Do Birds of a Feather Flock Together? Speculator Herding in the World Oil Market

This paper looks at speculative behavior in the international oil market. Much of the blame for oil-market turbulence has been placed on speculators, particularly hedge funds. Speculative capital has been characterized as “hot money,” with capital flows driven by “herding,” “flocking,” and “contagion.” Policies to deal with volatility by weakening, or even disabling speculation, have been based largely on anecdote, convenience (speculators have long served as scapegoats for various problems), and ideology, rather than careful analysis. Part of the problem arises from the secrecy with which speculators operate. Because speculative trading cannot easily be observed, it is difficult to assess speculators’ contribution, if any, to volatility. The paper utilizes a large, detailed database on individual trader positions in crude-oil and heating-oil futures markets. The paper is exploratory, with focus on measuring and assessing the tendency of speculators to herd (trade in the same direction as a group) and flock (trade in the same direction by subgroups of speculators).

The past few years have witnessed unprecedented levels of volatility in oil and gas markets. The price of a barrel of crude oil has vaulted from less than $10 in the late 1990s to more than $70 as of mid-2006. Natural gas prices have also climbed sharply. This volatility and the causes behind it have been a source of concern to the public and policymakers.

Attracting particular scrutiny has been the role played by speculators, exemplified by a recent U.S. Senate report, The Role of Market Speculation in Rising Oil and Gas Prices: A Need to Put the Cop Back on the Beat (Permanent Subcommittee on Investigations, 27 June 2006). The report grew out of concern over the dramatic surge of speculative capital into oil and gas markets, primarily from hedge funds--investment funds that are largely unregulated and unavailable to the general public.

The Senate report claims that speculation contributes to oil-price volatility and recommends tighter controls on speculators. In contrast, RFF 2005-2006 Gilbert White Scholar Robert Weiner, in Do Birds of a Feather Flock Together? Speculator Herding in the World Oil Market (Discussion Paper 06-31), finds that speculators' influence on oil prices and price volatility is at best limited. The implications are clear: analysts and policymakers should spend less time following hedge-fund activity in oil, as well as capital flowing into commodities, and instead focus on supply and demand.

Any policy recommendation requires an understanding of the underlying causes of the current price spikes. If speculators exacerbate (or even cause) market instability, then society would benefit from policy measures restricting their activity. Such measures range from the "Tobin Tax" on speculative activity (which would tax foreign-exchange transactions) proposed by Nobel-prizewinner James Tobin, to stricter government regulation, to closing down markets entirely. Conversely, if speculation serves to mitigate volatility, then trading should be encouraged.

Views about the causes of high and volatile petroleum prices are numerous, however. One perspective focuses on "fundamentals"-- for example, political turmoil in oil-exporting countries or changes in supply and demand stemming from economic growth in China, India, and other countries. This view emphasizes increasing scarcity of petroleum as a non-renewable resource.     

An alternative view is that speculators (traders from outside the oil industry seeking gains from price fluctuations) are behind volatility in these markets. Speculative activity in oil and other commodities is climbing rapidly with the expansion of hedge funds. Moreover, pension funds and other investors are sinking more capital into commodities, including oil.    

Many analysts in the industry, governments, financial institutions, and the trade press take this view, pointing to the heightened volatility accompanying the rise in capital flows into commodity markets. While perhaps intuitively appealing, this view is not supported by any research, as none has been undertaken, and proponents have offered neither evidence nor a coherent rationale for speculators' effects on markets. In "Do Birds of a Feather Flock Together?" Weiner aims to provide both.

For speculators such as hedge funds to have a significant effect on oil prices, they must trade roughly in parallel-- that is, in the same direction. For example, if half the speculators are buying and half are selling on any given day, speculation cannot influence oil prices or volatility. The extent to which speculators act in parallel versus independently is an empirical question, but little hard evidence on speculators' actions is available to researchers and policymakers. As a result, policy recommendations are often made on the basis of anecdotes and ideology.

"Do Birds of a Feather Flock Together?" takes advantage of a large, detailed database on individual trader positions in crude oil and heating oil futures to address the question of speculator behavior directly. The paper is exploratory, with focus on measuring and assessing the tendency of speculators to herd (trade in the same direction as a group) and flock (trade in the same direction as subgroups of traders of various types).

Weiner estimates the extent of parallel trading in the oil futures markets and finds that speculators as a group did not herd during the time period for which data are available. There is evidence that some subgroups of speculators tend to act in parallel, notably commodity-pool operators (the futures-market equivalent of mutual-fund managers). Even among subgroups that flock, however, the extent of parallel trading is modest.

Weiner concludes that speculators cannot affect oil prices much. Volatility may be a cause of the dramatic increase in speculative oil trading, but it is unlikely to be an effect. Instead, he suggests that volatility is related to shocks to oil supply and demand stemming from factors like geopolitics, weather, and economic growth. Policymakers--such as the authors of the U.S. Senate report--concerned about oil-market volatility should focus on these market fundamentals, rather than on speculation.

Further Reading:  "Do Birds of a Feather Flock Together?"is part of an ongoing research stream by Weiner examining volatility and crises in the world oil market. In Default, Market Microstructure, and Changing Trade Patterns in Forward Markets: Case Study of North-Sea Oil (Journal of Banking and Finance, 1994), he examines default by trading companies during the price collapse of 1985-1986, when prices fell from $30/barrel to $10/barrel in a few months--a shock that damaged the economies of oil-exporting countries and regions of the United States. The paper finds that despite predictions that defaults would disrupt the market itself, trading survived, with minor structural changes. A second paper, Speculation in International Crises: Report from the Gulf (Journal of International Business Studies, 2005) focuses on the role of speculation during the Gulf Crisis. The paper finds that speculation tended to play more of a stabilizing role during crises than at other times, exactly the opposite of the view widely held in industry and policy circles. A third paper, Do Crises Tear the Fabric of Oil Trade? (RFF Discussion Paper 06-16, 2006) focuses on the changing role of trading companies in the oil market. The paper looks at oil supply disruptions, finding that the Gulf Crisis diminished the role trading companies played in petroleum trade--both during the crisis and after.