External Developments Division

Do financial investors destabilize oil prices?

The opinions expressed here are personal and not necessarily shared by the ECB or the Eurosystem

Energy Information Administration24 August 2011

byMarco J. Lombardi and Ine van RobaysEuropean Central Bank and Ghent Univeristy

2

Motivation

• Oil price surged with increasing momentum between 2003-2008 before falling in the wake of the financial crisis and the subsequent economic downturn. After that, prices recovered again.

• Oil price increases came against the background of surging demand and stagnating supply.

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spot oil price in USD/barrel

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Financialization of oil

• The financialization of the oil futures market was also blamed: the number of open futures contracts more than tripled over period 2000 – 2008

• Did financial activity drive up the price of oil? Do we need stricter regulations on trading in the oil futures market?

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Open interest futures market spot oil price

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Policy-relevant questions

1. Has financialization distorted the pricing mechanism in futures markets?

2. Does this transmit to spot prices?3. If so, should commodity futures markets be more

regulated?

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WHAT’S EXACTLY FINANCIALIZATION?

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Why derivatives?

• Futures markets exists to transfer risk of oil price fluctuations

• 2 types of traders– Commercial traders may want to hedge against

price fluctuations by fixing the price they will pay or receive for delivery in the future

– Also non-commercial traders enter the futures markets to achieve exposure to oil price risk and make a profit.

• The activity of non-commercial traders is usually defined as speculation

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Does financial activity distort pricing?

STABILIZING ACTIVITYIf trading is based on expected fundamentals, activity in the futures markets will make markets more liquid and allow information to be priced in immediately and efficiently

DESTABILIZINGACTIVITYTraders may distortefficient pricing in the futures markets only when they take positions that disregard (expected) fundamentals

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The role of index investment

• Recently, banks have popularized commodity investment by marketing index funds

• Index funds trace popular commodity indexes with a passive strategy– They just go long and roll

over contracts as the delivery date approaches

• Is this putting constantly upward pressure on prices?

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Total flows

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Findings on the impact of index funds

• Index investment does not cause changes in futures prices (Stoll and Whaley 2010)

• Index investment does not increase volatility (Irwin and Sanders 2010)

• Increase in commodity correlation due to hedge funds (Büyüksahin and Robe 2010)

• Index funds affect futures prices around roll-over dates (Mou 2010)

• Index investment increased commodity correlation (Tang and Xiong 2010)

• Index investment is affection prices beyond the short term (Singleton 2011)

Is this a data issue?

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Our contribution

• We evaluate the importance of financial activity in determining the spot price without explicitly using positions data

• We focus on shock to the futures market not linked to fundamentals– deviation from the no-arbitrage condition

• We use a structural VAR model with sign restrictions– Fundamental oil supply and demand-side shocks– Precautionary demand shock– Non-fundamental financial activity shock

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THEORETICAL SETUP

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Spot and futures prices

• Financial activity in the futures markets only matters if these traders can affect the spot price of oil

• Linkage between spot and futures market by a no-arbitrage condition (Pindyck 1994)

Convenience yield;additional benefit fromhaving oil in storage

Spot oil priceSpot oil priceSpot oil price

Risk-free bond rate;Opportunity cost

Futures price;for delivery in t+τ

Convenience yield;additional benefit fromhaving oil in storage

( ) ( ), ,1 1t t t t t tP r Fττ τ+ ++ = +Ψ

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No-arbitrage condition

• … or taking logs:

• Re-writing gives:

• This condition should hold if markets are efficient and arbitrage opportunities are instantaneously exploited.

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Convenience yield

• In turn, the convenience yield is:

– spot oil price, inventories and expected oil fundamentals (Pindyck 1994)

• It is more beneficial to have oil inventories if– Oil spot price is higher– The current level of inventories is lower– Expected oil demand and supply are tighter

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No-arbitrage futures price

• Substituting the expression for the convenience yield gives…

• The futures price in the no-arbitrage, efficient markets’ case is solely dependent on current and expected fundamentals

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Deviations from the no-arbitrage price

• Destabilizing financial activity can distort efficient pricing if traders buy or sell futures based on reasons not related to (expected) fundamentals

• So the observed futures price can deviate from the no-arbitrage value:

Observed futures price = no-arbitrage price + DESTAB. FINANCIAL SHOCKderived above which distorts efficient pricing

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The observed futures price

• Substituting in the no-arbitrage futures price gives :

• The observed futures price is driven by:– Current and expected fundamentals– Destabilizing financial activity shock

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Spot-futures spread

• Rewriting this in terms of the futures–spot spread

• The spread is negatively affected by changes in current and expected fundamentals (also incl. stabilizing activity in futures markets) (1)

• The spread is positively affected by destabilizing financial shocks (2)– …we can use this finding to uniquely identify the fundamental

shocks from the non-fundamental financial activity shock in the data

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EMPIRICAL RESULTS

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Our Structural VAR

• Estimation of an SVAR model for the global oil market:

– Global oil production– Oil spot price– World economic activity– Inventories– 3-month oil futures price– (Futures-spot spread, defined within the model)

• Monthly data, over 1991M1-2010M2 with 12 lags

( ) ttt uYLAcY ++= −1

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Identification

• Disentangle different types of shocks that determine oil prices– Fundamental versus non-fundamental shocks– Different types of fundamental shocks

• We identify shocks using sign restrictions• Non-fundamental shock = destabilizing financial

activity shock • Shocks to fundamentals = shocks to (current and

expected) supply and demand

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Oil supply shock

• E.g. supply disruptions

Qoil Poil Ywd INVoil Foil SF-P

Oil

production

Spot oil

priceWorld econ.

activityInventories

Oil futures price

Futures -spot spread

Oil supply shock <0 >0 <0 >0 <0

Oil demand shock driven by economic activity

Oil-specific demand shock

Destab. financial shock

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Economic activity shock

• E.g. strong growth of emerging economies

Qoil Poil Ywd INVoil Foil SF-P

Oil

production

Spot oil

priceWorld econ.

activityInventories

Oil futures price

Futures -spot spread

Oil supply shock <0 >0 <0 >0 <0

Oil demand shock driven by economic activity >0 >0 >0 >0 <0

Oil-specific demand shock

Destab. financial shock

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Oil demand shock

• E.g. oil-gas substitution shock

Qoil Poil Ywd INVoil Foil SF-P

Oil

production

Spot oil

priceWorld econ.

activityInventories

Oil futures price

Futures -spot spread

Oil supply shock <0 >0 <0 >0 <0

Oil demand shock driven by economic activity >0 >0 >0 >0 <0

Oil-specific demand shock >0 >0 <0 >0 <0

Destab. financial shock

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Destabilizing financial shock

• E.g. index funds?

Qoil Poil Ywd INVoil Foil SF-P

Oil

production

Spot oil

priceWorld econ.

activityInventories

Oil futures price

Futures -spot spread

Oil supply shock <0 >0 <0 >0 <0

Oil demand shock driven by economic activity >0 >0 >0 >0 <0

Oil-specific demand shock >0 >0 <0 >0 <0

Destab. financial shock ? ? ? >0 >0

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Response to fundamentalsO

IL S

UPP

LYO

IL D

EMA

ND

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N.

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IVIT

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IL-S

PECI

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AN

D

oil price oil production inventories world econ.activity futures-spot spread

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Response to financial activity

• Some temporary effect on the spot price• No effect on oil production, inventories or on economic activity• The spread permanently increases

oil price oil production inventories world econ.activity futures-spot spread

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Variance decomposition

Oil spot price Oil futures price

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oil supply oil demand driven by econ. activity oil-specific demand other destab. fin. activity

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• Fundamentals explain about 90% of oil price movements in the short run

• relevance of destabilizing financial activity is limited.

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Historical decomposition

• Financial activity exacerbated gyrations in the oil market

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Cont

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oil supply oil demand econ. activity oil-specific demand destab. fin. activity oil price

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Conclusions

• Financial activity can significantly destabilize spot prices in the short run

• Importance is limited in the long run and the pass-through is incomplete

• Trading according to (expected) oil fundamentals still explains about 90% of oil spot price movements

• Further regulating futures markets may reduce liquidity and risk-absorbing capacity in the oil futures market

• Something to look into: financial stability implications of index investment