A key characteristic of the oil market is that the oil path shows large swings either up or down, which are then followed by reversal swings arounda certain central tendency. Prices and inventory levels oscillate considerablyfrom day-to-day or from week-to-week. This is partially due to predictable forces (deterministic components, i.e., seasonal shifts) and unpredictable factors (stochastic component, i.e. random shocks). In the ﬁrst case, a key role is played by geopolitical developments, supply and demandfactors and fears of potential disruptions. These movements are principally linked to their impact on expectations regarding the future evolution of thefundamentals than on proper structural changes. In the second case, the ﬁnancial character of oil prices has been a relevant source of this unstable oilpath. Here, the causes and forces of oil shocks during the last forty yearshave to be investigated both from deterministic forces and stochastic drivers.
If during the 1970s, the key cause of oil shocks was the reduction inglobal oil supply, currently one of the principal features of the turmoil in 2008 has been the increasing oil demand from emerging countries, such as China and India. In parallel with the physical side market developments due to an higher demand level, the related oil derivativesmarkets have seen an increased number of ﬁnancial operators involved inaccumulating substantial net short and long positions in crude oil futures, principally in the over-the-counter market (OTC) (Fattouh 2010). This growing importance of the futures market over the last two decades is aresult of a number of key transformations in the oil international marketsuch as the change in the international pricing system, the massive new-entry of ﬁnancial players, and the increasing number in players diversity,such as hedge and investment funds in the oil ﬁnancial markets. As noted by Alan Greenspan (2004),“… It became apparent that the world industry was not investing enough to expand crude oil production capacity quickly enoughto meet rising demand, increasing numbers of hedge funds and other institutional investors began bidding for oil.”
A good percentage of the billions of dollars poured into oil ﬁnancial products came from ﬁnancial institutions and investment funds that “do not use the commodity as part of their business”: this is deﬁned as speculationby the Commodity Futures Trading Commission (Buyuksahin, 2008).
FIGURE 1 SPREAD % CHANGE BETWEEN SPOT AND FUTURE PRICES ON OIL
Source: Author elaborations on Bloomberg dataset
Further, that additional demand forthe physical oil barrels delivery drives up the spot price increasing theuncertainty on its future level (fig. 1). However, the size of this increased demandoriginated by the speculative channel is still a matter of extensive discussion. The US Senate (2006) estimates that speculative oil futures purchases could contribute toadd a further 20-30% per barrel to the current price. Furthermore, bypurchasing large numbers of futures contracts, speculators have provided aﬁnancial incentive for oil companies to buy more oil and place it in storage.The result is a strong increase of oil inventories reached in 2010.
Extending Moosa (1996) model, Silvapulle and Moosa (1999) deﬁne speculation as the difference between the current futures price and the futuresprice expected to prevail in the future. Pindyck (2001) includes thespeculative element in the error term, stating that fundamental forces areable to explain a consistent part of the short-run dynamics of prices, but not the other factors inﬂuencing oil price formation. Investigating the stochastic oil prices movements starting with the 2008 oil price peak, Masters (2008) shows that the ﬁrst cause of this turmoil has to be addressed to the oil ﬁnancialization aspect. Contrary, Masters (2008) and Hamilton (2008) state that a low price elasticity of demand and the failure of physical production to increase haveplayed a bigger role in this turmoil. Sustaining the Hamilton idea, Stevensand Sessions (2008) say that there is not any empirical evidence toidentify the financial speculation as the principal responsible of abrupt oil rises, and that sucha hypothesis is completely unsupported by the rudiments of supply anddemand. Furthermore, they observe a normal level in inventories, which implies that the rise in oil prices is not the result of runaway speculation, but it is rather the consequence of decreasing supply and the rapid growthof developing economies such as China and India. They claim that if themarket regulators priority is in limiting the oil speculation, theyshould keep the shorter-term (one-two months) futures contracts erasing the more speculative six-month futures contracts. Focusing again on the 2008oil shock, Amenc et al. (2008) point out that low demand growth ofreserves from non-OECD countries, OPECs strategy to increase prices, andslow growth in oil supply from non-OPEC countries have been the mostimportant cause of the oil spikes. According to the IEA report of July, 2008 “Blaming speculation is an easy solution which avoids taking the necessary steps to improve supply-side access and investment or to implement measures to improve energy efficiency”.
As already stated in Dicembrino and Scandizzo (2011) the financial speculation issue on international markets is a crucial problem where policy makers have to provide concrete answers to limit the negative impact in terms of production and trade, that the oil shock might take to the potential and real output. In this direction, targeted policies have to be implemented to limit the speculation, as such as the “Tobin Tax” on financial transactions; a bigger market transparency able to limit the surprise effect of news and deep changes in market regulation would prevent short-run movements destabilizing the financial markets.
Amenc. N., Till, B., and N. Maffei., Oil prices: the true role of speculation. Edhec Risk and Asset Management Research Centre, 2008.
Buyuksahin, B. Haigh, M.S., Harris, J.H., Overdahl., J.A. and Robe, M.A., Market Growth and Trader Participation in Futures Markets, CFTC-Office of the Chief Economist, Working Paper, 2008.
Dicembrino, C., and Scandizzo, P.L., The Fundamental and Speculative component of the oil spot price: A real option approach. Paper presented at the ESE Energy and Finance Conference, Rotterdam School of Economics, 5th October 2011.
Greenspan, A., Oil. Speech Presented at the National Italian American Association, 2004.
Fattouh, B., Oil market dynamics through the lens of the 2002-2009 price cycle. Oxford Institute for Energy Studies, 2010.
Hamilton, J.D., Understanding Crude Oil Prices. NBER Working Papers (14492) 2008.
Hooker, A.M., What happened to the oil price-macroeconomy relationship? Journal of Monetary Economics, 38 (195-213), 1996.
Masters, M., Managing member portfolio manager, masters capital management, llc. Testimony before the U.S. Senate Committee on Homeland Security and Governmental, 2008.
Moosa, I.A., An econometric model of price determination in the crude oil futures markets. In M. McAleer, P., and Leong, K: Proceedings of the Econometric Society Australian Meeting, 3 (373-402), 1996.
Moosa, I.A., Silvapulla, P., The relationship between spot and futures prices: Evidence from the crude oil market the relationship between spot and futures prices: Evidence from the crude oil market. Journal of Futures Markets, (157-193), 1999.
Pindyck, R.S., The Dynamics of Commodity Spot and Futures Markets: A Primer. The Energy Journal, 22 (1-29), 2001
Stevans, L.K., and Sessions, D.N., Speculation, Futures Prices and U.S. Real Price of Crude Oil. Available at SSRN: http://ssrn.com/abstract=1154686, 2008.