DO FINANCIAL INVESTORS DESTABILIZE THE OIL PRICE? pdf - Tài li?u text
DO FINANCIAL INVESTORS DESTABILIZE THE OIL PRICE? pdf
WORKING PAPER SERIESNO 1346 / JUNE 2011by Marco J. Lombardiand Ine Van RobaysDO FINANCIAL INVESTORS DESTABILIZETHE OIL PRICE?WORKING PAPER SERIESNO 1346 / JUNE 2011DO FINANCIAL INVESTORS DESTABILIZE THE OIL PRICE? 1by Marco J. Lombardi 2 and Ine Van Robays 3 1 This paper was initiated when the second author was with the European Central Bank. Without implicating, we would like to thank Bahattin Büyüksahin, Gert Peersman, Jaap Bos, Julio Carrillo, Lutz Kilian, Punnoose Jacob, Sandra Eickmeier and an anonymous referee for their useful comments and suggestions.2 Directorate General Economics, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Mai, G e-mail: marco.lombardi@ecb.europa.eu3 Department of Financial Economics, Ghent University, Woodrow Wilsonplein 5D, B-9000 Gent, B e-mail: ine.vanrobays@ugent.beThis paper can be downloaded without charge from http://www.ecb.europa.eu or from the Social Science Research Network electronic library at /abstract_id=1847503.NOTE: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.In 2011 all ECBpublicationsfeature a motiftaken fromthe EUR100 banknote.(C) European Central Bank, 2011AddressKaiserstrasse 2960311 Frankfurt am Main, GermanyPostal addressPostfach 16 03 1960066 Frankfurt am Main, GermanyTelephone+49 69 1344 0Internethttp://www.ecb.europa.euFax+49 69
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(online)3ECBWorking Paper Series No 1346June 2011Abstract 4Non technical summary 51 Introduction 72 Understanding fi nancial activity in oil futures markets 102.1 The oil futures market 102.2 The link between spot and futures prices 123 Model specifi cation and identifi cation 163.1 A structural VAR model 163.2 Identifi cation of different types of oil shocks 174 Empirical results 204.1 Effects of different types of oil shocks 204.2 Relevance of different types of oil shocks 224.3 Explaining recent oil price fl uctuations 234.4 Robustness of the results 255 Conclusions 27References 29Appendix 32Figures 34CONTENTS4ECBWorking Paper Series No 1346June 2011AbstractIn this paper, we assess whether and to what extent …nancial activity in the oilfutures markets has contributed to destabilize oil prices in recent years. We de…nea destabilizing …nancial shock as a shift in oil prices that is not related to currentand expected fundamentals, and thereby distorts e? cient pricing in the oil market.Using a structural VAR model identi…ed with sign restrictions, we disentangle thisnon-fundamental …nancial shock from fundamental shocks to oil supply and demandto determine their relative importance. We …nd that …nancial investors in the futuresmarket can destabilize oil spot prices, although only in the short run. Moreover,…nancial activity appears to have exacerbated the volatility in the oil market over thepast decade, particularly in . However, shocks to oil demand and supplyremain the main drivers of oil price swings.Keywords: Oil price, Speculation, Structural VAR, Sign restrictions.JEL Classi…cation : C32, Q41, Q31.5ECBWorking Paper Series No 1346June 2011Non-technical summaryThe massive oil price ?uctuations observed in the last few years have stimulated thedebate on the role of …nancial activity in the determination of oil prices. The oil futuresmarket has indeed become increasingly liquid, and the activity of agents that do not dealwith physical oil, the so-called ‘non-commercials’, has greatly increased. This led some tohypothesize that in?ows of …nancial investors in the futures market may have pushed oilprices above the level warranted by fundamental forces of supply an d demand, whereasothers argue that the impact of …nancial activity on the oil spot market is negligible ornon-existent beyond the very short term.In this paper, we evaluate the importance of …nancial activity in determining the spotprice of oil relative to the role of oil market fundamentals, by relying on a sign-restrictedstructural VAR model. We disentangle stabilizing from destabilizing …nancial activity inthe oil futures market based on a set of simple theoretical equations that link the oil spotmarket to the futures market through a no-arbitrage condition. A destabilizing …nan-cial shock enters this framework by creating a deviation from the no-arbitrage condition,thereby distorting e? cient price formation by driving oil futures prices away from the lev-els justi…ed by oil market fundamentals. On the other hand, stabilising …nancial activityis de…ned as driven by changes in oil supply and demand-side fu nd amentals. Elab oratingupon the work of Peersman and Van Robays (2009a,b) and Kilian and Murphy (2010) byexplicitly including the futures market in a sign-restricted VAR, we identify four di¤erenttypes of oil shocks: an oil supply shock, an oil demand shock driven by economic activ-ity, an oil-speci…c demand shock which captures changes in oil demand other than thosecaused by economic activity, and a destabilizing …nancial shock.Our results suggest that …nancial activity in the futures market can signi…cantly a¤ectoil prices in the spot market, although only in the short run. The destabilizing …nancialshock only explains about 10 percent of the total variability in oil prices, and shocks tofundamentals are clearly more important over our sample. Indeed, looking at speci…cpoints in time, the gradual run-up in oil prices between 2002 and the summer of 2008was mainly driven by a series of stronger-than-expected oil demand shocks on the back ofbooming economic activity, in combination with an increasingly tight oil supply from mid2004 on. Strong demand-side growth together with stagnating supply were also the maindriving factors behind the surge in oil prices in 2007-mid 2008, and the drop in oil prices6ECBWorking Paper Series No 1346June 2011in the second half of 2008 can be mainly explained by a substantial fallback in economicactivity following the …nancial crisis and the associated decline in global oil demand. Sincethe beginning of 2009, rising oil demand on the back of a recovering global economy alsodrove most of the recovery in oil prices.However, we …nd that …nancial investors did cause oil prices to signi…cantly divergefrom the level justi…ed by oil supply and demand at speci…c points in time. In general,ine? cient …nancial activity in the futures market pushed oil prices about 15 percent abovethe level justi…ed by (current and expected) oil fundamentals over the period 2000-mid2008, when th e volume of crude oil derivatives traded on NYMEX quintupled. Particularlyin , destabilizing …nancial shocks aggravated the volatility present in the oilmarket and caused oil prices to respectively over- and undershoot their fundamental valuesby signi…cant amounts, although oil fundamentals clearly remain more important.7ECBWorking Paper Series No 1346June 20111 IntroductionThe massive oil price ?uctuations observed in the last few years led many commentatorsto reexamine the functioning of the price-setting mechanism in the oil market (Khan 2009,Kaufmann and Ullman 2009, Miller and Ratti 2009 and Lombardi and Mannucci 2011).1The increasing …nancialization of the oil futures markets was blamed by some as the maindriver of the escalation of oil prices, in addition to the more conventional explanationsof surging demand and tight oil supply. It is indeed true that the oil futures markethas become increasingly liquid, and the activity of agents that do not deal with physicaloil, the so-called ‘non-commercials’, has greatly increased. Furthermore, passive indexfunds, whose goal is to provide investors with long-only exposure to oil, have witnessedsubstantial in?ows in recent years (CFTC 2008). This led some to hypothesize that suchin?ows in the futures market may have pushed oil prices above the level warranted byfundamental forces of supply and demand.Using a sign-restricted structural VAR model, this paper evaluates the importance of…nancial activity in d etermining the sp ot price of oil relative to the role of oil marketfundamentals. Our identi…cation scheme is based on a set of simple theoretical equationsthat link the oil spot market to the futures market through a no-arbitrage condition.A destabilizing …nancial shock enters this framework by creating a deviation from theno-arbitrage condition, thereby distorting e? cient price f ormation by driving oil futuresprices away from the levels justi…ed by oil market fundamentals. This way, we separatestabilizing from destabilizing …nancial activity in the oil futures market.Our results suggest that …nancial activity in the futures market can signi…cantly desta-bilize oil prices in the spot market, although only in the short run. In contrast, fundamentalshocks to oil supply and oil demand cause oil prices to shift permanently. Over di¤erentforecast horizons, the des tabilizing …nancial shock only explains about 10 percent of thetotal variability in oil prices, as shocks to fundamentals account for about 90 percent of theforecast error variance decomposition over our sample. Moreover, we …nd that …nancialinvestors d id cause oil prices to diverge signi…cantly from the level justi…ed by oil supplyand demand at speci…c points in time over the past decade, particularly in .1After having surged with increasing momentum to an unprecedented level of USD 120 per barrel inthe summer of 2008, oil pric es fell abruptly to reach USD 45 per barrel at the end of 2008 in the wakeof the …nancia l crisis and the subsequent globa l economic downturn. Oil prices s tarted rebounding in thesecond quarter of 2009 and ex perienced a strong upturn rising since then.8ECBWorking Paper Series No 1346June 2011However, innovations to fundamentals still account for most part of recent oil price ?uc-tuations. More speci…cally, the gradual run-up in oil prices between 2002 and the summerof 2008 was mainly driven by a series of stronger-than-expected oil demand shocks on theback of booming economic activity, in combination with an increasingly tight oil supplyfrom mid 2004 on. Strong demand-side growth together with stagnating supply are alsothe main driving factors behind the surge in oil prices in 2007- mid 2008, consistent withthe results in the literature (e.g. Hamilton 2009, Kilian 2009 and related pape rs). Nev-ertheless, …nancial activity caused oil prices to signi…cantly overshoot their fundamentallevel in the …rst half of 2008. This is also true for the second half of 2008, in which oilprices dropped considerably in the wake of the …nancial crisis and the subsequent globaleconomic downturn. Again, most part of the decline in oil prices was driven by a strongunexpected drop in global oil demand, but …nancial activity caused oil prices to declinefar below the level explained by the reduction in oil demand. The contributions of thedestabilizing …nancial shock to the oil price over time can be associated with large ?ows inand out of passive index funds linked to oil. Finally, we …nd that rising oil demand on theback of a recovering global economy drove most of the recent recovery in oil prices sincethe beginning of 2009.This paper relates to di¤erent strands of the oil literature. First, several studies haveanalyzed the e¤ect of speculation on the oil spot price, mostly using data on trader’spositions in the futures market (IMF 2006, Haigh et al. 2007 and Büyüksahin et al. 2008).However, the distinction made between speculative activity (i.e. non-commercial trading)and non-speculative activity (i.e. commercial trading or hedging) may be arbitrary in somecases, and the publicly available data on spe culative trading activity is not completelyrepresentative of all sorts of …nancial activity in these futures markets.2For example, theabove-mentioned index fund s only enter on the long side of the crude oil futures marketto hedge. Although the activity of index funds is typically not regarded as speculation, asthey follow a passive investment strategy, the index funds can distort price formation bycausing oil prices to deviate from levels justi…ed by fundamentals by creating additionaldemand in the futures market. This type of …nancial activity is not accounted for whenusing non-commercial trading data to assess the impact of speculative trading on the oilprice. Moreover, studies that want to evaluate the role of the index funds directly usingtrader’s position data, also have to rely on rough approximations.3For this reason, we will2See Sanders et al. (2004) for a more deta iled explanation.3Irwin and San ders (2010), for example, proxy index fund positio ns by swap d ealer positions in the9ECBWorking Paper Series No 1346June 2011assess the impact of …nancial activity on oil spot prices without relying on trader positiondata. Moreover, we will only evaluate the impact of …nancial activity that e¤ectivelydistorts price formation in the oil market, and that can create deviations in the oil pricefrom the level justi…ed by oil demand and supply-side fund amentals.A second strand of related literature examines the e¤ect of changing oil demand andsupply-side fundamentals on the oil price. In addition to the non-f un damental shock,we identify shocks to oil market supply and demand-side fundamentals. Most of thepolicy and academic literature still ascribes the recent oil price ?uctuations to changesin fundamentals. The gradual rise over the pe riod
is usually explained byincreasing oil demand, and also the oil price run-up of
is mainly attributed tostrong oil demand confronting stagnating global oil pro du ction (Hamilton 2009, Kilian2009 and related papers). Baumeister and Peersman () observe that the priceelasticities of oil demand and supply have become much smaller over time, leading toincreased oil price sensitivity to similar changes in fundamentals. Anzuini, Lombardiand Pagano (2010) highlight that expansionary monetary policy may have fueled oil priceincreases, but also report that it appears to exert its impact through expectations of higherin?ation and growth, rather than on the ?ow of global liquidity into oil futures markets.By identifying both fundamental and non-fundamental oil sho cks, we are able to balancethe importance of fundamentals against that of ine? cient …nancial activity. Elaboratingupon the work of Peersman and Van Robays (2009a,b) and Kilian and Murphy (2010) byexplicitly including the futures market in a sign-restricted VAR, we identify four di¤erenttypes of oil shocks: an oil supply shock, an oil demand shock driven by economic activity,an oil-speci…c demand shock which captures changes in oil demand other than those causedby economic activity, and a destabilizing …nancial shock.The paper is organized as follows: in the next section we cast a formal de…nition ofdestabilizing …nancial activity in a simple theoretical framework. We describe the VARmodel speci…cation and the identi…cation strategy in Section 3, and discuss the empiricalresults in Section 4; Section 5 concludes.futur es market to evalua te the impact of index funds on commodity futures market s. Although th is is afair approxim ation for agricultural commodity market s, this is not the case for energy markets as swapdealers operating in en ergy markets only conduct a limit ed amount of long-only inde x swap transactions(CFTC 2008).10ECBWorking Paper Series No 1346June 20112 Understanding …nancial activity in oil futures marketsIn the oil futures markets, we can separate desirable ‘stabilizing’from undesirable ‘desta-bilizing’…nancial activity. The former relates to the fact that agents intervening in the oilfutures market bring their information sets and expectations on future fundamentals intothe pricing me chanism, thereby contributing to the price-discovery mechanism, in additionto making the markets more liquid. However, if agents place their bets disregarding theexpectations on fundamentals the price-setting mechanism can be distorted. Only thislatter type of ine? cient …nancial activity matters to policy makers and regulators, andwe will regard this non-fundamental …nancial shock in the futures markets as related tospeculative activity. In this section, we shed some light on the concept of destabilizing…nancial trading by looking at the functioning of oil futures markets and the link betweenthe futures and the spot market for crude oil.2.1 The oil futures marketIn the case of commodities, futures markets exist as a means of transferring risks ofprice ?uctuations. Typically, two main type of traders are identi…ed to be active in theoil futures market, i.e. commercial and non-commercial traders. Agents who deal withphysical oil, often labeled as commercials, may wish to hedge against price ?uctuationsby …xing in advance the price they will have to pay or receive for a delivery in the future.Oil producers will therefore have the opportunity to secure their in come today by sellingfutures contracts, and oil consumers will buy futures contracts in order to pin down theirfuture costs. Yet, agents not dealing with physical oil also participate in the market,making the oil market more liquid. These non-commercials intervene in oil futures marketbecause they want to achieve exposure to oil price risk, either on the upside or downside,to make a pro…t.Typically, speculative behavior in the oil market is attributed to the …nancial activityof traders that actively enter the futures market and buy or sell according to (expected)fundamentals. The CFTC ascribes speculative activity to the non-commercial traders thatmake pro…ts based on their expectations of the future oil supply-demand balance. Withoutrelying on trader position data, Kilian and Murphy (2010) also de…ne speculation in theoil market as related to oil fundamentals, i.e. a speculation shock in their framework is“any oil demand shock that re?ects shifts in expectations about future oil production or11ECBWorking Paper Series No 1346June 2011future real activity (p.9)”.In reality, however, movements in futures prices do not always re?ect e? cient pricing ofthe expected oil supply-demand balance. For example, agents may intervene in the futuresmarket not because they have expectations on the future dynamics of oil fund amentals, butrather because they want to allocate part of their portfolio to oil. There is indeed a goodmotivation to do so, as oil futures are commonly thought to be a hedge against in?ation,and to be negatively correlated with stock market indices. Commodity-related index fun dswere created to allow investors to easily achieve exposure to commodity price risk, andaccordingly they only enter on the long side of the crude oil futures market, independent onwhether future oil fundamentals are strong or weak. Although they follow a passive tradingstrategy, these …nancial funds may distort price formation by causing oil prices to deviatefrom levels justi…ed by current or expected fundamentals. The magnitude of the in?owsinto such index funds is precisely one of the reasons why many observers attributed forthe recent volatile behavior of oil prices to speculation. This type of speculation, or moregenerally …nancial activity, is neither captured by looking at non-commercial positions, asindex fund traders are regarded as commercial traders, nor is it speci…cally captured inthe framework employed by Kilian and Murphy (2010).4To wrap up, we de…ne destabilizing …nancial trading in oil markets based on identifyingtwo types of …nancial activity in the oil futures market. The …rst type occurs on the backof changing expectations about oil market fundamentals. This does not distort the e? cientfunctioning of the oil market, but rather enhances the oil price formation mechanism bybringing in new information on expected fundamentals. Conversely, the second type of…nancial activity occurs independently of (current and expected) oil supply and demandfundamentals, thereby distorting e? cient pricing in the futures and spot market by causingprices to deviate from their levels justi…ed by fundamentals. We will de…ne this type oftrading as destabilizing …nancial activity. In the next subsection, we will exploit thetheoretical link between the oil spot and futures market to better characterize these twotypes of …nancial ac tivity.4The scheme used by Kilian and Murphy (2010) to identify the speculation sh ock could be consistentwi th the way we identify the ine? cient …nancial shock later on, under the condition that ine? cient …nancialtrading contemporaneo usly a¤ects oil prices and inventories in the spot market. However, our aim is tofocus on non-fundamental futures market shocks and remain agnostic about the impact of destabilizing…nancial activity on oil prices and inventory holdings in the spot market, as the exact transm ission to theoil spot market is not explicitly known.12ECBWorking Paper Series No 1346June 20112.2 The link between spot and futures pricesOf course, …nancial activity in the futures market only matters if changes in futures pricescan a¤ect oil prices in the spot market. This linkage betwee n the spot and the futuresmarket for oil is commonly represented by a no-arbitrage condition (Pindyck 1993, Alquistand Kilian 2010). We will rely on this condition to give a theoretical characterization ofthe two types of activity in futures markets, fundamental versus non-fundamental, whichwill also prove useful for the identi…cation of these shocks later on.Let us consider an investor who holds Ptunits of the numeraire at time t. He caneither invest in a risk-free bond with yield rt, or buy oil, store it and sell it on the futuresmarket for delivery in t + ? . Buying oil, however, also brings an additional bene…t, inthat the investor has access to a commodity that he can exploit, if needed. We will labelthis bene…t as the convenience yield, and denote it as ?t;t+?(Pindyck 1993).5By theno-arbitrage principle, the two investment strategies should bear the same return. If wedenote the spot price as Ptand the future price Ft;t+?, we have:Pt(1 + rt)?= Ft;t+?+ ?t;t+?(1)Taking logarithms, Equation (1) becomes:pt+ ?rt= ft;t+?+ t;t+?(2)So, if markets are e? cient and arbitrage opportunities are exploited instantaneously,Equation (2) would hold. If the convenience yield, net of storage costs, is positive, this willimply that spot prices are higher than futures, which explains why the futures curve incommodities markets is often negatively sloped (backwardation). However, if storage costsare higher than the convenience yield, it would be possible to observe a positive-slopedfutures curve (contango). Rewriting Equation (2) gives an expression of the futu res pricein terms of the spot oil price, the convenience yield and the risk-free rate:ft;t+?= pt? t;t+?+ ?rt(3)Pindyck (1994) p ostulates a relationship between the convenience yield on the onehand, and the oil spot price, oil inventories and expected fundamentals on the other: t;t+?= G[pt; It; E(Dt;t+?)] (4)5Here, we abstrac t from the fac t that oil has to be stored and this operation has a price, hence theconvenience yield will be expres sed net of storage costs.13ECBWorking Paper Series No 1346June 2011where Itis the level of inventories, E(Dt;t+?) is the expected demand over period t tot + ? and G denotes a generic function.6G is increasing in pt, since higher prices imply ahigher convenience in holding inventories, decreasing in Itsince at times of low inventoriesthe marginal yield of an additional unit is higher, and increasing in E(Dt;t+?) since higherexpected demand makes holding inventories more convenient, as future market tightnessis expected. Note that also expected future supply tightness will increase the convenienceyield of holding inventories. Hence, we can assume th at the term E(Dt;t+?) captures theoverall e¤ect of expected fundamentals on the convenience yield.Substituting Equation (4) into Equation (3) gives the following:ft;t+?= pt? G[pt; It; E(Dt;t+?)] + ?rt(5)In the e? cient, no-arbitrage case, the futures price depends positively on the currentspot price, negatively on expected oil fundamentals and positively on the risk-free rate.If agents in the economy are homogeneous, they will all have access to the sameinformation set and process the ?ow of news homogeneously, so that Equation (5) willalways hold. More speci…cally, all other things equal, futures prices will be moved by the?ow of news that changes expectations on future demand and supply, such as an expecteddepreciation of the US dollar or other fundamental shocks that can a¤ect the future oilsupply-demand balance. Based on this news on (expected) fundamentals, agents will placetheir bets in both the futures and spot market and thereby change the futures and spotprice according to the no-arbitrage condition, so that it will always hold.However, and without the need to depart from rationality, players in commodity mar-kets are ind eed not homogeneous. Let us concentrate on the oil futures market, in whichplayers can participate for other reasons than buying or selling futures based on theirexpectations on oil fundamentals. When an index fund receives an in?ow by an investor,e.g. by someone who wants to invest in commodities to hedge against in?ation risks, it willthen buy oil futures irrespective of its expectations on the oil supply and demand balance.Conversely, if an out?ow from an index fund materializes, e.g. because an investor needsto reduce his leverage, the fund will sell oil futures, again irrespective of fundamentals.76There is no need to s pecify the funct ional form of the function G in more detail, as the identi…cationof the di¤erent types o f oil shocks will only depend on the sign of the relationsh ip between the convenienceyield and its deteminants.7More generally, this reasoning will apply to any agent that places his bets irrespective of fundamentals,e.g. uni nformed noise tr aders or technical analysts who try to jump on pr ice trends.14ECBWorking Paper Series No 1346June 2011Such interventions will also a¤ect the futures price set in the market, thereby generatinga deviation from the fundamental no-arbitrage relationship, so that the observed futureprice becomes:f?t;t+?= ft;t+?+ ?ft(6)with ft;t+?the futures price that would prevail if the no-arbitrage condition was alwayssatis…ed and the futures price is solely determined by fundamental factors, i.e. the onefound in Equation (5). The term ?ft, which we assume to be weakly stationary, representsthe deviation of the observed future price from its no-arbitrage value. This shock ?ft, whichwe will label the destabilizing …nancial shock, creates a perturbation in the futures marketin the sense that demand for futures contracts driven by this sort of speculation movesthe observed futures price away from its fundamentally justi…ed level.8How can an ine? cient perturbation to oil futures prices transmit to oil spot prices?In the no-arbitrage framework, if expected changes in oil fundamentals move the futuresprice, the spot price will be a¤ected via the inventory channel. This is exactly how Kilianand Murphy (2010) identify their speculation shock, i.e. as an inventory demand s hock inthe spot market. We, however, want to assess the e¤ect of …nancial activity in the futuresmarket that is not related to fu nd amentals, and enters our framework as a deviationof the no-arbitrage equation.9The e xact transmission of this ine? cient …nancial shockis thu s less well-known. A …rst possibility is that arbitrageurs in the spot market willrecognize the perturbation as not linked to expected fundamentals, and hence accumulate(or dump) inventories to exploit the arbitrage opportunity. In addition to this, otherplayers in the physical market may instead interpret the price signal as genuinely relatedto changing expectations on fundamentals, and hence adjust their supply and demand8In order for the deviation to persist and he nce be observa ble, we must hypothesize that there arefrictions (e.g. physical constraints) that prevent agents to immed iately arbitrage away the misalignment.In general, we remark that the presence of fricti ons cannot be interpreted as a sou rce of misalignment inthe pricing equations (i.e. they do not constitue per se a shock), but rather they impact on the absorptionof misal ignments (i.e. the speed at which shocks die out).9As mention ed before, the speculation shock identi…ed in Kilian a nd Murphy (2010) could be consistentwi th the way we identify the ine? cient …nancial shock if we impose that the transmissi on to the spotmarket goes through the inventory channel and necessarily a¤ects the spot price and oil production withinthe same month that the shock hits. However, our aim is to model fundamental versus non-fundamental…nancial activity in the futures market to assess to which extent ine? cient …nancial activi ty transmits tooil spot prices, whereas Kilian and Murphy (2010) assume complete pass-through from the futures to thespot market, and therefore do not include the futures price in their model.15ECBWorking Paper Series No 1346June 2011decisions. Moreover, it could also be that it takes some time for the agents in the spotmarket to recognize and interpret this d eviation. A priori, it is n ot exactly known howa change in the futures price following a destabilizing speculation shock is transmittedto the spot market, and therefore we remain agnostic on this. More speci…cally, we willdecide to leave the response of the spot price and oil inventories over to the data in theempirical part. What we do know is that the destabilizing …nancial shock has an impacton the spread. Let us substitute Equation (5) into Equation (6) to get:f?t;t+?= pt? G[pt; It; E(Dt;t+?)] + ?rt+ ?ft(7)According to Equation (7), the observed futures price is a function of the spot price,current and expected changes related to fundamentals and the destabilizing …nancial shock.So, futures are allowed to vary based current or expected changes to oil supply and demandas well as for destabilizing speculation in the futures market. Hence, Equation (7) capturesthe two types of activity in oil futures markets de…ned above in Section 2.1.To see this more clearly, let us rewrite Equation (7) in terms of the observed futures-spot spread:s?t;t+?= f?t;t+?? pt= ?G[pt; It; E(Dt;t+?)] + ?rt|{z }(1)+ ?ft|{z}(2)(8)where s?t;t+?is the observed futures-spot spread between t and t + ? . This equation ex-presses the spread in terms of a fundamental component (1) and a component (2) that takesinto account destabilizing …nancial activity and the chance that prices may be misalignedwith respect to the level warranted by (current and expected) fundamentals. Assumingthat storage costs are constant, changes in (expected) fundamentals will negatively a¤ectthe spread, whereas the destabilizing …n ancial shocks will have a positive impact, since itincreases observed futures prices via Equation (6). Th e fact that the futures-spot spreadreacts di¤erently to the two di¤erent kind s of activity in the futures market (i.e. tradingbased on fundamentals and destabilizing …nancial activity) will prove useful to uniquelyidentify these shocks and their importance later on.10For example, suppose that the ex-10Note that although the risk free rate is part of the fundam ental component, it positively a¤ects thespread and therefore c ould be wrongly identi…ed as part of t he destabilizing …nancial shock. However,as long as interest rates are at low levels, and we look at short matur ities, this should not mat ter much.Indeed, based on our results, the correlation between the structural …nancial shock and the risk-free interestrate, proxied by the Federal Funds ra te, is onl y 0.01 and insigni…cant, which indicates that we are no tcon…using ine? cient …nancial shocks for shocks to the interest rate.16ECBWorking Paper Series No 1346June 2011pected oil supply-demand balance becomes tighter because of unrest in the Middle-East,then both the futures and the spot price will increase to satisfy the no-arbitrage condition,but as the convenience yield will rise as well, the increase in the spot price should be morepronounced than the rise in the futures prices so that the futures-spot spread declines.On the other hand, when an in?ow in an index fund pushes the futures price upwards,the spot price might in crease as well, but not by more than the futures price. If expectedfundamentals do not change after the destabilizing …nancial shock but inventory holdingspossibly increase, then the convenience yield will decline. In turn, this decrease in theconvenience yield will counteract a possible decline in the spread as spot prices increase -cfr. Equation (8).3 Model speci…cation and identi…cationAlthough the importance of …nancial activity in determining oil price ?uctuations is stillstrongly debated, it is common knowledge that, at least in the long run, oil ?uctuationsare mainly driven by changes in oil supply and demand. In order to get a comprehensiveview on the determinants of oil prices, we will identify oil price movements that are drivenby conventional oil supply and demand shocks in addition to those related to destabilizing…nancial activity.3.1 A structural VAR modelTo evaluate the role of the di¤erent types of shocks in determining the oil price, weemploy a structural vector autoregression (SVAR) framework that has the following generalrepresentation:Xt= c + A (L) Xt?1+ B&tThe vector of endogenous variables Xtcaptures the global dynamics in the oil spot andfutures market by including world oil production (Qoil), the price of crude oil expressedin US dollars (Poil), a measure of world economic activity (Yw), the futures p rice of oil(Foil) and oil inventories (It). To avoid redundant variables, we do not include the spread(st;t+?) in the model, but generate the response as the di¤erence between the estimatedlevel response of the futures and spot price of oil. c is a vector of constants, A (L) is amatrix polynomial in the lag operator L and B is the contemporaneous impact matrix17ECBWorking Paper Series No 1346June 2011of the vector of orthogonalized error terms &t. The oil price is the nominal Brent crudeoil spot price and the futures-spot spread is based on the associated 3-month futurescontracts. Although the Brent futures market is somewhat thinner than the WTI market,we use the Brent oil price as a global benchmark for the reason that WTI oil is mainlyused in the US, whereas the Brent is used to specify two-thirds of crude oil exchangedworld-wide on the ICE futures exchange.11We proxy global ec onomic activity by theOECD measure of global industrial p rodu ction, which covers the OECD countries and thesix major non-OECD economies, including e.g. China and India. Following Kilian andMurphy (2010), we proxy global crude oil inventories as total US crude oil inventories,scaled by the ratio of OECD petroleum stocks over US petroleum stocks. The VAR modelis estimated using monthly data over the sample period 0:02, and we include12 lags of the endogenous variables.12All the variables are transformed to monthly growthrates by taking the …rst di¤erence of the natural logarithm, and the variables are correctedfor seasonality. In general, the results are quite robus t to d i¤erent speci…cations of thevariables and the SVAR model, see the discussion in Section 4.4.3.2 Identi…cation of di¤erent types of oil shocksThe recent literature has clearly sh own that di¤erent factors can drive oil price movements,and that the economic consequences crucially depend on the unde rlying source of the oilprice change (Kilian 2009 and related papers, Peersman and Van Robays 2009a,b). Weidentify four di¤erent types of shocks: an oil supply shock, an oil demand shock drivenby economic activity, an oil-speci…c demand sh ock (i.e. the f un damental shocks), and adestabilizing …nancial shock (i.e. the non-fundamental shock). We do this by relying onthe following set of sign restrictions:1311Moreover, the Brent price is gaining momentum as a glob al benchmar k as rece nt movements in theW TI crude oil price were mainly re?ecting regional surplus inventory capacity in Cushing, Oklah oma,instead of pricing in the increase d market tightn ess following unres t in the Middle-East.12Al though lag selection criteria propose to on ly include 2 or 3 lags, we decide to inclthis is required to allow fo r enough dynamics in the macroecono mic variables following an oil shock, seeHamilton and Hererra (2004). The start of the sample period is determined by the availab ilty of futuresprice data.13The sign restrictions are shown for oil shocks that increase the oil futures price. A more detailedexplanation on the use of sign restrictions can be found in the appendix.18ECBWorking Paper Series No 1346June 2011STRUCTURAL SHOCKS QoilPoilYwItFoilst;t+?Non-fundamental shocksDestabilizing …nancial activity ? 0 ? 0Fundamental shocksOil supply ? 0 ? 0 ? 0 ? 0 ? 0Oil demand driven by economic activity? 0 ? 0 ? 0 ? 0 ? 0Oil -speci…c demand ? 0 ? 0 ? 0 ? 0 ? 0First, we disentangle the f un damental oil shocks from the non-fundamental …nancialshocks. We do this by imposing opposite signs on the response of the spread, based onEquation (8). The fundamental shocks which increase oil prices have a negative e¤ecton the futures-spot spread, whereas des tabilizing …nancial activity increases the spreadafter increasing the futures price of oil.14Hence, we de…ne the destabilizing …nancialshock as a shock to the futures markets that raises the oil futures price and increases thefutures-spot spread. This could for example re?ect the trading behavior of index fundsthat enter the oil futures market to provide a hedge against in?ation, irrespective of oilmarket fundamentals. Note that we do not restrict any of th e responses in the oil spotmarket following a destabilizing …nancial shock, as the e¤ect on the oil spot market andthe exact transmission mechanism is a priori unknown.Second, we further disentangle the fundamental shocks into shocks caused by shiftingoil demand and oil supply. Following Baumeister and Peersman (2010) and Peersmanand Van Robays (2009a,b), we disentangle the fundamental oil supply and oil demandshocks by relying on a set of signs derived from a simple supply-demand scheme of theoil market. Shocks on the supply side of the oil market shift the oil supply curve andtherefore move oil prices and oil production in opp osite directions. Shocks on the demandside of the oil market shift the oil demand curve and therefore cause oil prices and oilproduction to move in the same direction. More speci…cally, an unfavorable oil supplyshock is an exogenous shift of the oil supply curve to the left which lowers oil productionand increases oil prices, whilst world industrial production does not increase. Exogenous14In order to disentangle the fundamental versus the non-fundamental shocks, we only look at the changein the spread, i.e. the di¤erence between the change in the level of the futures price an d the change inthe level of the oil spot price. The restriction impo sed on the sprea d does thus not impl y that the ma rketshould be in contango or backwardation.19ECBWorking Paper Series No 1346June 2011oil production disruptions caused by geopolitical tensions in the Midd le-Eas t are a naturalexample. Consistent with the no-arbitrage condition, oil futures prices will increase afterthis shock, but less than proportionally, so that the futures-spot spread declines. This isbecause the convenience yield will also be higher after the increase in oil spot prices drivenby the oil supply shock.In contrast, a favorable oil demand shock driven by global economic activity and theaccompanying rise in overall commodity demand will increase both oil production andoil prices as this shock is represented by an upward shift of the oil demand curve . Byde…nition, such shocks are associated with an increase in global economic activity. Anatural example of this type of shock is the surge in oil demand on the back of strongeconomic growth in emerging economies such as China and India. Again, to satisfy theno-arbitrage condition, the futures price will increase and the futures-spot spread willdecline.Finally, an unfavorable oil-speci…c demand shock is a demand shock for oil which is notdriven by stronger economic growth. This shock also raises oil prices and oil production,but is associated with a negative, or rather non-positive, e¤ect on economic activity. Asthis oil price increase is also driven by fundamentals, the futures price will increase andthe spread will decline according to the no-arbitrage condition. Two examples of this arean oil substitution shock and an expected oil fundamentals shock. Rising demand for oilcaused by increased substitution of coal for oil will drive up the price of oil, increase oilproduction and will not be favorable for economic activity because of the higher oil price.On the other hand, an expected fundamental shock, e.g. tighter expected oil supply ordemand, will raise oil demand due to an increased demand for oil inventories. This willincrease both the oil price and production, and will not stimulate economic activity asoil prices are higher. However, we do not restrict the response of inventories followingthe oil-speci…c shock to capture a broader set of oil-speci…c demand shocks beyond theseexpected fundamental shocks.Kilian and Murphy (2010), in contrast, separately identify an expected oil fundamentalshock in their SVAR model identi…ed with sign restrictions. Their expected fundamentalshock is characterized as an oil inventory demand shock, which increases oil inventories,the oil price and production, and decreases world economic activity. As mentioned before,they interpret this expected fundamentals shock as a speculation shock. We, however,focus on …nancial activity that is actually detrimental for the functioning of the oil futures20ECBWorking Paper Series No 1346June 2011market, i.e. all the trading activity in the fu tures market that can not be related to(expected) fundamentals. In our framework, we consider the expected oil fundamentalshock of Kilian and Murphy (2010) as one that still re?ects e? cient market functioning,and is part of the more general fundamental oil-speci…c demand shock.As we only identify four oil shocks using a …ve-variable SVAR model, a residual shockwill capture all the structural shocks not accounted for. This residual shock has no di-rect economic interpretation, and based on the results described in the next se ction, itsimportance in explaining oil spot and futures prices appears to be small.4 Empirical results4.1 E¤ects of di¤erent types of oil shocksFigure 1 s hows the estimated 68% con…dence bands of the impulse response functions tothe di¤erent types of oil shocks. The estimated responses are shown in levels up to 60months after the shock, and the oil shocks have been normalized to contemporaneouslyincrease the oil price by 10%. We …nd it convenient to also show the estimated medianresponse as a possible summary measure, even though the median responses are prone tosome criticism and should therefore be interpreted with caution (see Fry and Pagan 2010for more details).15Similar to Kilian (2009) and Peersman and Van Robays (2009a,b), we …nd that thee¤ects of an oil price increase crucially depen d on the underlying source of the increase.First, the exogenous oil supply shock causes oil production to decline and oil prices toincrease permanently. A temporarily lower level of inventories partially counterbalancesthe fall in oil supply, although not signi…cantly, and the oil supply shock signi…cantlyreduces the level of economic activity. The dynamics of the response of the oil futuresprice is very similar to those of the oil price in the spot market, although the futures priceincreases by less so that the spread declines. This decline is only temporary, indicatingthat following the oil supply shock, the slope of the oil futures curve does not signi…cantlychange in the somewhat longer term. Second, the permanent oil price increase caused bya shock in oil demand driven by economic activity is associated with an increase in oil15The results based on th e 68% range are instead no t subject to this crit ique as they describe a rangeof possible outcomes.21ECBWorking Paper Series No 1346June 2011production and a positive e¤ect on industrial production, which is not surprising giventhat this shock is identi…ed as an aggregate demand shock that boosts demand for oil. Oilinventories tend to lower temporarily to partially address the increased demand for oil,although this decline is not signi…cant. Again, the response of the oil futu res price is verysimilar to the one of the spot price, and the spread temporarily declines. Third, the oil-speci…c demand shock also causes oil spot prices to be permanently higher. The increaseddemand for oil raises oil production and has a negative e¤ect on the level of economicactivity. Oil inventories do not respond signi…cantly, which is probably due to the factthat this shock captures a wide variety of oil-speci…c demand shocks with diverging e¤ectson inventories.16The spread again only declines in the short-run.Interestingly, not only the fundamental shocks, but also the destabilizing …nancialshock a¤ects oil spot prices signi…cantly. As expected, this e¤ect on the oil spot price isonly short-lived, in contrast to the oil price responses following the fundamental shockswhich are permanent. The pass-through of the destabilizing …nancial shock in futuresprices to the spot market price for oil is incomplete, an d the futures-spot spread increasespermanently.17We do not …nd a signi…cant reaction of oil production or oil inventories, nordo we …nd that destabilizing …nancial activity has real economic e¤ects.18The insigni…cantresponse of oil inventories is interesting given the current discussion in the literature on therelationship between inventories and speculation. Much of the anecdotal evidence againsta role of speculation is that during the past few years, there was no noticeable increasein inventories (e.g. Irwin and Sanders 2010). However, using a simple theoretical model,Hamilton (2009) shows that speculation can a¤ect spot oil prices without triggering asigni…cant rise in inventories as long as the price elasticity of oil demand is small. We…nd that …nancial activity is indeed not necessarily associated with a signi…cant change in16For exam ple, an expecte d fundamental shock is likely to increase inventories as agents in the physicalmarket want to anticipate the future oil price increase, and a substituti on shock is more likely to decreaseoil inventories because of the unex pected increase in oil demand.17This implies that it is necessary to include futures market variable s in th e model when assessing therole of speculation, since relying on a full pass-throu gh of futures pric e shocks to oil spot prices via theno-arbitrage co ndition is empiric ally not correct. Therefore, the assumpt ion made by Kili an and Murphy(2010) to not explicitly model the oil futures ma rket when assessing the role of speculation, and only usespot oil market variables in their SVAR, is restrictive.18The insigni…cant response of production can not be conclusive on the validity of t he Hotelling principle,which argu es that oil producers have the tendency to keep oil production in th e ground as futur es pricesare higher than spot prices. We would expect this e¤ect to play only when the m arket is in contango, i.e.spot prices are lower than futures prices.22ECBWorking Paper Series No 1346June 2011inventories but can still a¤ect the spot price of oil, if speculation is de…ned as ine? cienttrading in the futures market.194.2 Relevance of di¤erent types of oil shocksThe impulse response analysis shows that destabilizing …nancial activity in the f uturesmarkets can matter as it signi…cantly a¤ects spot oil prices. The forecast error variancedecomposition will shed some light on the overall importance of destabilizing …nancialtrading for explaining the variability of oil spot prices over our sample, relative to thefundamental shocks. Figure 2 shows this forecast error decomposition of the oil sp ot priceand th e oil futures price. The variance decompositions are obtained using the posteriormedian draw.20The left-hand side of Figure 2 displays the forecast error variance decomposition ofthe oil spot price. It is clear that the largest part of oil price ?uctuations over our sampleare explained by shocks to fundamentals. Over the di¤erent forecast horizons, more than90 percent of the forecast error is attributable to fundamental shocks in oil demand andsupply. Not surprisingly, oil demand shocks driven by economic activity account for mostpart of this contribution, explaining more than 40 percent of the forecast error variance.Shocks to oil supply account for about 30 percent of the forecast error in the short run,which however declines in the longer run. Clearly, this implies that the importance ofnon-fundamental …nancial shocks is rather limited. Over the di¤erent forecast horizons,the destabilizing …nancial shocks accounts for about 10 percent of the forecast error de-composition on average. Although this contribution is very limited relative to those of thefundamental shocks, ine? cient trading can account for a non-negligible part of oil pricevariability.The right-hand side of Figure 2 shows the forecast error decomposition of the futuresprice. Destabilizing …nancial activity plays a signi…cantly larger role in explaining futuresprice movements, contributing more than 20 percent to the forecast errors at very short19In their SVAR, Kili an and Mur phy (2010) limit the response of inventor ies following thei r speculationshock by restricting the magnitude of the price elasticity of oil dem and, in order to be consistent with thetheoretical results of Hamilton’s (2009) model on speculation. This is rather counterintuitive since theyactually de…ne a speculation shock as an oil inventory shock in the spot market. By de…ning speculationdi¤erently, i.e. an ine? ciency shock in the futures market, we do not need to impose this restrictio n.20We refer to Section 4.4 for robustness checks on alternative choi ces of this speci…c draw. The forecasterror decompositions of the other variables in the SVAR model ar e avail able on req uest.23ECBWorking Paper Series No 1346June 2011horizons. This contribution declines somewhat at longer horizons, reaching 16 percent inthe long run. Indeed, futures price variability is also for most part explained by shocksto (expected) fundame ntals, and by oil demand shocks driven by economic activity inparticular. The smaller contribution of the destabilizing …nancial shock in the spot marketindicates that not all ine? cient trading in the oil futures markets is passed on to the oilspot market, which is consistent with the incomplete pass-through of the destabilizing…nancial shock to oil spot prices found in the impulse response analysis. Finally, notethat the contribution of the non-identi…ed residual shock is very small in the short run,implying that the four shocks identi…ed in our framework capture almost the entire short-run forecast error variability of oil spot and futures prices over our sample.4.3 Explaining recent oil price ?uctuationsAlthough ine? cient …nancial trading only explains a limited part of the overall oil pricevariability over our sample, speculative activity could still be important for understandingthe increased volatility in oil prices over the last decade, and during
in particular.To assess these contributions at each point in time, it is u sef ul to look at the historicaldecomposition together with the nominal oil spot price in USD per barrel given in Figure3. The historical decompositions are obtained from the posterior median draw.21Thehistorical contributions are accumulated and expressed in percentage deviations from thebaseline unconditional forecast excluding the structural shocks. A declining contributionis associated with a negative shock that reduces oil prices, and vice versa. For the reasonthat the more recent p eriod is of main interest, and the …nancialization of the commoditymarkets gained momentum from 2000 on, we concentrate on the evolution of the oil priceover the period 2000:01 - 2010:02.22In 2001, after having ?uctuated around USD 25 per barrel in 2000, oil prices declinedowing to a series of negative global oil demand shocks due to a slowdown in economicactivity. This decrease in oil demand can be related to the global decline in GDP growthin 2001 in the context of the early millennium slowdown. Since early 2002, however, oilprices surged with increasing momentum to reach about USD 120 per barrel in June 2008,before plummeting to around USD 45 per barrel in the aftermath of the …nancial crisis21We ref er to Section 4.4 for the robustness of the resu lts of the historica l decomposition to this choice.22The contributions are normalised to zero in 2000:01. The historical decompositi on of t he oil price andthe other variables in the model over the full sample period are available upon request.24ECBWorking Paper Series No 1346June 2011which hit the global economy in the summer of 2008. Figure 3 clearly shows that thecontinued increase in oil prices from 2002 till mid 2008 is mainly caused by positive oildemand shocks driven by growing economic activity, which pushed oil prices more than30 percent higher than the baseline projection over this period. It is well known that theemerging economies became increasingly important as major oil importers since the early2000s. Accordingly, strong economic growth in the emerging economies which b oosteddemand for commodities in general can explain most part of th e surge in oil prices overthis period.23This ris ing demand came against the background of increasing tightness inoil supply when global oil prod uc tion began to stagnate in 2004, mainly due to non-OPECcountries. Therefore, negative oil supply shocks also contributed signi…cantly to the surgein oil prices, causing them to be about 12 percent higher than the baseline projectionbetween 2003 and mid-2008. Oil-speci…c demand shocks lifted oil prices higher by morethan 20 percent, which makes the total contribution of oil demand shocks in general clearlydominant. Although the contribution of the oil-speci…c demand shock is compatible witha variety of interpretations, one possibility is increased demand for oil driven by a tighterexpected oil supply-demand balance in the future.There is some consensus that steeply rising oil demand together with tighter oil supplyare the driving factors behind the gradual increase in oil prices since 2003 (e.g. ECB 2010).On the factors behind the strong ?uctuations in the oil spot price between 2007 and thebeginning of 2010, there is less clarity. Hamilton (2009) …nds that it is possible to explainthe main part of the oil price run-up in
based on fundamentals, i.e. strongdemand confronting stagnating supply. Using a simple theoretical model, however, heargues that speculation could have played a role as well, although fundamentals are likelyto be more important. By testing this within an empirical framework, we …nd similarresults for destabilizing …nancial activity. Figure 3 clearly shows that the considerablerise in oil prices was due to a series of oil demand shocks driven by econ omic activity,together with increasingly tighter oil supply which aggravated the upward move in oilprices. This can be linked to the observation that the capacity utilization rate at whichOPEC was producing increased, leaving less room to absorb unexpected oil demand shocks.Interestingly, we …nd that also …nancial trading plays an important role in explaining thesteep oil price run up in , and pushed oil prices about 12 percent higher than23Al so Baumeister and Peersman (2008), Ha milton (2009), Kilian (2009) and related pape rs …nd thatshocks to oil demand are mainly responsible for the continued increase in oil prices since 2003.
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