SHEEP IN WOLVES’ CLOTHING? Speculators and Price Volatility in Petroleum Markets

The 1990s have been a decade of upheaval in international financial markets. Much of the responsibility for financial instability has been placed on speculators, particularly hedge funds. Speculative capital has been characterized as “hot money,” with capital flows driven by “herding” and “contagion” among players in foreign-exchange, stock, bond, and commodity markets. Policies to deal with financial instability 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. Since speculative trading cannot easily be observed, it is difficult to assess speculators’ contribution, if any, to financial volatility. This paper looks at speculative behavior in one of the largest, and most volatile, international financial markets, petroleum derivatives. It utilizes a large, detailed database on individual trader positions in crude-oil and heating-oil futures markets. The paper is exploratory, focusing on measuring and assessing the tendency of speculators to herd. Two theories behind rational herding behavior are examined – the asymmetric information view (poorly-informed traders make decisions based on observing wellinformed traders, rather than market fundamentals) and the monitoring/incentive view (institutional investors make decisions knowing that their incentives are based on performance relative to a benchmark such as mean returns for a group). These theories generate different predictions regarding the types of speculators most likely to herd. The evidence does not support the view that herding among speculators as a group is widespread in this market. In contrast, evidence in favor of a moderate degree of herding among one group of speculators, commodity-fund managers. the evidence is supportive of the monitoring/incentive theory, but not the asymmetric-information theory. ...I explained to you the instability of [stock] prices and the reasons therefore...and discussed the frenzy and foolishness of speculation. ...As there are so many people who cannot wait to follow the prevailing trend of opinion, ...they think only of doing what others do and following their examples... -excerpted from de la Vega [1688]