The volatility of the price of crude oil, as demonstrated in 2008-2009, raises a number of questions over how the price of oil is determined and the complex game of interdependencies between the physical and financial markets. It has also forced governments to recently take initiatives.
The oil markets have been transformed radically over the last ten years, with the following main features:
- 2000-2003 was marked by relative price stability inside a variation band (22-28 dollars a barrel) which had been decided and set up by the Organisation of the Petroleum Producing Countries (OPEC) following the price collapse in 1998 (10 dollars). This variation range was considered adequate, neither too low to meet the financial needs of exporting countries nor too high to avoid the negative effects on the world economy;
- the years between 2004 and 2008 were marked by an explosion in the demand for oil sustained by strong world economic growth, both in emerging countries and in the United States. Prices soared towards 100 dollars without affecting world economic growth too severely;
- at the same time, there was a huge upsurge in financial markets for oil, refined products and, more generally, for commodities . This rapid growth of the financial sphere – with a volume of transactions that would today represent about thirty-five times the oil traded in the physical market – goes hand in hand with increasing numbers of participants, financial products and marketplaces, some regulated (organised markets) and others, of increasing importance, unregulated (over-the-counter – OTC – markets).
- the 2008-2009 period has therefore raised the problem of interactions between the physical and financial elements. It is marked by three successive phases: between January and July 2008, oil prices rose to 145 dollars, which quickly raised questions over the potential role played by financial markets; between July and December 2008, they dropped to 36 dollars, due to a financial adjustment in investors’ positions and falling demand resulting from the economic crisis; during 2009, prices rose to 80 dollars which seems contrary to the state of the physical fundamentals, notwithstanding OPEC’s production cuts.
Oil prices are essentially determined on organised futures markets (American WTI and European Brent contracts) according to both physical and financial fundamentals. The first define the dynamic balance between supply and demand: both feature very low short-term price elasticity, which thus creates conditions of intense volatility. The second go beyond the petroleum market alone and contribute to the operation of financial markets as a whole, where different types of assets, including oil, are constantly competing with each other. Oil therefore creates two distinct demands in the physical and financial markets: a demand for “physical” oil and a demand for “paper” oil.
Players in these markets can have different objectives: price hedging, taking trading positions (speculation), arbitrages over time and between products, portfolio management and risk diversification, especially for indexed funds. One and the same participant can sometimes cover all these objectives.
The complexity of interactions between the physical and the financial therefore restricts any unequivocal explanation of the massive oil price variations in the recent period. In the many published works on the subject, it is difficult to distinguish between the defenders of physical fundamentals (the demand from emerging countries, the fears of a “peak oil”, the economic crisis, etc.) and the defenders of financial fundamentals (the role of exchange and interest rates, the upsurge in “paper” oil, the development of new products like commodity index funds, the “herding” behaviour of investors, the action of arbitrageurs between spot and futures markets and its limits).
Nor do available statistical data establish clearly the links of causality between the open positions of financial investors in futures markets and the prices observed in the spot market.
On the other hand, nothing suggests these links can be excluded. It is therefore reasonable to conclude that:
- speculation by some financial actors has amplified the upwards or downwards price movements, increasing the natural volatility of oil prices;
- it cannot be excluded that such movements occur again in the years to come, with natural volatility joined by that of financial investors who consider oil (and more generally commodities) as a class of arbitrable assets compared with others;
- strong pressure on the prices will appear by the end of the decade, mainly due to physical fundamentals (under-investment in new production capacities);
- the functioning of financial oil markets and the financial logic of their operators include risks which are difficult to control and may generate a systemic risk.
The question of the price of oil therefore ends in the more general problem of financial market regulation.
This conclusion is derived from a working group on oil price volatility, I recently chaired. Our report commissioned by the French Minister of Finances also proposed a genuine oil strategy for Europe which would include:
- developing demand scenarios for petroleum products for the Union, consistent with the medium-term energy guidelines ;
- an active role in monitoring, even regulating physical oil markets, as much for concerns over transparency and competition as to ensure consistency with actions undertaken in the financial commodities markets;
- improve the reliability and shorten the delay for publishing statistics on petroleum products stocks in Europe, before even thinking about increasing the frequency of these publications;
- harmonisation of oil taxation in the context of low-carbon energy issues;
- improved coordination of national energy-environmental policies to manage jointly the construction of a less carbon-intense energy package, with controlling demand for petroleum products playing a central role in these policies;
- cooperation with the Southern countries who are also seeking to reduce their dependency on oil and the volatility of prices.
Jean-Marie Chevalier, Professor at the University Paris-Dauphine and Director of the Centre of Geopolitics of Energy and Raw Materials