Whither Oil Prices and Volatility?

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OIL PRICE VOLATILITY OIL PRICE VOLATILITY

What Do We Know?

Robert J. Weiner Robert J. Weiner

Professor of International Business, Public Policy &

Public Administration, and International Affairs, Public Administration, and International Affairs,

George Washington University George Washington University Membre Associ

Membre Associé é, GREEN, Universit , GREEN, Université é Laval Laval GWU

GWU – – WB Global International Finance Forum WB Global International Finance Forum

Oil Price Volatility, Economic Impacts, & Financial Management Oil Price Volatility, Economic Impacts, & Financial Management

Washington Washington 10 March 2008 10 March 2008

1

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

from $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.

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 long

of 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 permanent

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2

Term Structure of Futures Prices Suggests Term Structure of Futures Prices Suggests

Shocks Expected to be Permanent Shocks Expected to be Permanent

Parallel movements in term structure indicate expectations of pe

Parallel 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

Long- Long -Term Market Price also Higher Term Market Price also Higher and More Volatile

and More Volatile

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4

Market expectations of future volatility Market expectations of future volatility

have also increased have also increased

•

The distribution of likely future prices has widened, reflecting The distribution of likely future prices has widened, reflecting increased uncertainty

increased uncertainty

December 2008 Brent Crude Oil Price Distribution

Implied in Call Option Prices (source: IMF)

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

Feb. 28, 2008 Nov 26, 2007

Jan 7, 2008

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Why is oil price volatility important?

1. 1. Volatility matters a great deal to world economy Volatility matters a great deal to world economy

•

Trade flows Trade flows

•

Investment flows Investment flows 2.

2. On the exporter side, the boom- On the exporter side, the boom -and and- -bust cycle presents bust cycle presents economywide challenges

economywide challenges

•

capital inflows capital inflows

•

budget cycles budget cycles

•

development planning development planning

•

competitiveness of the non- competitiveness of the non -oil sector oil sector

•

governance and accountability of oil revenues governance 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 obstacles

obstacles

•

economic growth economic growth

•

investment investment

•

trade trade

•

development planning development planning

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6

Is Elevated Volatility likely to Continue?

1.1.

A A yes yes answer would have very different implications answer would have very different implications than a

than a no no answer for fiscal management, public answer for fiscal management, public- - and and private

private- -sector investment, current sector investment, current -account stability in - account stability in oil- oil -exporting and oil exporting and oil- -importing developing countries, importing developing countries, and many other dimensions of the world economy and many other dimensions of the world economy

2.

Addressing this question requires understanding and Addressing this question requires understanding and assessment of the underlying

assessment of the underlying causes causes of volatility of 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

FACTORS DRIVNG OIL PRICE VOLATILITY FACTORS DRIVNG OIL PRICE VOLATILITY

► ► Market fundamentals. Market fundamentals . Fluctuations in supply, Fluctuations in supply, demand, and market power

demand, and market power

Some fundamentals related to expectations of Some fundamentals related to expectations of future production, consumption, so not easily future production, consumption, so not easily observable

observable

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

some circumstances

Speculation is the focus of this presentation

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Speculation Widely Claimed to Drive Volatility Speculation 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, hav Geopolitical 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 today

a 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 prices

a significant role in driving up prices

.”.” (emphasis added)

Investment Analysts

Investment Analysts (Soci ( Socié ét té é Gé G én né érale rale Cross- Cross -Asset Asset Research, Multi

Research, 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 Investigations US Senate Permanent Subcommittee on Investigations

The Role of Market Speculation in Rising Oil and Gas Prices: A N

The Role of Market Speculation in Rising Oil and Gas Prices: A Need to Put eed to Put the Cop Back on the Beat, June 2006

the 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 view Some memorable experience consistent with this view

Gulf Crisis as Gulf Crisis as impetus for impetus for concern concern

Oil prices spiked, Oil prices spiked, then plummeted then plummeted Little evident Little evident change in change in fundamentals fundamentals Speculators, Speculators, futures markets futures markets claimed

claimed

responsible for responsible for market volatility market volatility

CRUDE OIL PRICES, $/barrel

15 20 25 30 35 40

1989 1990 1991

Gu l f C r i s i s

HOWEVER HOWEVER … …

►►

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

►

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

intuition, not facts or systematic analysis

►►

Economic theory → Economic theory → speculators cannot affect price speculators cannot affect price levels

levels, but could affect price , but could affect price volatility volatility

►►

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 targets Speculators make convenient targets

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SPECULATORS SERVE AS SCAPEGOATS SPECULATORS SERVE AS SCAPEGOATS

FOR BOTH PRICES AND VOLATILITY FOR BOTH PRICES AND VOLATILITY

“... “ ... among the among the causes of low causes of low [crude [crude- -oil] oil] prices prices [are] [are] the the manipulation of

manipulation of [inventory] [inventory] stocks by speculators stocks by speculators and and buyers to depress price to suit their purposes

buyers to depress price to suit their purposes, which , which are always adverse to the interests of producers

are always adverse to the interests of producers” ” (Petroleum (Petroleum Producers

Producers’ ’ Union, 1878 Union, 1878

; ; emphasis added)

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

(Leon Hess, 1996)

“Derivatives are “ Derivatives are ‘ ‘financial weapons of mass destruction financial 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 fundamentals

detaches itself from the fundamentals. .” ” (PIW, 28 Feb (PIW, 28 Feb 2005,

2005, Pension Funds Help Inflate Price Bubble Pension Funds Help Inflate Price Bubble

; ; emphasis added)

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Crude

Crude- -Oil Futures Open Interest up Sharply Oil Futures Open Interest up Sharply

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

commercial traders increasing

Source: IMF Crude 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 TREND VOLATILITY HIGH BUT NO CLEAR TREND

Annualized standard deviation of daily crude

Annualized 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

ANALYTICAL PERSPECTIVE ANALYTICAL PERSPECTIVE

How How can speculation influence price volatility? can speculation influence price volatility?

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

player or herding

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

entry barriers too low

► ► Second has long history in financial markets Second 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 therefore

reasons 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

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What is Herding, and is it Rational?

►

Easier to recognize than define Easier to recognize than define

►

Broadly, making decisions by observing others and Broadly, making decisions by observing others and copying them, rather than by assessing fundamentals copying them, rather than by assessing fundamentals

►

Can be rational if others are better informed. Wide- Can be rational if others are better informed. Wide - spread phenomenon: buying books on best

spread phenomenon: buying books on best- -seller seller lists, choosing restaurants because they are crowded lists, choosing restaurants because they are crowded

►

In financial markets, fixed asset supply In 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. “Flocking “ Flocking” ”

►

Herding can move prices away from fundamentals Herding can move prices away from fundamentals and exacerbate volatility. Possibility of

and exacerbate volatility. Possibility of “ “stampede stampede” ” as as speculators try to buy or sell simultaneously

speculators try to buy or sell simultaneously

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Summary of Analysis Summary of Analysis

1. 1. Problem Problem Actions of speculators difficult to Actions of speculators difficult to monitor

monitor

2. 2. Approach Approach Use of CFTC microdata to Use of CFTC microdata to

measure parallel trading parallel trading in measure parallel trading parallel trading in petroleum futures markets

petroleum futures markets

3. 3. Methodology Methodology Count number of speculators Count number of speculators

buying and selling each day, and test if

most are on same side of the market

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Summary of Findings Summary of Findings

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 crude in crude -oil or heating - oil or heating- -oil futures oil futures

2.

No evidence of parallel trading among speculators No evidence of parallel trading among speculators (noncommercial participants)

(noncommercial participants) as a group as a group in the in the crude

crude- -oil or heating oil or heating- -oil futures markets oil futures markets

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.

Interpretation Interpretation Roughly half the active speculators Roughly half the active speculators buying, rest selling on any day

buying, rest selling on any day→ → effect of trading on effect of trading on pieces limited

pieces limited

Implications and Conclusions Implications and Conclusions

Oil Prices Reflect Fundamentals, not Speculation Oil Prices Reflect Fundamentals, not Speculation

1.

1. Oil prices determined by current supply and demand, Oil prices determined by current supply and demand, and expectations of future supply and demand

and expectations of future supply and demand

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 oil Futures reasonable basis for oil- -price forecasts. price forecasts.

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

scrutiny

4.

4. Futures prices reasonable basis for hedging Futures prices reasonable basis for hedging programs

programs

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Implications and Conclusions

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

Oil Prices Reflect Fundamentals, not Speculation Oil Prices Reflect Fundamentals, not Speculation

1.

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 fluctuations continued price fluctuations

For gory details, check out the paper on the web:

www.rff.org/rff/News/Features/Do

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