity of the reclassified trader was substantial; it constituted 11% of the market. However, this trader’s net position, including options, was short, not long, and represented just 0.1% of the market.
A careful evaluation of the available data coupled with an understanding of how the futures contracts and markets operate does not support the mainstream media representations that the trader reclassification is evidence of massive market manipulation by noncommercial traders-speculators that was masked by incorrect classifications by CFTC. The reclassification does not provide support for proposed tightening of controls on noncommercial market participants.
References
- Davis, Ann, “‘Speculator’ in oil market is key player in real sector,” Wall Street Journal, Aug. 20, 2008, and Cho, David, “A few speculators dominate vast market for oil trading,” Washington Post, Aug. 21, 2008.
- The position size for the reclassified firm is found by subtracting the postchange long from the prechange long (= 150,716) and the postchange short from the prechange short (= 146,856). Noncommercial spreading, postchange, increased by 146,856, and longs increased by 3,860. Noncommercial short positions are not altered postchange, because all shorts for this trader are offset by longs of different maturity.
- Cho, op. cit.
- If the price of both maturities moves in the same direction and by the same amount (a parallel shift of the forward curve), there is no gain.
- Commercial traders also make extensive use of options on futures contracts in this market to meet their hedging requirements.
The author
Ronald D. Ripple ([email protected]) is professor of mineral economics in the Western Australian School of Mines at Curtin University of Technology in Perth. Prior to his current position, he was associate professor in the economics department at Macquarie University in Sydney. He served as vice-president and senior economist for Economic Insight Inc. in Portland during 1988-2002 and previously was a senior research fellow at East-West Center, serving as coordinator for the Pacific Islands Energy Project in Honolulu. Earlier in his career, Ripple was principal economist for the McDowell Group in Juneau, Alas., and served as special assistant to the commissioner for the Alaska Department of Commerce and Economic Development and as senior economist in Alaska’s Office of Management and Budget, Division of Budget and Management, in Juneau. Ripple has held various teaching positions at University of Oregon; University of Portland; Edith Cowan University (ECU), Perth; and Chinese University of Hong Kong. He also served in the US Marine Corps. Ripple earned a BS in finance and an MA in economics from The Pennsylvania State University and a PhD in economics at University of Oregon. He has published 15 papers, reports, books, and other publications.