Watching oil prices crash below $30 a barrel is a sobering lesson in the limits of our ability to predict the future. I was at the helm of the CFTC in 2008 when the price of oil topped $145 a barrel. At the time, certain members of the “Peak Oil” crowd were predicting $200 per barrel by that year’s end. As recently as last year, the U.S. Energy Information Administration forecast that Brent crude oil prices would average $58 per barrel in 2015 and $75 per barrel in 2016. EIA is now predicting Brent prices will average $38 per barrel in 2016, almost 50% lower than last year’s forecast.
What does that tell us? First, it tells us that market prices are an immensely powerful force at redirecting capital to where investments are most needed. Record high prices led to fracking, deep sea drilling and curbed demand, which ultimately led to the global over-supply of petroleum and record low prices. It also tells us that predicting the price of oil is an incredibly difficult undertaking, even for the so-called experts. Importantly, it also tells us why so many businesses use the derivatives markets to protect themselves from unpredictable movements in commodity prices.
Looking back over the last several years, we’ve seen periods when oil prices were relatively flat, and other periods when prices moved dramatically. Yet throughout these cycles the use of futures and options to manage oil price risk has been steadily rising. Take a look at the volume of trading in the two leading benchmarks—the WTI oil futures contract, and the Brent crude oil futures contract. In the last ten years, the number of contracts traded has risen by three times—from just under 150 million in 2006 to almost 450 million in 2015.
That's quite a jump, and it shows that smart businesses are using our markets to reduce the risk that comes with uncertainty. But volume is only one measure of a market’s health. In fact, many market users are saying that it is getting more expensive to hedge and more difficult to access the markets. We hear time and again from customers that liquidity is drying up, particularly for firms who are looking to hedge risks that are further out in time.
At FIA we are particularly focused on the impact of regulation on liquidity. Everyone agrees with the overall goals of post-crisis reforms. Building safer and more transparent markets is good for markets and good for the economy. After the financial crisis, the listed and cleared derivatives markets were singled out as the models for success. But as new rules increase the cost of using these markets, there’s a growing consensus that the cumulative effect of new regulations must be reviewed.
A significant driver of these new costs is the inconsistent and conflicting implementation of cross-border regulations on global commodities. The oil market truly is global, with literally thousands of barrels of oil moving from one corner of the globe to another. And yet its regulatory treatment varies from jurisdiction to jurisdiction, often creating conflicting rules. These conflicts between jurisdictions create barriers to access, and ultimately lead to fragmented liquidity, higher costs for customers and unwanted occasions for regulatory arbitrage.
I am delighted by the recent announcement that Europe and the U.S. have finally resolved their conflicts over clearinghouse regulation after nearly two years of negotiations. But I can’t help but worry that it took this long to reach agreement on such an essential issue. And I worry that other similar conflicts may lie ahead with no structure or process in place to avoid such border wars.
FIA strongly supports the IOSCO principles in this area and believes that a flexible, outcomes-based approach to mutual recognition that is based on strong global standards will help us to avoid a recurrence of protracted negotiations.
Only then will we avoid fracturing liquidity in these markets and harming our ability to manage risk in an uncertain world.
