Financialization in Oil Markets – lessons for policy

In the last decade, purely financial players with no interest in the physical commodity such as hedge funds, pension funds, insurance companies, and retail investors have become more prominent in oil futures and derivatives markets.  In parallel, there has been an explosion in the variety of instruments that permit speculation in oil. These movements in financial participation bear some rough relation to the oil price. Some have been led to conclude that greater financial participation has changed oil price behaviour. There have even been calls for policy intervention to limit financial participation in oil per se.

In this comment, we discuss recent research on whether underlying changes in the incentives and constraints of purely financial players could have interfered with the workings of the oil market. We find no support for the view that greater financialization has had an important effect on oil market variables and harmed final consumers. In contrast, shifts expectations of supply and demand can have important impacts on prices, spreads, welfare, and even on financial market participation.  Therefore, before oil financial market policies are contemplated, it is crucial in the first instance to identify the channels through which financialization can result in market failure.

By: Bassam Fattouh , Lavan Mahadeva

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