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High oil prices are caused by consumers, not speculators

Steven Kopits, European Energy Review
High oil prices are often blamed on speculators, but it is perfectly possible to explain recent oil price history in terms of supply and demand forces, argues energy consultant Steven Kopits. His analysis shows that it was the reluctance of US consumers to reduce oil demand in the face of rising oil prices that led to the price spike in 2008. If this is true, then why did prices peak again in 2012, although US consumers had adjusted their consumption? Because, says Kopits, prices are not set anymore in the US, but in China. That’s the bad news: in the battle for barrels, China and the other emerging economies will force the US and other OECD countries to yield consumption.

When oil prices are high and consumers irritable, politicians are apt to roll out “speculators” as the cause of all ills. It hardly matters that many studies have debunked this notion, including several by James Hamilton of the University of California, San Diego (USCD) and Lutz Killian of the University of Michigan. These show, for example, that although there are similar numbers of open contracts for oil and gas futures, oil prices have recently been near historical highs, even as natural gas prices have collapsed to recent lows. Were the volume of interest – from oil traders, hedge funds, exchange-traded funds (ETFs) and others – the driving factor in price setting, natural gas prices should be as high as oil prices. But exactly the opposite is true. Therefore, the amount of interest from investors in a commodity cannot be shown to be directly correlated to price levels, nor can the presence of financial investors in a given commodity be shown to lead to high commodity prices.

Moreover, speculation (which in reality should be interpreted as “net long positions”) should be accompanied by inventory builds. In order to drive up prices, supply must be withheld from the market. Financial speculators, by definition, do not produce oil. Consequently, they cannot by themselves change oil production. They can, however, withhold oil supplies from the market by putting them into inventory. This happened in the silver market in the 1980s, when the Hunt brothers tried to corner the market in silver futures to drive up silver prices. The effort ultimately failed, but nevertheless illustrates how speculation of this sort works. In the case of oil, inventories were in fact being drawn down at a ferocious rate in late 2007 and early 2008, exactly when the price spike occurred. More recently, tensions with Iran led to modest inventory builds – about a half day’s global consumption – in the early months of this year, but levels have returned to normal since. Therefore, we fail to find the characteristic fingerprint of upward price manipulation (“speculation”), which is difficult to envision absent inventory builds…
(21 June 2012)
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Oil Price Spike Exacerbated by Wall Street Speculation?

Lutz Kilian, Econbrowser
A recent study by Luciana Juvenal and Ivan Petrella suggests that the financialization of oil futures markets contributed significantly to the surge in oil prices after 2003. Lutz Kilian, Professor of Economics at the University of Michigan, questions their analysis and highlights that their paper actually does not shed any light on the role of Wall Street speculation.

The question of how much speculative pressures contributed to the surge in the real price of oil between 2003 and mid-2008 continues to be hotly debated in policy circles. A common view among policy makers is that excessive speculation driven by the financialization of oil futures markets played a key role in causing oil prices to peak at unprecedented levels in mid-2008. This interpretation has been driving recent policy efforts to tighten the regulation of oil derivatives markets in the U.S. as well as abroad. In sharp contrast, the academic literature on this subject is virtually unanimous that financial speculation played no independent role in this episode. One of the rare studies claiming some success in pinning down the effects of financial speculation has been a working paper by Luciana Juvenal and Ivan Petrella (2012) originally published by the St. Louis Fed in 2011. This study has received considerable media attention, but what does it really show and how were its surprising conclusions arrived at?

Based on estimates of a structural vector autoregressive (VAR) model of the global market for crude oil, Juvenal and Petrella (2012) report that, overall, financial speculation (as captured by what I will refer to as the “hybrid speculative shock” and what they call somewhat imprecisely the “speculative shock”) accounts for about 15% of the surge in the real price of oil from 2003 to mid-2008. This compares with 9% attributed to oil supply disruptions (or “flow supply shocks”) and with 58% attributed to oil demand shocks associated with global business cycle fluctuations (or “flow demand shocks”) – not 40% as has been widely, but incorrectly reported in the media on the basis of the Juvenal-Petrella study (see Figure 1 below).

These results are presented by the authors as evidence in favor of the view that the financialization of oil futures markets is to blame for speculative pressures on oil prices. To quote Juvenal and Petrella: “The effect that speculation had on oil prices over this period coincides closely with the dramatic rise in commodity index trading – resulting in concerns voiced by policymakers.” [1] Indeed, their paper prompted headlines such as “Oil Prices Spike Exacerbated by Wall Street Speculation, Federal Reserve Study Finds” (Huffington Post, May 20, 2012), and has been used to justify tighter regulation of oil derivatives markets.

It is fair to say that this study received disproportionate attention in the media because it seemed to produce for the first time solid evidence of financial speculation, reinforcing existing public perceptions. Many casual readers of this study skipped the details and remained unaware of the caveats and assumptions on which Juvenal and Petrella’s conclusions were based. This is not surprising because these details can be complicated, as I know from my own work, which has dealt with the difficult question of how to quantify the role of speculation. In fact, in an earlier structural VAR study with Dan Murphy at the University of Michigan we answered exactly the same question posed by Juvenal and Petrella, but found no evidence that speculative demand shocks (or for that matter financial speculation) caused the real price of oil to increase after 2003 (see Kilian and Murphy (2011)). This raises the question of how the answer obtained by Juvenal and Petrella can be so different. To understand the differences in conclusions, one needs to examine Juvenal and Petrella’s analysis in more detail…
(25 July 2012)
The paper referred to in the article can be accessed here.

Crude truths about oil prices

Jyoti Mukul, Business Standard, India edition
The year 2008 is remembered as the crisis year that saw Fannie Mae and Freddie Mac go down, followed by Lehman Brothers and a host of others. Then, everything else to do with financial markets went topsy-turvy. Not unrelated but relatively less commented on was the simultaneous swing in oil prices that saw Brent touching $147 a barrel in the summer and then dropping to $40 in November of the same year.

Oil had seen swings earlier, too, but this one had a much larger connection with the financial world that is often inadequately explained. Financial analysts dissecting the reasons for such a play rarely tell the full story, choosing to throw the dart on the growing demand from India and China. An engineer by training and an advisor with Eni, Salvatore Carollo has successfully attempted to unravel the mystery. Understanding Oil Prices, part of the Wiley Finance series, explains the complicated world of oil pricing in the context of 2008 and debunks the classic demand-supply theory to explain why oil prices go awry. Carollo comes with the insider’s perspective that gives the book a critical view of how the financial markets dabble in oil. He tells a story that is refreshingly different from the standard one of oil geopolitics. He starts with how oil prices were benchmarked to those set by American oil companies, covers the formation of Opec and explains how the Saudi attempt to have a net-back value system gave way to the creation of the Brent standard.

Recounting the slipping of control of the oil market out of the hands of Opec countries to London and Wall Street, Carollo explains how Brent futures moved away from the purpose of imparting transparency to a market that operated purely for financial purposes using the analogy of cherry and tomato stickers. “The market of oil stickers is a market that is almost totally independent from the real oil market, with bodies operating there and dominating it (controlling it and manipulating it) that normally have no relationship with or interest in the oil industry,” says Carollo.

Brent, which was born to support the trading operations of the oil companies, has seen a tenfold increase in volumes, causing “complete disruption in the internal dynamics of oil”. Interestingly, during 2008-09, about $51,000 billion was traded on the futures market, 27 times more than the physical market and six to seven times more than the entire world production of crude. Carollo, in fact, questions the logic of calling the Brent quotation the price of crude oil…
(26 July 2012)
You can learn more about the book here.