The Role of Financial Markets in Determining Physical Oil Prices: A Survey of the Literature

84 Pages Posted: 1 Oct 2012

See all articles by Louis H. Ederington

Louis H. Ederington

University of Oklahoma - Division of Finance

Chitru S. Fernando

University of Oklahoma - Michael F. Price College of Business

Thomas K Lee

Energy Information Administration - US DOE

Scott C. Linn

University of Oklahoma - Michael F. Price College of Business

Anthony D. May

Wichita State University - W. Frank Barton School of Business

Date Written: August 30, 2011

Abstract

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

Ederington, Louis H. and Fernando, Chitru S. and Lee, Thomas K. and Linn, Scott C. and May, Anthony D., The Role of Financial Markets in Determining Physical Oil Prices: A Survey of the Literature (August 30, 2011). Available at SSRN: https://ssrn.com/abstract=2154642 or http://dx.doi.org/10.2139/ssrn.2154642

Louis H. Ederington

University of Oklahoma - Division of Finance ( email )

Norman, OK 73019
United States
405-325-5591 (Phone)
405-325-7688 (Fax)

Chitru S. Fernando (Contact Author)

University of Oklahoma - Michael F. Price College of Business ( email )

Adams Hall
307 West Brooks Street
Norman, OK 73019-4004
United States
405-325-2906 (Phone)
405-325-7688 (Fax)

HOME PAGE: http://faculty-staff.ou.edu/F/Chitru.Fernando-1/

Thomas K. Lee

Energy Information Administration - US DOE ( email )

1000 Independence Avenue, SW
Washington, DC 20585
United States

Scott C. Linn

University of Oklahoma - Michael F. Price College of Business ( email )

307 West Brooks
Norman, OK 73019-4004
United States
405-325-3444 (Phone)
405-325-1957 (Fax)

Anthony D. May

Wichita State University - W. Frank Barton School of Business ( email )

1845 N. Fairmount
Wichita, KS 67260
United States

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