Oil prices have been excessively volatile since the mid-2000s, ranging from $147 in 2007 to $30 in 2015, with sharp swings in between. Apart from the fallout of the global financial cycle (GFC), this volatility is a major reason for continued slow global growth. Volatility leads to gainers and losers who create spillovers for each other, dampening growth. For example, India’s actual gains from the 2014 oil price crash were less than expected, since the slowdown in global export growth moderated gains. Commodity exporting nations are in dire straits.
So, what are possible reasons for this excess price movement? Chinese demand slowing was blamed for the sharp fall in oil prices in 2014. But Chinese growth had slowed to 7.7% in 2012 from 9.3% the previous year without reducing oil prices. Both average price levels and their volatility rose to their highest values after 2000 suggesting prices were deviating from fundamentals. Even oil producers consider oil futures to be too volatile. They prefer a price band of $60-80, which would sustain steady production.
As a physical commodity, the price of oil depends on the supply-demand balance, inventories, oil production capacity and costs. If inventories are low, supply or demand shocks can lead to large short-term price fluctuations. But as administrative price mechanisms were given up in the physical market, price discovery also began to take place in deep and liquid futures markets, which aggregated diverse views. These were expected to aid discovery and make it more forward-looking. As a financial asset, the price of oil depends on the structure of markets, expectations of oil fundamentals and of news impacting them. Prior to 2000, the expected long-run price of oil was stable. An oil price shock was expected over time to reduce demand and to raise supply. But these feedback mechanisms did not work well to reduce fluctuations in the subsequent period.
In the 1990s, investors had begun taking positions in commodity futures as part of a diversified portfolio. The US Commodity Futures Modernization Act passed in 2000 lightened position limits, among other deregulations. “Swap dealers”, who facilitate over-the-counter investment in exchange-traded funds tracking commodity indices, were granted exemptions from position limits. Following this, open interest in oil derivatives more than tripled and the number of traders doubled over 2004-08. Large-scale index-based investment took place as pension funds diversified their portfolios after the dot com crash. This financialization of oil markets has coincided with high price volatility. It heightened the tendency of financial markets to excess optimism or pessimism, which makes them pro-cyclical and more volatile. Post GFC, the quantitative easing (QE) led excess liquidity sustain the process despite some regulatory tightening.
Unfortunately, financial reforms after the GFC have focused too much on banks, neglecting markets and other financial institutions. Macro-prudential regulation has emphasized capital buffers, whose primary purpose is shock absorption, and borrower-based restrictions such as loan-to-value and loan-to-income ratios. This led to arbitrage to non-banks, such as shadow banks, hedge funds and commodity trades whose share in assets under management rose to 40% of global financial assets—from $50 trillion in 2004 to $76 trillion in 2014.
Lender-based prudential measures, such as position limits and leverage caps, are easier to apply universally to non-banks also. Research shows emerging markets (EMs) used macro-prudential tools, such as caps and limits, four times more intensively compared to advanced economies before GFC. The ratio fell to 3.3 after GFC, as the value of such tools in reducing systematic spillovers became apparent. The UK also imposes no position limits, although major EMs like India and China do so. Perhaps, Brexit will be an opportunity for these to emerge as alternative centres of commodity price discovery.
Moreover, capital is scarce in EMs. Since they have more direct measures that restrain leverage, they should not have to lock up so much capital in capital buffers. Even for banks, International Monetary Fund’s empirical assessment finds that prudential measures are more effective in reducing the growth in banks’ leverage, asset and non-core to core liabilities ratio compared to countercyclical buffers, although the latter also do reduce leverage and assets.
Better prudential regulation in commodity markets could have mitigated oil-price bubbles and their fallout. If Group of Twenty nations, or G-20, works towards regulatory coordination with use of margin requirements and position limits across countries, this could mitigate distortions in price discovery by making sentiment-driven position-taking more costly, and limit some of the negative spillovers of QE. It would reduce risks from Chinese shadow banks. The Chinese G-20 presidency has focused on innovation, but improving global financial governance is also a priority area for them.
Detailed supervision inhibits technology driven innovation in and with new funding instruments such as crowdfunding. Prudential regulations that affect participant incentives remain feasible, however. Regulatory discretion itself imposes delays and costs. Prompt corrective action based on objective criteria reduces the need for such discretion.
G-20’s major potential contributions have been in cementing global coordination in a number of areas. One of its major successes has been in tax harmonization to reduce base erosion and profit shifting (Beps). In many areas involving global standard setting, a country cannot impose tougher standards by itself since it would lose out compared to its lax neighbours. Coordination is required for this and is easier when the proposed action can be shown to benefit most countries. Post GFC, it is clear moderating fluctuations in commodity prices and reducing excess volatility in capital flows would benefit most countries. Beps had to act against the same type of lobbies that resist stronger regulations. It showed action is possible against strong corporate lobbies. There is also resistance to learning from EMs. It is up to G-20, with its greater diversity in membership, to convince the world that types of financial governance that have worked well in EMs will work well elsewhere also.
Ashima Goyal is a professor at the Indira Gandhi Institute of Development Research, Mumbai.
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