Many factors influence oil prices such as oil reserves, strength of the dollar, and the political atmosphere in producer countries. No one would argue against the influence of speculation on oil prices, however, the extent of this influence is the subject of constant heated debate. A recent research paper examined how changes in oil contract positions of hedge funds affect oil prices. It found correlation, NOT causation; leading us to believe that the extent of oil speculation influence is limited. Yet, the research was hampered by the fact that hedge funds are notorious for their secrecy and generally do not publicly disclose their trades.

Source: The Economist

The graph above shows that whenever prices increase; hedge funds would have a net long position. Whenever that position declines or goes negative; oil prices decline.

On a related note, Tuesday’s (July 7th) Wall Street Journal headline read “Oil Speculators Under Fire.” The article discussed how France and the UK are launching efforts to crack down on oil speculation. Further, it suggested that the US is pondering a similar stance.

In my opinion, any curtailing in the oil speculation market would lead to unfavorable circumstances. Such act will limit the oil market to just the suppliers and the end users (refiners, utilities companies, etc.). It will deny companies that are dependent on oil, such as airlines, the opportunity to take on hedges to limit their exposure to changing oil prices, thus, adding uncertainty to their earnings. Moreover, it will lead to a significant imbalance in the power of suppliers and end users since it removes an important middleman. Speculation usually smooth out the changes in oil prices as it increases the pool of oil specialists attempting to fairly price oil, and trying to take advantage of any arbitrage opportunities. A possible solution that could ease Washington’s worries would be to put a limit on speculative trades as a percentage of total oil trades, as is prevalent among other commodities.