Financial Energy Markets and the Bubble in Energy Prices- March 2007
Does the Increase in Energy Trading by Index and Hedge Funds Affect Energy Prices?
SUMMARY: This paper is an exploration into the question of whether financial energy markets affect both the level and the volatility of oil and gas prices. We use the term "financial energy markets" here to mean the collective of trading arenas in which forward energy prices evolve from trades on (1) formal traditional exchanges (notably the New York Mercantile Exchange), (2) new forms of exchanges that combine traditional and over-the-counter transactions (notably, the Intercontinental Exchange), and (3) bilateral energy contracts whose prices are indexed to those of the exchanges.
Discussions within the oil and finance community reflect various perspectives on this issue. The discussions raise a very important question: did the increase in oil prices above $50/barrel and natural gas prices above $10 per MMBTU in 2006 reflect classic commodity "bubbles" in which financial markets played a distinct, sui generis role; or a "new regime" of permanently higher prices brought about by sharp increases in demand and enduring changes in supply, which pushed both crude oil and natural gas into suddenly much higher marginal production costs? As always, the answers are not mutually exclusive. We may also have lived through a period when there was a "perfect storm" of conditions conducive to higher prices.