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Commodities - November 07, 2008

What really drives oil prices?

By Hilary Till, Research Associate at the EDHEC Risk and Asset Management Research Centre and Co-Founder of Premia Capital Management, LLC

Hilary Till

In US dollar terms, crude oil prices increased 525% from the end of 2001 through July 31st, 2008. Was this rally yet another speculative bubble? Specifically, was the oil-price rally based on speculative excess rather than fundamental supply-and-demand factors?

In a new position paper, “The Oil Markets: Let the Data Speak for Itself”, we argue that when the oil supply-and-demand balance becomes sufficiently tight and that when effective OPEC spare capacity becomes sufficiently low that it is logical to see very high prices to ration demand and/or encourage additional supply. That is the job and message of price, even if this message is unpopular.

We discuss how many facets of the world oil market are too opaque, including future productive capacity estimates from important suppliers, inventory statistics from important non-OECD consumers, and summary position data from over-the-counter derivatives participants. For policymakers and their economists to make sound decisions, there must simply be more transparency in these markets.

We take the position that the petroleum-complex futures markets contribute to the transparency of the oil markets. Even when fundamental data on the oil markets are sparse or opaque, large-scale supply-and-demand shifts leave footprints in futures-price relationships, from which one can potentially infer the market’s fundamentals.

Our paper provides several case-studies on this type of analysis. In the presence of active futures markets, an observer need not be a member of a cartel or a large corporation to gain insights into the oil market. That said, we accept that, as has been known since at least 1941, one can expect interaction effects between futures trading activity and market fundamentals, which in turn can result in prices temporarily overshooting (or undershooting) longer-term averages. Our paper provides several concrete examples of these phenomena as well.

We also note how the magnitude of the oil-price rally varies significantly depending on whether the price of oil is denominated in dollars, euros, or ounces of gold, with the appreciation greatest when denominated in dollars (through the end-of-July-2008.) Therefore, the currency effect must be included as one of the fundamental factors behind the oil-price rally.

Our position paper covers the many nuances and caveats that unavoidably come with such a complex system as the world oil markets, including the requirement to be modest in claiming to identify any single factor at any single time as the sole driver in the evolution of price.

What we can say is that there are plausible fundamental explanations that arise from any number of incidental factors that come into play when supply and demand are balanced so tightly, as was the case with light sweet crude oil.

During the first seven months of 2008, these incidental factors could be argued to include a temporary spike in product imports by China in advance of the Beijing Olympics, purchases of light sweet crude by the US Department of Energy for the Strategic Petroleum Reserve, instability in Nigeria, and tightening environmental requirements in Europe. Then, at least through July 2008, there may have been a self-reinforcing feedback loop between the price of oil and the value of the dollar, which likely occurred as oil exporters attempted to diversify their dollar windfalls into other currencies.

We also fully acknowledge that in the short term, it is very plausible for the actions of traders to influence (temporarily) the price of a commodity, especially one that is exhibiting scarcity. The natural conclusion to observing that many seemingly inconsequential factors, in combination, could lead to such a large rise in the price of crude oil is that the market was signalling a pressing need for an increase in spare capacity in light-sweet crude oil, however achieved.

We also realise that in both the United States and in continental Europe there is a long history, dating to at least the 1890’s—the last great era of globalisation—of scrutiny and scepticism of commodity futures markets. Over the past 120 years, two determinations have prevented futures trading from generally being banned or heavily restricted.

The first supportive determination has been a general (although not unanimous) recognition by policymakers that futures markets serve a legitimate economic function. The second determination has been to base public policy on an objective examination of extensively gathered facts, which are summarised via appropriate statistical measures.

In 2008, we believe that public policy governing futures markets should continue to rely on this framework. There are preliminary indications that this will indeed continue to be the case.

Finally, we would emphasise that all efforts to make data transparent on the oil markets, whether regarding supply, demand, or market-participant statistics, are extremely important for making informed public policy decisions about these markets.

[Miffre & Till State-of-the-Art Commodities Investing Seminar, 21-22 April, 2009, London]