U.S. Energy Information Administration - EIA (2024)

Market participants not only buy and sell physical quantities of oil, but also trade contracts for the futuredelivery of oil and other energy derivatives. One of the roles of futures markets is price discovery, and assuch, these markets play a role in influencing oil prices.

Oil market trading activity involves a range of participants with varying motivations, even within individualparticipants. Some, such as oil producers and airlines, have a significant commercial exposure to changes in theprice of oil and petroleum-based fuels, and may seek to hedge their risk by buying and selling energyderivatives. For example, an airline may want to buy futures or options in order to avoid the possibility thatit* future fuel costs will rise above a certain level, while an oil producer may want to sell futures in orderto lock in a price for its future output.

Banks, hedge funds, commodity trading advisors, and other money managers-who often do not have interests intrading physical oil-are also active in the market for energy derivatives to try to profit from changes inprices. In recent years, investors have also shown interest in adding energy and other commodities asalternatives to equity and bond investments to diversify their portfolios or to hedge inflation risks. Everytransaction must involve both a buyer and a seller, and the desired "long" buyer and "short" seller positions ofthose with direct commercial interests in the oil market do not necessarily equal one another. Banks, hedgefunds, and other "non-commercial" investors can add liquidity to futures and derivative markets by taking theother side of transactions with commercial participants. On the other hand, concerns have been raised thatnon-commercial commodity trading and investment may "use up" liquidity and amplify price movements, particularlyat times when momentum is running strongly in a particular direction.

Activity in commodity exchange contracts has risen in recent years. One measure of activity in futures marketsis open interest on exchanges, which indicates the number of contracts in a trading session that have not beensettled or closed. Open interest on exchange-traded crude oil futures contracts increased substantially over thepast decade, as measured by the New York Mercantile Exchange (NYMEX), the main commodities exchange for energyproducts in the United States. Both commercial participants (those that have a direct interest in physical oilproduction, consumption, or trade) and non-commercial investors (money managers and funds that are interested intrading contracts for investment and diversification purposes) have shown increased trading activity. Care mustbe taken in interpreting these data, however, because the vast majority of positions are held in the lesstransparent over-the-counter (OTC) market rather than on exchanges. In addition to futures contracts, anotherway for market participants to invest in crude oil is through the buying and selling of options contracts.Options allow for investment exposure with limited potential for losses and provide an insurance-like instrumentagainst adverse commodity price movements.

The Commodity Futures Trading Commission publishes a weekly activity report on oil trading that occurs onexchanges (e.g., NYMEX), the Commitment of Traders Report. In this report, the activities of multiple tradingcategories are detailed, including physical participants (producers, merchants, processors, and end users),money managers (usually hedge funds or other sophisticated traders), and swap dealers (traditionally investmentbanks or commodity broker/dealers). On a net basis (subtracting short positions from long positions), physicalparticipants tend to be net short while traders in the money managers category tend to be net long.

During the world financial crisis that occurred in the latter half of 2008 and 2009, markets saw a dramaticincrease in the correlation between crude oil and other commodities as demand decreased for raw materials.However, both before and after the world economic slowdown, there were observable increases in the correlationsbetween commodity prices. At the same time as this rise in correlations was a rise in interest in generalcommodity exposure. A growing number of investors have gained exposure to commodities by investing in indexfunds-market instruments that provide exposure to baskets of commodities. These index funds usually establishshares of various energy and other commodities to provide diversity across a range of commodities. Also,exchange traded funds (ETFs)-which can be bought and sold throughout the day like individual common stocks-arean increasingly popular means for investors, including individuals, to gain exposure to commodities as an assetclass.

Correlation is not the same as causation, however, and the relationship between crude oil and other financialmarkets is complex. Even with observed movements in correlation levels, influences between crude oil pricechanges and changes in values of other asset classes are unclear. For example, it is possible that highcorrelations are due to more primary relationships with a third common factor, such as economic growthexpectations. Another complicating factor is that these relationships and their strength vary over time.Analysts continue to work to better understand the connections between these markets.

Most index funds are "long only" funds whose value will increase only when the prices of theunderlying commodities rise. Investors in such instruments expect commodity prices to rise; money is lost if thevalues of the underlying commodities in the index decrease. Many of the managers of index-style investments donot trade the individual components of an index on a daily basis; instead, they buy and hold these investmentsover periods of months or years, rolling contracts forward to avoid physical delivery.

Some market observers believe that increased trading activity by investors and long-only index funds in oilmarkets has had a significant impact on the energy price formation process. Although a growing body of researchby academics and securities market analysts examines this issue, no definitive conclusion either proving ordisproving a causal linkage between non-commercial trading and large energy price swings over the past few yearshas been reached.

Because the vast majority of positions are held in the less transparent OTC derivatives market, however,analysis that relies only on readily available data from the transparent portion of the market may offer onlylimited insights. Additional data and analysis are needed to better understand the relationship between energyderivatives trading and price movements. In addition, the global nature of trade in energy-related derivativesadds to the challenges of analyzing trading activity.

Other financial markets

Prior to 2007, stocks, bonds, and exchange rates showed only infrequent, fleeting correlations to oil futuresprices. In contrast, the price of crude oil showed positive correlations with stocks from 2008-2010, negativecorrelations with the value of the U.S. dollar during most of late-2007 to the present, and more irregular butoften negative correlations with bond prices during 2008-2010.

For each asset class, there are financial, physical, and common underlying economic factors-such as theeconomic downturn and recovery-that could be influencing these more significant correlations. Financial factorsinclude developments such as the growing interest over the last decade in crude oil as an investment asset. Thisinvestment interest has altered the financial money flow into and out of commodities. Physical crude oil marketscan also be influenced by outside factors. Exchange rates and economic factors play a role in crude oilproduction and consumption, possibly leading to price correlations.

Stocks

Stocks have traditionally been the largest investment market. Economic conditions can cause prices for stocksand commodities, including oil, to move higher or lower together. As macroeconomic conditions improve (orworsen), earnings for companies increase (or decrease) and demand for commodities as raw materials rise (orfall) as well. Economic expectations are one possible reason why a positive correlation was observed during2008-2010 between the S&P 500, a benchmark for stock markets, and crude oil, one of the most heavily tradedcommodities in the world.

In addition, there were significant changes in the level and appetite for risk during 2008-2010. Over the pastdecade, crude oil has shown similar risk/return characteristics to stocks. As a result, during periods whererisks were rising significantly (during the financial crisis) and then abating (during recovery), stocks andprices for crude oil and other commodities could tend to move in the same direction.

Bonds

As economic conditions improve (or worsen), interest rates on government bonds will tend to rise (or fall).Since bond prices and interest rates move in opposite directions, U.S. Treasury bond prices and the price ofcrude oil would also tend to move in opposite directions in times of significantly changing economicconditions.

In addition, bonds, the second-largest investment market, are often viewed as lower-risk investments thanstocks, albeit with lower average returns. As an asset class, bonds are generally less volatile and carry alower chance of losing principal. U.S. Treasury bonds, in particular, are usually considered a risklessinvestment. As investors become worried about future returns in higher risk assets, such as stocks andcommodities, they tend to increase allocations to bonds in their portfolios.

Currencies

Several hypotheses have been offered that tend to support an inverse relationship between the exchange value ofthe dollar relative to other currencies and crude oil prices. The first is simply that because oil benchmarksare traditionally priced in U.S. dollars, a depreciation of the dollar decreases the effective price of oiloutside the United States. This decreased cost may increase consumers' demand for oil, adding upward pressure toprices.

A second potential reason is that U.S. dollar depreciation will decrease the effective profits of non-U.S.producers, when converted into foreign currencies. To counteract this, these countries may target higher dollarprices of oil to maintain real revenue, budget levels, and purchasing power in world markets. Dollardepreciation also reduces the returns on dollar-denominated assets, when measured in foreign currencies, whichmay increase the attractiveness of foreign investing in commodities like oil. Commodity investment may alsobecome more attractive to U.S. investors as a hedge against inflation if dollar depreciation tends to increaseexpectations of greater inflation.

Finally, a rise in oil prices also expands the U.S. trade imbalance, which can put additional downwardpressures on the dollar, again yielding a negative correlation albeit with causation going in the reversedirection. Despite these many possible explanations, the actual correlation between oil prices and exchangerates has not been stable over time, and was close to zero for more than half of the last decade.