A new report from Rice University’s Baker Institute for Public Policy shows a clear increase in the size and influence of speculators, defined as noncommercial traders, in the oil futures market.

Since regulations were eased by the Commodities Futures Modernization Act of 2000, speculators now constitute about 50% of outstanding positions in the U.S. oil futures market, compared with only about 20% prior to 2002.

The correlation between oil prices and the dollar has strengthened significantly over the past several years, according to the report’s coauthors, Kenneth Medlock and Amy Myers Jaffe. Jaffe is a fellow in energy studies at the Baker Institute and associate director of the Rice Energy Program, and Medlock is an energy fellow at the Baker Institute and adjunct professor of economics.

They recommend that government revise its policies to reverse these trends.

Using data from the Commodity Futures Trading Commission (CFTC), they maintain that the commission’s previous claims that speculation wasn’t influencing the oil futures markets were based on faulty analysis. They offer up new evidence that speculative trading is playing an increasingly important role.

The question of what has produced sharp swings in oil prices since 2005 is complex and requires further and deeper study. But there are inescapable facts that should be part of the debate about regulating the activities of institutions betting on movements in oil price purely for financial gain, according to the report.

Specifically, speculators, which the CFTC designates as any reportable trader who is not using futures contracts to hedge, have increased their footprint in the marketplace dramatically since the late 1990s.

Hedgers are typically producers and consumers of a physical commodity that use futures markets to offset price risk. Speculators seek profits by taking market positions to gain from changes in the commodity price, but are not involved in the physical receipt or delivery.

“To protect the U.S. economy and American consumers, there needs to be greater market oversight,” Medlock says. “The tremendous increase in the market presence of speculators by fifteenfold speaks for itself.”

The 2007 Commodities Futures Modernization Act, written by the U.S. Government Accountability Office, made it easier for financial players to obviate speculative limits and more difficult for the CFTC to regulate the oil futures markets.

Meanwhile, changes at the London International Petroleum Exchange (now called the Intercontinental Commodities Exchange) regarding U.S. delivery-based contracts also created problems with monitoring and limiting speculative activity because these contracts were outside the CFTC’s jurisdiction.

While there were short windows of time before 2001 when the oil price and value of the dollar were strongly correlated, a sustained period of higher correlation emerged during the 2000s, according to the Baker Institute study. Given this new strong correlation, the dollar is at risk of being caught in a vicious cycle. Continually rising oil prices feed the U.S. trade deficit, leading to increased U.S. indebtedness and an even weaker dollar, and further increasing oil prices.

New policies are needed, say the authors. When oil prices started rising during 2007 and 2008, from $65 per barrel to $125, governments around the world built strategic stockpiles. Certain stated policies indicated to OPEC and other oil-market participants that governments would not use strategic petroleum stocks to ease prices, except during major wartime supply shortfalls.

This gave speculators confidence to expand their exposure in oil market futures exchanges without fear of revenue losses from a surprise release of U.S. or International Energy Agency strategic oil stocks.

“We need to reevaluate our policies for how we utilize strategic oil stocks in light of the oil and dollar linkages,” says Jaffe. “Clearly, our government needs to fashion a better response.”

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