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Benefits and Pensions MonitorDo Traders Help Or Hurt The Markets? By: Jim Helik While the price of oil today makes the nightly newscasts, it is worthwhile remembering that, for the longest time, few people seemed to care about the movements in crude oil prices. Less than a decade ago, crude was under $15 a barrel. Since then, things have changed for the entire energy complex. Natural gas was cheap for the longest time, before it became very expensive, and is now back down to where it was a few years ago. So what causes these movements in prices? For those looking for conspiracies, there are plenty of culprits – oil companies, hedge funds, and unnamed ʻspeculators.ʼ But more specifically, what do all of these market participants bring to the table? Do all of those guys in funny coloured jackets standing on the floor of the New York Mercantile Exchange (NYMEX) actually provide anything of value, or do they actually increase volatility and price swings? Light On This Issue Some light on this issue is shed in a recent paper by Michael Haigh, Jeffrey Harris, James Overdahl, and Michael Robe (all of the U.S. Commodity Futures Trading Commission). In Market Growth, Trader Participation and Pricing in Energy Futures Markets, the authors use a rich data set of the Commodities Futures Trading Commissionʼs large trader reporting system (which includes large traders such as hedge funds, pension funds, and arbitrageurs) as well as a data set of trader positions on the NYMEX to examine changes in the crude oil futures market since 2000. They found that the NYMEX crude oil futures market has grown substantially since the beginning of this century and become far more liquid over time. Daily net positions in short-term futures contracts – those with expiration dates in three months or less – have grown by 145 per cent from the year 2000. Growth has been even stronger in long-term contracts (those expiring in three years or more). These have jumped by 262 per cent over the same time period.
In 2000, the crude oil market was relatively illiquid at this long-term end, with long-dated futures contracts amounting to less than 4.5 per cent of total open interest in all crude oil futures contracts. This part of the market has grown so substantially that, as of 2006, the daily net positions in long-dates futures contracts is roughly the same size as the highly liquid short-term contract sector was in the year 2000. Continued Liquidity So who is driving this continued liquidity? The short answer is, almost everybody. The paper concludes that there has been greater participation from nearly every type of trader in both short-term contracts as well as long-dated contracts, even though these participants have very different trading objectives, especially when it comes to long-term contracts. More specifically, with short-term contracts, swap dealers – as well as floor brokers and dealer/merchants – have accounted for much of this growth. For long-dated contracts, growth was driven by hedge funds, commodity swap dealers, floor brokers, and dealer/merchants. So we have more participants, with differing investment/trading objectives, providing greater liquidity to the overall market. The authors also show that all of this activity has lead to greater integration with underlying cash markets for crude oil, as well as co-integrations of all oil futures contracts. Much of this price convergence can be attributed to the actions of hedge fund trading on the now far more popular long-term contracts. Hedge And Arbitrage Why does all of this matter? As a result of this pricing integration across oil futures contracts, traders are able to hedge and arbitrage their energy positions more effectively. You donʼt have to go far back into investment history to note an example of when such a lack of price integration was one of many contributing causes to what was then the largest derivatives loss in history – Metallgesellschaftʼs derivatives loss of around $1.5 billion in 1993. As part of a complex crude oil hedging strategy, that company found that it was unable to fully hedge away its risks in the NYMEX oil futures market. Sudden and steep derivatives losses were the result. As the authors note, “We show that specific trader types, particularly financial traders who may have little vested interest in the underlying commodity, can add important dimensions towards integrating derivative markets and making markets in general more informationally efficient.” This seems to be another way of stating what Adam Smith wrote of centuries ago: that people pursuing their own self interest make things better for the entire group. Markets seem to work – in this instance, at least.
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Jim Helik is co-author of ʻEnergy Markets Risk Management,ʼ a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University in Toronto.