Paying the price for ignoring the real economy

Data on crude oil trade on the NYMEX are revealing. The futures net long position held by non-commercials (non-hedgers, better known as speculators) as a percentage of open interest is the key to deciphering the level of speculative interest in rising prices. For instance, as of April 1, futures net long as a percentage of open interest was just about 3 per cent. The all-time high was 18 per cent. Therefore, the level of speculative funds in the crude market is much less than it is widely believed to be.

Contrast crude with, say, gold. There is huge speculative interest in the yellow metal as evidenced by high volatility and fund play. As of April 1, on the Comex, futures net long as a percentage of open interest was 40 per cent. The all-time high has been 49 per cent. In other words, speculative long positions in gold are significantly large.
A large and rising speculative long position potentially creates downside risk to the market. Thus the gold market has a large downside risk, while crude has a limited downside risk.

Importantly, the crude market is fundamentally tight. Output trails demand, albeit marginally at present. Because the probability of output catching up with demand is small, the market sentiment is bullish. The present price level has little to do with rampant speculation, as erroneously believed.

In sensitive and critical commodities such as crude, producers follow a pricing policy that helps skim the market but does not lead to demand compression. That’s why OPEC is cautious in its output policy, which ensures just about adequate supplies or a marginal shortfall so as to keep the mood buoyant. These markets do not work on a traditional ‘cost-plus’ basis.

The Hindu