Lessons for policy

Dec 22 2012, 02:20 IST
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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.

oil prices could both be due to anticipations of supply and demand changes, and are not necessarily driven by the incentives of financial players.

Moreover, comparing the vertical and horizontal striped bars, financialisation is predicted to have lowered expected future prices even if it raised current prices. This latter finding is, we argue, a quite general feature of financial layer changes. Incentives to financial players do not affect spot supply and demand directly; financial layer changes only alter how much inventory will be carried over from current to future spot markets. Thus if any change in the financial layer leads to more inventory accumulation, it will indeed raise current spot prices, but then also lower expected prices. If it leads to fewer inventories, then current prices will fall as expected prices rise. Either way, the consequence of financialisation shifts for final consumers who buy spot oil now and in the future will be limited as the current and expected future spot prices will only move in opposite directions and of a very similar magnitude. Because it can have only a seesaw effect on the term structure of prices, it would take an implausibly huge change in financialisation in order to lead to the large change in the level of spot prices we have observed.

In conclusion, these findings (and others in the paper) act as a warning to inferring that greater financialisation has caused higher oil prices on the basis of relationships such as in Figure 1. Theory predicts powerful natural limits on the ability of financialisation shifts to raise spot prices in frictionless markets. In contrast, anticipations of net supply shifts can have important impacts on prices, spreads, welfare, and even on financial market participation.

It is true, however, that many of the theory-based papers on this type of question do not model frictions displayed in real-world financial markets. For example, financial speculators in Fattouh and Mahadeva (2012) are not leveraged and there is no moral hazard in their risk taking. It is quite possible that financial layer changes might be predicted to have large effects under other circumstances.

But even if these fundamental market failures were crucial in establishing an important effect of financialisation, they would elicit their own specific policy solutions. For example, if it were found that the entrance of highly leveraged financial speculators disrupts oil markets, the implication is that prudential regulation should be employed on leveraged investors. Therefore,

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