The Role of Financial Markets in Determining Physical Oil Prices: A Survey of the Literature
84 Pages Posted: 1 Oct 2012
Date Written: August 30, 2011
The extraordinary oil price volatility of the 2007-08 period has resulted in special attention being focused on the role of financial market factors in determining physical oil prices. We survey the literature to assess the state of research on this topic. The literature provides substantial evidence that fundamental factors, namely stagnant supply, unexpected economic growth from China, India and other countries, low interest rates, and a weak U.S. dollar, were at least associated with and may have contributed to the recent oil price volatility. There is also some evidence to suggest that the price run-up and decline may have been exacerbated by an oil price bubble. Despite considerable evidence of a major increase in oil derivatives trading, including the growth of commodity index trading, and a significant change in the composition of derivatives traders over the past decade, the contribution, if any, of these traders and of speculation in oil derivatives to the 2007-08 oil market turbulence remains undetermined. First, the existing body of research does not provide a definitive answer to the question of how oil inventories respond to the futures-spot price spread, which should be the mechanism connecting financial market speculation and physical oil prices. Second, causality tests that have been conducted to date to test whether open interest position changes by speculators lead or lag futures price changes shed little light on how speculation impacts oil futures prices.
Keywords: Oil prices, energy markets, energy derivatives, commodity index funds, speculation, arbitrage
JEL Classification: Q41, Q49, D40, G13, G18
Suggested Citation: Suggested Citation