Lessons for policy

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SummaryIn the last decade, purely financial players with no interest in the physical commodity, such as hedge funds, pension funds, insurance companies and retail investors, have become more prominent in oil futures and derivatives markets.

uncertainty.

Thus, as Parsons (2009) explains, we have to be humble about our ability to capture destabilising speculation as what is left over, using the patchy data that we have on oil fundamentals. Similarly, it should also be hard to try and pick the destabilising rise in financial participation from that which is a healthy consequence of secular trends in financial globalisation and financial innovation. Another route is to ask if more underlying changes, such the greater appetites or resources of purely financial investors, can be damaging for final consumers. This is a complementary strategy to an empirical approach. As the Confucian analect goes, “Learning without thought is labour lost; thought without learning perilous” (Legge 1893).

In a recent paper (Fattouh and Mahadeva 2012), we built a small model of the oil market where financial speculators’ risk aversion and wealth are exogenous. We calibrate it to match the pre-2003 data and ask if, as a result of a fall in the risk aversion of financial speculators or a rise in the financial resources they can muster, we can expect a greater participation by purely financial investors and a higher oil price level.

The sizes of these shifts are considerable. We lower the risk appetite of financial players halfway towards making them completely indifferent to risk and raise their wealth by a considerable 25%. A control is provided by shifts in the physical layer of the oil market, such as a sudden expectation of a 5% more expansive net supply as could have occurred in 2006-8.

Figure 2 describes one of our results. Even large changes in financial players’ incentives— shown in the first two sets of columns — are not predicted, by themselves, to have led to more than a small rise in financial player’s futures positions. And they are predicted to imply only small rises in the current spot level.

On the other hand, as the right-hand side of Figure 2 shows, an expected 5% loosening of net supply leads to a large fall in financial participation. This suggests that the fall in participation in 2008 may have been the result of an anticipation of slack in spot oil. Conversely when there is an expected tightening of future supply, inventories will be accumulated and this will stimulate greater need for the hedging services of purely financial players. We should expect a rise in financialisation during these episodes. The implication is that financial participation and

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