Whither Oil Prices and Volatility? - World...

Dr Robert J Weiner, Gilbert White Fellow, Resources for the Future

Does Speculation Cause Oil Price Volatility? 1

OIL PRICE VOLATILITYOIL PRICE VOLATILITY

What Do We Know?What Do We Know?Robert J. Weiner Robert J. Weiner

Professor of International Business, Public Policy & Professor of International Business, Public Policy & Public Administration, and International Affairs, Public Administration, and International Affairs,

George Washington UniversityGeorge Washington UniversityMembre AssociMembre Associéé, GREEN, Universit, GREEN, Universitéé LavalLaval

GWU GWU –– WB Global International Finance ForumWB Global International Finance ForumOil Price Volatility, Economic Impacts, & Financial ManagementOil Price Volatility, Economic Impacts, & Financial Management

WashingtonWashington10 March 200810 March 2008

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Whither Oil Prices and Volatility?Whither Oil Prices and Volatility?1.1. The past decade has witnessed unprecedented levels of The past decade has witnessed unprecedented levels of

volatility in oil. The price of a barrel of crude oil has vaultevolatility in oil. The price of a barrel of crude oil has vaulted d from $10 in the late 1990s to over $100 in 2008from $10 in the late 1990s to over $100 in 2008

2.2. Not only have current (spot) prices of oil risen far more than Not only have current (spot) prices of oil risen far more than other commodities, but market participants expect similar other commodities, but market participants expect similar increases over the long term. increases over the long term. The term structure of crude The term structure of crude oil futures prices has moved up in parallel oil futures prices has moved up in parallel

3.3. As of March 3, 2008, prices were expected to be over As of March 3, 2008, prices were expected to be over $97/bbl through 2013. The BP Royalty Trust (BPT) indicator $97/bbl through 2013. The BP Royalty Trust (BPT) indicator of expected longof expected long--term oil prices has also risen sharply term oil prices has also risen sharply

4.4. These indicators suggest that market participants expect These indicators suggest that market participants expect most of the dramatic increase in oil prices to be permanentmost of the dramatic increase in oil prices to be permanent



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Term Structure of Futures Prices Suggests Term Structure of Futures Prices Suggests Shocks Expected to be PermanentShocks Expected to be Permanent

Parallel movements in term structure indicate expectations of peParallel movements in term structure indicate expectations of permanent shocksrmanent shocks

WTI Futures Term Structure

50

60

70

80

90

100

110

Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13

Mar 3 08

$/bbl

Jan 16 07

Aug 15 07

Oct 15 07

Dec 31 07

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LongLong--Term Market Price also Higher Term Market Price also Higher and More Volatileand More Volatile



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Market expectations of future volatility Market expectations of future volatility have also increasedhave also increased

•• The distribution of likely future prices has widened, reflectingThe distribution of likely future prices has widened, reflectingincreased uncertainty increased uncertainty

December 2008 Brent Crude Oil Price Distribution Implied in Call Option Prices (source: IMF)

40 50 60 70 80 90 100 110 120 130 140 150US$//bbl

Feb. 28, 2008

Nov 26, 2007

Jan 7, 2008

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Why is oil price volatility important?Why is oil price volatility important?1.1. Volatility matters a great deal to world economyVolatility matters a great deal to world economy

•• Trade flowsTrade flows•• Investment flowsInvestment flows

2.2. On the exporter side, the boomOn the exporter side, the boom--andand--bust cycle presents bust cycle presents economywide challengeseconomywide challenges

•• capital inflowscapital inflows•• budget cyclesbudget cycles•• development planningdevelopment planning•• competitiveness of the noncompetitiveness of the non--oil sectoroil sector•• governance and accountability of oil revenuesgovernance and accountability of oil revenues

3.3. On the importer side, high & volatile oil prices present On the importer side, high & volatile oil prices present obstaclesobstacles

•• economic growtheconomic growth•• investmentinvestment•• trade trade •• development planningdevelopment planning



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Is Elevated Volatility likely to Continue?Is Elevated Volatility likely to Continue?

1.1. A A yesyes answer would have very different implications answer would have very different implications than a than a nono answer for fiscal management, publicanswer for fiscal management, public-- and and privateprivate--sector investment, currentsector investment, current--account stability in account stability in oiloil--exporting and oilexporting and oil--importing developing countries, importing developing countries, and many other dimensions of the world economyand many other dimensions of the world economy

2.2. Addressing this question requires understanding and Addressing this question requires understanding and assessment of the underlying assessment of the underlying causescauses of volatilityof volatility

3.3. To gauge whether oil prices are likely to be volatile in To gauge whether oil prices are likely to be volatile in the future, it is necessary to understand why they are the future, it is necessary to understand why they are volatile today volatile today

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FACTORS DRIVNG OIL PRICE VOLATILITYFACTORS DRIVNG OIL PRICE VOLATILITY

►► Market fundamentalsMarket fundamentals.. Fluctuations in supply, Fluctuations in supply, demand, and market powerdemand, and market powerSome fundamentals related to expectations of Some fundamentals related to expectations of future production, consumption, so not easily future production, consumption, so not easily observableobservable

►► Trading, especially speculationTrading, especially speculation. Traders can . Traders can move prices away from fundamental values in move prices away from fundamental values in some circumstancessome circumstances

Speculation is the focus of this presentationSpeculation is the focus of this presentation



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Speculation Widely Claimed to Drive VolatilitySpeculation Widely Claimed to Drive Volatility

OPEC OPEC (Press Release, 14 July 2006)(Press Release, 14 July 2006)

““Geopolitical developments, over which OPEC has no influence, havGeopolitical developments, over which OPEC has no influence, have e been behind this sudden rise in volatility, and these have come been behind this sudden rise in volatility, and these have come at at a time when the market was already out of line with todaya time when the market was already out of line with today’’s s supply and demand fundamentals,supply and demand fundamentals, with speculation playing with speculation playing a significant role in driving up pricesa significant role in driving up prices..”” (emphasis added)

Investment Analysts Investment Analysts ((SociSociééttéé GGéénnééralerale CrossCross--Asset Asset Research, MultiResearch, Multi--Asset Portfolio, October 2006)Asset Portfolio, October 2006)

““Exponential price rises observed since summer 2005 were not consistent with fundamental valuations (for example, 45% overvaluation, still, on current oil price)…Hedge funds have been a massive force amplifying the positive uptrend in commodity prices. At the peak of the commodity cycle, they held more than 17% of the most liquid of them, the oil market.” (emphasis added)

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Speculation Widely Claimed to Drive Volatility, Speculation Widely Claimed to Drive Volatility, contcont’’dd

US Senate Permanent Subcommittee on InvestigationsUS Senate Permanent Subcommittee on InvestigationsThe Role of Market Speculation in Rising Oil and Gas Prices: A NThe Role of Market Speculation in Rising Oil and Gas Prices: A Need to Put eed to Put

the Cop Back on the Beat, June 2006the Cop Back on the Beat, June 2006

“Based upon its investigation into the role of market speculation in rising oil and gas prices, the Subcommittee staff makes the following findings and recommendations.

A. Findings

1. Rise in Speculation. Over the past few years speculators have expended tens of billions of dollars in U.S. energy commodity markets.

2. Speculation Has Increased Prices. Speculation has contributed to rising U.S. energy prices, but gaps in available market data currently impede analysis of the specific amount of speculation, the commodity trades involved, the markets affected, and the extent of price impacts.”



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Some memorable experience consistent with this viewSome memorable experience consistent with this view

Gulf Crisis as Gulf Crisis as impetus for impetus for concernconcernOil prices spiked, Oil prices spiked, then plummetedthen plummetedLittle evident Little evident change in change in fundamentalsfundamentalsSpeculators, Speculators, futures markets futures markets claimed claimed responsible for responsible for market volatilitymarket volatility

CRUDE OIL PRICES, $/barrel

15

20

25

30

35

40

1989 1990 1991

Gu l f C r i s i s

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HOWEVERHOWEVER……

►► Tremendous growth in trading across commodities, Tremendous growth in trading across commodities, securities, foreign exchange, etc. in recent yearssecurities, foreign exchange, etc. in recent years

►► Conventional wisdom: trading Conventional wisdom: trading →→ volatility. Based on volatility. Based on intuition, not facts or systematic analysisintuition, not facts or systematic analysis

►► Economic theory Economic theory →→ speculators cannot affect price speculators cannot affect price levelslevels, but could affect price , but could affect price volatilityvolatility

►► A couple of studies using aggregate data do not find A couple of studies using aggregate data do not find support for any effect support for any effect (CFTC 2005, IMF 2006)(CFTC 2005, IMF 2006)

►► Speculators make convenient targetsSpeculators make convenient targets



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SPECULATORS SERVE AS SCAPEGOATS SPECULATORS SERVE AS SCAPEGOATS FOR BOTH PRICES AND VOLATILITYFOR BOTH PRICES AND VOLATILITY

““... ... among theamong the causes of lowcauses of low [crude[crude--oil]oil] pricesprices [are][are] the the manipulation ofmanipulation of [inventory][inventory] stocks by speculatorsstocks by speculators and and buyers to depress price to suit their purposesbuyers to depress price to suit their purposes, which , which are always adverse to the interests of producersare always adverse to the interests of producers”” (Petroleum (Petroleum ProducersProducers’’ Union, 1878Union, 1878; ; emphasis added)

““NYMEX is the cheapest gambling house in AmericaNYMEX is the cheapest gambling house in America””(Leon Hess, 1996)(Leon Hess, 1996)

““Derivatives are Derivatives are ‘‘financial weapons of mass destructionfinancial weapons of mass destruction’”’”(Warren(Warren Buffett, 2003)Buffett, 2003)“…“…The growing influx of money has led some to believe a The growing influx of money has led some to believe a commodity price bubble is forming as commodity price bubble is forming as investor enthusiasm investor enthusiasm detaches itself from the fundamentalsdetaches itself from the fundamentals..”” (PIW, 28 Feb (PIW, 28 Feb 2005, 2005, Pension Funds Help Inflate Price BubblePension Funds Help Inflate Price Bubble; ; emphasis added)

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CrudeCrude--Oil Futures Open Interest up SharplyOil Futures Open Interest up Sharply

►► Percentage of open contracts held by nonPercentage of open contracts held by non--commercial traders increasingcommercial traders increasing

Source: IMFCrude Oil Futures – NYMEX

Open Interest (thousand contracts)

0

100

200

300

400

500

600

700

800

900

1000

Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

Non-Commercial

Commercial

Non-Reporting



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VOLATILITY HIGH BUT NO CLEAR TRENDVOLATILITY HIGH BUT NO CLEAR TRENDAnnualized standard deviation of daily crudeAnnualized standard deviation of daily crude--oil price changesoil price changes

APSP Avg. Producer Spot Price, Implied volatility imputed from Brent options

Source: IMF World Economic Outlook

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ANALYTICAL PERSPECTIVEANALYTICAL PERSPECTIVEHowHow can speculation influence price volatility?can speculation influence price volatility?

►►Only two theoretical possibilities Only two theoretical possibilities –– dominant dominant player or herdingplayer or herding

►► First unrealistic First unrealistic –– the market is too large and the market is too large and entry barriers too lowentry barriers too low

►►Second has long history in financial marketsSecond has long history in financial markets”…”…I explained to you the instability of [stock] prices and the I explained to you the instability of [stock] prices and the reasons thereforereasons therefore……and discussed the frenzy and foolishness and discussed the frenzy and foolishness of speculation. of speculation. ……As there are so many people who cannot As there are so many people who cannot wait to wait to follow the prevailing trend of opinion, follow the prevailing trend of opinion, ……they they think only of doing what others do and following their think only of doing what others do and following their examplesexamples”” ((de la Vegade la Vega,, Confusion de ConfusionesConfusion de Confusiones, 1688), 1688)



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What is Herding, and is it Rational?What is Herding, and is it Rational?►► Easier to recognize than defineEasier to recognize than define►► Broadly, making decisions by observing others and Broadly, making decisions by observing others and

copying them, rather than by assessing fundamentalscopying them, rather than by assessing fundamentals

►► Can be rational if others are better informed. WideCan be rational if others are better informed. Wide--spread phenomenon: buying books on bestspread phenomenon: buying books on best--seller seller lists, choosing restaurants because they are crowdedlists, choosing restaurants because they are crowded

►► In financial markets, fixed asset supplyIn financial markets, fixed asset supply →→ can only can only take place among a subset of participants, e.g. take place among a subset of participants, e.g. speculators. speculators. ““FlockingFlocking””

►► Herding can move prices away from fundamentals Herding can move prices away from fundamentals and exacerbate volatility. Possibility of and exacerbate volatility. Possibility of ““stampedestampede”” as as speculators try to buy or sell simultaneouslyspeculators try to buy or sell simultaneously

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Summary of AnalysisSummary of Analysis

1.1. ProblemProblem Actions of speculators difficult to Actions of speculators difficult to monitormonitor

2.2. ApproachApproach Use of CFTC microdata to Use of CFTC microdata to measure parallel trading parallel trading in measure parallel trading parallel trading in petroleum futures marketspetroleum futures markets

3.3. MethodologyMethodology Count number of speculators Count number of speculators buying and selling each day, and test if buying and selling each day, and test if most are on same side of the market most are on same side of the market



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Summary of FindingsSummary of Findings1.1. No evidence of parallel trading among commercial No evidence of parallel trading among commercial

participants participants ---- petroleum companies or financial petroleum companies or financial institutions institutions ---- in crudein crude--oil or heatingoil or heating--oil futuresoil futures

2.2. No evidence of parallel trading among speculators No evidence of parallel trading among speculators (noncommercial participants) (noncommercial participants) as a groupas a group in the in the crudecrude--oil or heatingoil or heating--oil futures marketsoil futures markets

3.3. Strong statistical evidence of flocking among fund Strong statistical evidence of flocking among fund managers in these markets, but levels moderate managers in these markets, but levels moderate

4.4. InterpretationInterpretation Roughly half the active speculators Roughly half the active speculators buying, rest selling on any daybuying, rest selling on any day→→ effect of trading on effect of trading on pieces limitedpieces limited

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Implications and ConclusionsImplications and ConclusionsOil Prices Reflect Fundamentals, not SpeculationOil Prices Reflect Fundamentals, not Speculation1.1. Oil prices determined by current supply and demand, Oil prices determined by current supply and demand,

and expectations of future supply and demandand expectations of future supply and demand2.2. Widely heard claim that speculation is adding $X to Widely heard claim that speculation is adding $X to

oil price incorrect. X=0 oil price incorrect. X=0 3.3. Futures reasonable basis for oilFutures reasonable basis for oil--price forecasts. price forecasts.

Forecasts that diverge from futures prices subject to Forecasts that diverge from futures prices subject to scrutinyscrutiny

4.4. Futures prices reasonable basis for hedging Futures prices reasonable basis for hedging programsprograms



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Implications and Conclusions Implications and Conclusions (cont(cont’’d)d)

Oil Prices Reflect Fundamentals, not SpeculationOil Prices Reflect Fundamentals, not Speculation1.1. Volatility unlikely to decrease unless factors driving Volatility unlikely to decrease unless factors driving

fundamentals stabilize fundamentals stabilize 2.2. Continuing increases in demand, and limited success Continuing increases in demand, and limited success

in establishing new supply sources in establishing new supply sources →→ low spare low spare capacity capacity

3.3. Continuing geopolitical uncertainty + low spare Continuing geopolitical uncertainty + low spare capacity capacity →→ continued price fluctuationscontinued price fluctuationsFor gory details, check out the paper on the web:For gory details, check out the paper on the web:

www.rff.org/rff/News/Features/Dowww.rff.org/rff/News/Features/Do--BirdsBirds--ofof--aa--FeatherFeather--FlockFlock--Together.cfmTogether.cfm

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