Trading Institutions and Price Discovery: The Cash and Futures Markets for Crude Oil

The futures market in West Texas Intermediate crude oil was introduced in 1983 with a posted-price cash market in which the posted price changed a few times a year. By 2002, the cash price changed almost daily. Evidence from producers’ invoices shows that this initially low frequency of price changes reflects transactions prices. Using experiments, we show that the introduction of a futures market with prices set in auctions can aggregate information and result in greater price volatility in a spot market that has prices set by posted bids. This evidence supports the proposition that information not previously aggregated into the cash price for crude oil can explain greater variability of the cash price after the opening of the futures market. Does a futures market increase the variability of cash market prices, and if it does, is that good or bad? Futures markets can affect spot markets by allowing producers to hedge, providing liquidity to holders of the commodity, providing information about the future price, and facilitating coordination of producers' decisions about future production. On a less positive note, there have been long-standing claims that futures markets adversely affect the spot market by increasing the variance of the spot price and producers’ profits. Empirical studies have found mixed results on whether the spot market price varies more when there is a futures market (Mayhew 2000). We show that the volatility of cash prices increased dramatically after the futures market in West Texas Intermediate crude oil opened on March 30, 1983. Researchers have attempted to identify the specific cause of the increased price volatility in the crude oil spot market, such as inventory changes or speculative trading behavior in the futures market (Smith 2002).They also have examined the effects of this variability on producers’ decisions. The source of the dramatic increase in price volatility in the crude oil market after the introduction of the futures, however, remains an open