Do financial investors destabilize oil prices? by Marco J. - - PowerPoint PPT Presentation

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Do financial investors destabilize oil prices? by Marco J. - - PowerPoint PPT Presentation

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Do financial investors destabilize oil prices? by Marco J. Lombardi and Ine van Robays European Central Bank and Ghent Univeristy The opinions expressed here are personal and not necessarily shared by the ECB or the Eurosystem Energy

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SLIDE 1

External Developments Division

Do financial investors destabilize oil prices?

The opinions expressed here are personal and not necessarily shared by the ECB or the Eurosystem

Energy Information Administration 24 August 2011

by Marco J. Lombardi and Ine van Robays

European Central Bank and Ghent Univeristy

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SLIDE 2

2

Motivation

  • Oil price surged with

increasing momentum between 2003-2008 before falling in the wake of the financial crisis and the subsequent economic

  • downturn. After that, prices

recovered again.

  • Oil price increases came

against the background of surging demand and stagnating supply.

20 40 60 80 100 120 140 2000M01 2001M01 2002M01 2003M01 2004M01 2005M01 2006M01 2007M01 2008M01 2009M01 2010M01 spot oil price in USD/barrel

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SLIDE 3

3

Financialization of oil

  • The financialization of

the oil futures market was also blamed: the number of

  • pen futures contracts

more than tripled over period 2000 – 2008

  • Did financial activity

drive up the price of oil? Do we need stricter regulations on trading in the

  • il futures market?

200 400 600 800 1000 1200 1400 1600 2000M01 2001M01 2002M01 2003M01 2004M01 2005M01 2006M01 2007M01 2008M01 2009M01 2010M01

  • pen contracts (in thousands)

20 40 60 80 100 120 140

  • il spot price (in USD/barrel)

Open interest futures market spot oil price

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SLIDE 4

4

Policy-relevant questions

  • 1. Has financialization distorted the pricing mechanism

in futures markets?

  • 2. Does this transmit to spot prices?
  • 3. If so, should commodity futures markets be more

regulated?

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SLIDE 5

5

WHAT’S EXACTLY FINANCIALIZATION?

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SLIDE 6

6

Why derivatives?

  • Futures markets exists to transfer risk of oil price

fluctuations

  • 2 types of traders

– Commercial traders may want to hedge against price fluctuations by fixing the price they will pay

  • r receive for delivery in the future

– Also non-commercial traders enter the futures markets to achieve exposure to oil price risk and make a profit.

  • The activity of non-commercial traders is usually

defined as speculation

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SLIDE 7

7

Does financial activity distort pricing?

STABILIZING ACTIVITY If trading is based on expected fundamentals, activity in the futures markets will make markets more liquid and allow information to be priced in immediately and efficiently DESTABILIZINGACTIVITY Traders may distort efficient pricing in the futures markets only when they take positions that disregard (expected) fundamentals

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SLIDE 8

8

The role of index investment

  • Recently, banks have

popularized commodity investment by marketing index funds

  • Index funds trace popular

commodity indexes with a passive strategy – They just go long and roll

  • ver contracts as the

delivery date approaches

  • Is this putting constantly

upward pressure on prices?

100 200 300 400 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Index funds & MTNs ETFs

  • 5

5 10 15 20 Total flows

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SLIDE 9

9

Findings on the impact of index funds

  • Index investment does not

cause changes in futures prices (Stoll and Whaley 2010)

  • Index investment does not

increase volatility (Irwin and Sanders 2010)

  • Increase in commodity

correlation due to hedge funds (Büyüksahin and Robe 2010)

  • Index funds affect futures

prices around roll-over dates (Mou 2010)

  • Index investment increased

commodity correlation (Tang and Xiong 2010)

  • Index investment is affection

prices beyond the short term (Singleton 2011)

Is this a data issue?

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SLIDE 10

10

Our contribution

  • We evaluate the importance of financial activity in

determining the spot price without explicitly using positions data

  • We focus on shock to the futures market not linked

to fundamentals – deviation from the no-arbitrage condition

  • We use a structural VAR model with sign restrictions

– Fundamental oil supply and demand-side shocks – Precautionary demand shock – Non-fundamental financial activity shock

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SLIDE 11

11

THEORETICAL SETUP

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SLIDE 12

12

Spot and futures prices

  • Financial activity in the futures markets only matters if these

traders can affect the spot price of oil

  • Linkage between spot and futures market by a no-arbitrage

condition (Pindyck 1994)

Convenience yield; additional benefit from having oil in storage Spot oil price Spot oil price Spot oil price Risk-free bond rate; Opportunity cost Futures price; for delivery in t+τ Convenience yield; additional benefit from having oil in storage

( )

( )

, ,

1 1

t t t t t t

P r F

τ τ τ + +

+ = + Ψ

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SLIDE 13

13

No-arbitrage condition

  • … or taking logs:
  • Re-writing gives:
  • This condition should hold if markets are efficient

and arbitrage opportunities are instantaneously exploited.

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SLIDE 14

14

Convenience yield

  • In turn, the convenience yield is:

– spot oil price, inventories and expected oil fundamentals (Pindyck 1994)

  • It is more beneficial to have oil inventories if

– Oil spot price is higher – The current level of inventories is lower – Expected oil demand and supply are tighter

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SLIDE 15

15

No-arbitrage futures price

  • Substituting the expression for the convenience yield

gives…

  • The futures price in the no-arbitrage, efficient

markets’ case is solely dependent on current and expected fundamentals

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SLIDE 16

16

Deviations from the no-arbitrage price

  • Destabilizing financial activity can distort efficient

pricing if traders buy or sell futures based on reasons not related to (expected) fundamentals

  • So the observed futures price can deviate from the

no-arbitrage value:

Observed futures price = no-arbitrage price + DESTAB. FINANCIAL SHOCK

derived above which distorts efficient pricing

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SLIDE 17

17

The observed futures price

  • Substituting in the no-arbitrage futures price

gives :

  • The observed futures price is driven by:

– Current and expected fundamentals – Destabilizing financial activity shock

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SLIDE 18

18

Spot-futures spread

  • Rewriting this in terms of the futures–spot spread
  • The spread is negatively affected by changes in

current and expected fundamentals (also incl. stabilizing activity in futures markets) (1)

  • The spread is positively affected by destabilizing

financial shocks (2)

– …we can use this finding to uniquely identify the fundamental shocks from the non-fundamental financial activity shock in the data

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SLIDE 19

19

EMPIRICAL RESULTS

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SLIDE 20

20

Our Structural VAR

  • Estimation of an SVAR model for the global oil market:

– Global oil production – Oil spot price – World economic activity – Inventories – 3-month oil futures price – (Futures-spot spread, defined within the model)

  • Monthly data, over 1991M1-2010M2 with 12 lags

( )

t t t

u Y L A c Y + + =

−1

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21

Identification

  • Disentangle different types of shocks that determine
  • il prices

– Fundamental versus non-fundamental shocks – Different types of fundamental shocks

  • We identify shocks using sign restrictions
  • Non-fundamental shock = destabilizing financial

activity shock

  • Shocks to fundamentals = shocks to (current and

expected) supply and demand

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SLIDE 22

22

Oil supply shock

  • E.g. supply disruptions

Qoil Poil Ywd

INVoil

Foil SF-P

Oil production Spot oil price World econ. activity Inventories Oil futures price Futures - spot spread

Oil supply shock

<0 >0 <0 >0 <0

Oil demand shock driven by economic activity Oil-specific demand shock

  • Destab. financial shock
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SLIDE 23

23

Economic activity shock

  • E.g. strong growth of emerging economies

Qoil Poil Ywd

INVoil

Foil SF-P

Oil production Spot oil price World econ. activity Inventories Oil futures price Futures - spot spread

Oil supply shock

<0 >0 <0 >0 <0

Oil demand shock driven by economic activity

>0 >0 >0 >0 <0

Oil-specific demand shock

  • Destab. financial shock
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SLIDE 24

24

Oil demand shock

  • E.g. oil-gas substitution shock

Qoil Poil Ywd

INVoil

Foil SF-P

Oil production Spot oil price World econ. activity Inventories Oil futures price Futures - spot spread

Oil supply shock

<0 >0 <0 >0 <0

Oil demand shock driven by economic activity

>0 >0 >0 >0 <0

Oil-specific demand shock

>0 >0 <0 >0 <0

  • Destab. financial shock
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SLIDE 25

25

Destabilizing financial shock

  • E.g. index funds?

Qoil Poil Ywd

INVoil

Foil SF-P

Oil production Spot oil price World econ. activity Inventories Oil futures price Futures - spot spread

Oil supply shock

<0 >0 <0 >0 <0

Oil demand shock driven by economic activity

>0 >0 >0 >0 <0

Oil-specific demand shock

>0 >0 <0 >0 <0

  • Destab. financial shock

? ? ? >0 >0

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SLIDE 26

26

Response to fundamentals

OIL SUPPLY OIL DEMAND ECON. ACTIVITY OIL-SPECIFIC DEMAND

  • il price
  • il production

inventories world econ.activity futures-spot spread

  • 2,4
  • 2,0
  • 1,6
  • 1,2
  • 0,8
  • 0,4

0,0

12 24 36 48

4 8 12 16

12 24 36 48

  • 2,5
  • 2,0
  • 1,5
  • 1,0
  • 0,5

0,0

12 24 36 48

0,0 0,5 1,0 1,5 2,0 2,5 3,0

12 24 36 48

  • 5
  • 4
  • 3
  • 2
  • 1

12 24 36 48

  • 1,6
  • 1,2
  • 0,8
  • 0,4

0,0 0,4 0,8

12 24 36 48

  • 4
  • 3
  • 2
  • 1

1

12 24 36 48

  • 4
  • 3
  • 2
  • 1

1 2

12 24 36 48

  • 6
  • 4
  • 2

2 4

12 24 36 48

5 10 15 20 25

12 24 36 48

  • 10

10 20 30

12 24 36 48

0,0 0,4 0,8 1,2 1,6

12 24 36 48

  • 1

1 2 3

12 24 36 48

  • 0,8
  • 0,4

0,0 0,4 0,8

12 24 36 48

  • 2
  • 1

1 2 3

12 24 36 48

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SLIDE 27

27

Response to financial activity

  • Some temporary effect on the spot price
  • No effect on oil production, inventories or on economic activity
  • The spread permanently increases
  • il price
  • il production

inventories world econ.activity futures-spot spread

  • 10

10 20 30 40

12 24 36 48

  • 2
  • 1

1 2

12 24 36 48

  • 2
  • 1

1 2 3

12 24 36 48

  • 3
  • 2
  • 1

1 2 3

12 24 36 48

  • 2
  • 1

1 2 3 4 5 6 7

12 24 36 48

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SLIDE 28

28

Variance decomposition

Oil spot price Oil futures price

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 6 12 18 24 30 36 42 48 54

  • il supply
  • il demand driven by econ. activity
  • il-specific demand
  • ther
  • destab. fin. activity

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 6 12 18 24 30 36 42 48 54

  • Fundamentals explain about 90% of oil price movements in the

short run

  • relevance of destabilizing financial activity is limited.
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SLIDE 29

29

Historical decomposition

  • Financial activity exacerbated gyrations in the oil market

20 40 60 80 100 120 140

  • 40
  • 20

20 40 60 80 2000:01 2000:07 2001:01 2001:07 2002:01 2002:07 2003:01 2003:07 2004:01 2004:07 2005:01 2005:07 2006:01 2006:07 2007:01 2007:07 2008:01 2008:07 2009:01 2009:07 2010:01 Oil price (in USD per barrel) Contribution of shocks (in %)

  • il supply
  • il demand econ. activity
  • il-specific demand
  • destab. fin. activity
  • il price
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SLIDE 30

30

Conclusions

  • Financial activity can significantly destabilize spot

prices in the short run

  • Importance is limited in the long run and the pass-

through is incomplete

  • Trading according to (expected) oil fundamentals still

explains about 90% of oil spot price movements

  • Further regulating futures markets may reduce

liquidity and risk-absorbing capacity in the oil futures market

  • Something to look into: financial stability implications of index

investment