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Oil Price Volatility: Causes and Recommendations to The EU

March 12th, 2010 by Jean-Marie Chevalier, University Paris-Dauphine

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

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12 Responses to “Oil Price Volatility: Causes and Recommendations to The EU”

  1. Oscar Says:

    I found your analysis of the oil prices’ volatility well structured and quite thorough. As it happens that I am actually studying Quantitative Finance, I know how important the Volatility is for a trader when pricing a financial instrument. Generally, a trader uses mathematical models, especially Black & Scholes, with several parameters, one of them, the most complicated to estimate, is the Volatility, but he often forgets what we can see behind figures.

    There is no doubt about the fact that oil price is based on physical and financial fundamentals, so that the price’s variations are a direct result of supply and demand curves. Let’s try to go in the details of to what extent do the physical and financial fundamentals affect the price and what repercussions do they have on the volatility parameter.

    While I agree with your general assumption that physical fundamentals play a more important role than the financial ones in the fluctuations of the Volatility in the middle and long term (see your report, pages 24-26), maybe it would have been more accurate to give precise figures about the exact role of each fundamentals.

    I finally believe that your recommendations (transparency, regulation…) concern essentially European countries, but as the OPEC countries hold the greatest influence in the making of prices, how do you think you would bring them to comply with transparency rules and what will be their benefits from such measures?

  2. Rémi de Guisa Says:

    One of the interesting guidelines of this article is that it would be useful to implement specific measures which are usually intended for the financial sphere regulation in order to avoid some potential troubles in oil price evolution, since it seems that the high oil price movements that recently occurred could be linked to the growing role played by financial actors. Indeed, if you want to avoid disorders on a financial market, you have to try to get information which is as reliable as possible. That is the reason why a regulating institution is required to monitor physical markets in order to ensure transparency. That is also the reason why statistics on petroleum products, such as those who are released on a three month basis by the IEA should be published more quickly and become more reliable. Isn’t it true that the oil price increase of 2008 was partly due to the fear of a “peak oil” based on the uncertainty of both forecasts and present statistics?

    Another interesting point needs to be mentioned: it is said that under-investments in new production capacities could put a strong pressure on price. Indeed, investments usually correlates with oil price, but this correlation has been less true since 2000. This can be explained by the saturation of oil sector: human resources are limited, production costs are increasing (for instance, between 2005 and 2007, rent expenses of an oil rig have been multiplied by three). Stresses between production and demand could appear due to under-investments.

    The general point I would like to add is the fact that such a high oil price volatility might incitivize countries who depends on oil producers to enhance their efforts in order to develop substitutiv energies.

  3. Oliver Says:

    Interesting read from a year ago. The situation is shifting more and more towards renewable energy sources but in reality it will take more time that we image to actually start lowering the amount of fossil fuels that the world uses every year. Oil companies are simply making too much money to let go of it before they use it to the max.

  4. Roy Thomsitt Says:

    “it cannot be excluded that such movements occur again in the years to come,”

    How prophetic that statement has proved with current turmoil in the oil producing nations such as Libya, adding fuel to the already motoring oil price. There were signs of another price surge before Egypt went into rebellious mode, so the financial market seemed ahead of the.

    What was so interesting in 2008 was the complete disconnect between the financial market and economic reality. Traditional thinking has it that poor economy means lower oil prices. Common sense says the same thing. In 2008 we had rampant price increases in paper oil with a stagnant economy, which can only mean the financial markets existed in the surreal world of speculation.

    This time around the fundamentals are rather different. Western economies are still not in good shape, but the upheavals in the Arab world do give some genuine reason for the higher prices we are seeing. That does not mean the speculators are not gaming the system as they appear to do with those other commodity pillars: gold and silver.

  5. pc performance test Says:

    @ Oliver

    I couldn’t agree more. Surely everyone knows that this is a big money game with so much at stake. Think about how much money big-time oil companies have at their disposal. It is mind-boggling. They have too much power to just simply “roll over” and allow society to start using alternative fuels (that are actually better). This also explains why we can’t produce vehicles that get better gas mileage. the technology is there, but oil companies will continue to block with it some way some how.

  6. Lynn Says:

    Not only are huge money sums at risk, but there are so many different objectives at play. You are dead on when you say that a single player will have multiple objectives – not only do their goals change over time, they are conflicted right from the start! It’s valuable to examine this with the hindsight that history affords us. Good post.

  7. John Hardgainer Says:

    How will the current political unrest throughout the Middle East affect the long term markets? Libya, Syria, Yemen….Saudia Arabia even. Prices are up short term, but is the situation causing any foundational shift?

  8. Donald Says:

    Well, to answer your question about foundational shifts in the situation, keep in mind the long, long history of the region. Without that as a backdrop, one is apt to make snap judgements that won’t hold over time. Of course, the issue is that the traders don’t care about the long term. The focus is squarely on the here and now with maybe 2 years of forecasting taken into account.

  9. Ian Says:

    @John Hardgainer
    “How will the current political unrest throughout the Middle East affect the long term markets?” I think growing demand is going to play a far longer term impact on oil prices than recent troubles. You can’t put a billion Chinese and Indians in cars on the road without a hug increase in the demand for gasoline.

  10. Dave Says:

    I can’t understand why the oil companies don’t diversify into alternative fuels. They have very large budgets which could be utilized for research and development, and would be able to keep up with demand at their widespread outlets.

  11. vick Says:

    The global economy is weak and demand destruction rampant especially with the previous spike in oil prices. There have been supply disruptions in Libya but from what I understand, Saudi Arabia has been committed to using more of its supply capacity and in fact has been having difficulty finding actual buyers to take physical possession of their oil. As far as China is considered, while their appetite for oil and energy is enormous, doesn’t most of their energy come from domestic production? I know this will change with time but it makes me wonder what exactly is shaping the current price of oil. Perhaps I’m missing something but I feel as if the fundamentals support a lower price of oil.

  12. richard mcgrath Says:

    Oliver’s comments (3/31/11).are right on! Has any study been done of the pricing policies of e.g. OPEC vis a vis the investment in fuel efficiency and alternative energy sources? I suspect that when world (or U.S.) opnion zeroes in on spending money to develop those areas, OPEC lowers its prices to dampen the ardor, and raises them again after the enthusiasm (in the face of lower oil prices) has declined. This would be classic oligopolistic conduct on a truly grand scale, and if done shrewdly would be difficult to detect. Comments anyone?

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