July 25, 2012
Guest Contribution: "Oil Price Spike Exacerbated by Wall Street Speculation?"
A recent study by Luciana Juvenal and Ivan Petrella suggests that the financialization of oil futures markets contributed significantly to the surge in oil prices after 2003. Lutz Kilian, Professor of Economics at the University of Michigan, questions their analysis and highlights that their paper actually does not shed any light on the role of Wall Street speculation.
The question of how much speculative pressures contributed to the surge in the real price of oil between 2003 and mid-2008 continues to be hotly debated in policy circles. A common view among policy makers is that excessive speculation driven by the financialization of oil futures markets played a key role in causing oil prices to peak at unprecedented levels in mid-2008. This interpretation has been driving recent policy efforts to tighten the regulation of oil derivatives markets in the U.S. as well as abroad. In sharp contrast, the academic literature on this subject is virtually unanimous that financial speculation played no independent role in this episode. One of the rare studies claiming some success in pinning down the effects of financial speculation has been a working paper by Luciana Juvenal and Ivan Petrella (2012) originally published by the St. Louis Fed in 2011. This study has received considerable media attention, but what does it really show and how were its surprising conclusions arrived at?
Based on estimates of a structural vector autoregressive (VAR) model of the global market for crude oil, Juvenal and Petrella (2012) report that, overall, financial speculation (as captured by what I will refer to as the “hybrid speculative shock” and what they call somewhat imprecisely the “speculative shock”) accounts for about 15% of the surge in the real price of oil from 2003 to mid-2008. This compares with 9% attributed to oil supply disruptions (or “flow supply shocks”) and with 58% attributed to oil demand shocks associated with global business cycle fluctuations (or “flow demand shocks”) – not 40% as has been widely, but incorrectly reported in the media on the basis of the Juvenal-Petrella study (see Figure 1 below).
Figure 1:Juvenal and Petrella’s (2012) Historical Decomposition of the Cumulative Change in the Real Price of Oil Since 2003
These results are presented by the authors as evidence in favor of the view that the financialization of oil futures markets is to blame for speculative pressures on oil prices. To quote Juvenal and Petrella: “The effect that speculation had on oil prices over this period coincides closely with the dramatic rise in commodity index trading – resulting in concerns voiced by policymakers.”  Indeed, their paper prompted headlines such as “Oil Prices Spike Exacerbated by Wall Street Speculation, Federal Reserve Study Finds” (Huffington Post, May 20, 2012), and has been used to justify tighter regulation of oil derivatives markets.
It is fair to say that this study received disproportionate attention in the media because it seemed to produce for the first time solid evidence of financial speculation, reinforcing existing public perceptions. Many casual readers of this study skipped the details and remained unaware of the caveats and assumptions on which Juvenal and Petrella’s conclusions were based. This is not surprising because these details can be complicated, as I know from my own work, which has dealt with the difficult question of how to quantify the role of speculation. In fact, in an earlier structural VAR study with Dan Murphy at the University of Michigan we answered exactly the same question posed by Juvenal and Petrella, but found no evidence that speculative demand shocks (or for that matter financial speculation) caused the real price of oil to increase after 2003 (see Kilian and Murphy (2011)). This raises the question of how the answer obtained by Juvenal and Petrella can be so different. To understand the differences in conclusions, one needs to examine Juvenal and Petrella’s analysis in more detail.
It is useful to start with some background on what we mean by speculation (also see Fattouh, Kilian and Mahadeva (2012)). From an economic point of view, anyone buying crude oil not for current consumption, but for future use is a speculator. Kilian and Murphy (2011) observe that the demand for stocks (or above-ground inventories) of crude oil shifts, as expectations about future demand and supply conditions evolve. We show how to distinguish such speculative demand shocks from shocks to the flow supply of oil or the flow demand for oil in particular. Speculative purchases of oil usually occur because the buyer is anticipating rising oil prices. The same expectations about rising oil prices may also trigger the accumulation of below-ground oil inventories (or reserves), as oil producers choose to keep oil below the ground. In our model such speculative supply shocks are observationally equivalent to flow supply disruptions.
Juvenal and Petrella take the original Kilian-Murphy framework as their starting point. They attempt to extend this model in an effort to distinguish between speculative supply shocks and conventional flow supply shocks, while retaining the speculative demand shock originally introduced by Kilian and Murphy. This is an ambitious and challenging undertaking, and I will show next that their proposed solution has serious limitations.
Juvenal and Petrella’s analysis appeals to a static economic model in which there is an exogenous upward shift in oil producers’ expectations of the real price of oil (possibly driven by the financialization of oil futures markets). Oil producers expecting a higher price for future deliveries, as a result, will withhold oil from the market and accumulate inventories. This accumulation takes the form of an accumulation of below-ground inventories notably in OPEC countries, resulting in a reduction in flow supplies, associated with a higher spot price and lower oil consumption and hence lower real activity. The problem is that, as observed earlier, such a shock is observationally equivalent to any other disruption of flow supplies, say due to civil strife or a strike. This observation prompted Kilian and Murphy (2011) to stress that for all practical purposes speculative supply shocks and flow supply shocks cannot be separately identified (also see the discussion in Hamilton BPEA 2009).
Juvenal and Petrella propose to circumvent this identification problem by imposing the working hypothesis that speculative supply shocks are perfectly correlated with speculative demand shocks such that we can think of these shocks as one “hybrid speculative shock”. This allows them to add the identifying restriction that the impact response of above-ground crude oil inventories in oil importing countries to a negative speculative supply shock is positive. This hypothesis, of course, is not an implication of economic theory. In addition, there are good reasons to believe that for parts of their estimation sample the notion that speculative supply and speculative demand shocks are perfectly correlated does not hold. For example, in 1990 Saudi Arabia as the supplier of last resort increased its oil production following the invasion of Kuwait when it should have cut back production according to Juvenal and Petrella’s model.
Interestingly, adding such a hybrid shock to the model renders the original speculative demand shock proposed by Kilian and Murphy redundant. Instead of dropping the latter demand shock, as one might have expected, Juvenal and Petrella impose an additional sign restriction on the inventory response to positive flow supply shocks. They insist that this impact response is negative – an identifying restriction for which there is no theoretical rationale, but that is crucial for estimating the model in question.
The problem here is that refiners may respond to a flow supply disruption by drawing down their above-ground inventories (if the supply disruption is considered temporary) or they may choose to accumulate additional inventories (if even higher future oil prices are expected). The latter situation may arise even when the supply disruption does not represent a speculative supply shock. Juvenal and Petrella defend their sign restriction on the grounds that it is consistent with empirical estimates in Kilian and Murphy (2011). That argument is not persuasive given that they also claim that the Kilian-Murphy model is wrong, making it impossible for them to appeal to our empirical results.
This second additional identifying assumption allows Juvenal and Petrella to retain two “speculative” shocks within their model and to distinguish them from the flow supply shock. The modified flow supply shock in their model, of course, now differs substantively from the original flow supply shock Dan and I were studying. To add further confusion, the paper mislabels and misinterprets the original speculative demand shock as an “inventory demand shock” reflecting only shifts in precautionary demand. Both this label and the interpretation of this shock are misleading. Figure 1 reinstates the correct label. Likewise, I have chosen to clean up the remaining shock labels, so they are correct and can be compared with our earlier work.
Even with these (and many other) changes in the model specification, Juvenal and Petrella’s estimates show that flow demand shocks are the primary cause of the oil price surge after 2003, confirming the substance of the findings in Kilian and Murphy (2011). The key difference is that they find some evidence for the presence of hybrid speculative shocks as well. This raises the question of whether the two models are equally credible and which result to believe. One obvious difference is that the original Kilian-Murphy analysis was based on uncontroversial implications of standard economic models rather than ad hoc assumptions without basis in economic theory. If that is not enough of an argument, we can also judge the credibility of their analysis by inspecting their empirical results.
For example, their paper shows that the hybrid speculative shock not only causes a sustained increase in the real price of oil, but also implies a booming world economy. That finding is robust across all specifications. If this result were taken at face value, it would imply that what is needed in today’s economy are more speculators in oil markets. This is not what the media picked up on as the message of the paper, of course, and the authors wisely do not dwell on this point. Common sense tells us that this result cannot be right, but then this fact implies immediately that the results of the historical decomposition in Figure 1 (which are based on the same impulse response estimates) cannot be correct either, so caution is called for. It is intuitively clear that, without this puzzling feature of increasing global real activity in response to a hybrid speculative shock, the model would assign lower weight to the hybrid speculative shock in fitting the data (and correspondingly even higher weight to the flow demand shock).
One additional reason why these results look strange is that they are not based on a proper econometric evaluation of the model. It is not clear at all how to interpret the impulse response estimates and historical decompositions shown. This general point has been discussed at length in recent work by Inoue and Kilian (2011). It might have been better to show the full range of results consistent with the data even if that dilutes the message of the paper. Yet another reason for skepticism is that Juvenal and Petrella fail to impose several additional identifying assumptions that Dan and I showed to be essential for identification. The failure to impose these restrictions immediately invalidates their model estimates (see Kilian and Murphy (forthcoming JEEA 2012)). How much of a difference this omission makes for the results is hard to tell ex ante, but certainly dropping the impact sign restriction on the response of real activity to the hybrid shock must have important effects on the estimator.
All these caveats suggest considerable caution in interpreting the results. Most importantly, however, their econometric analysis does not tell us anything about whether the hybrid speculative shock is actually associated with financial speculation, as implied by Juvenal and Petrella. Several of the problems I discussed earlier presumably could be fixed or mitigated by more careful attention to the shock identification and model specification, but this problem of interpretation is not one of them. Evidence of “speculation” in models such as Juvenal and Petrella’s merely means that agents expect the real price of oil to increase. It is entirely possible for that speculation to reflect perceptions of higher future scarcity of oil, driven by slower expected growth in world oil production than would be required to meet rising demand driven by emerging Asia, for example. It is also possible that speculative pressures between 2005 and mid-2006 might have arisen because of the positions taken by index fund traders and that those positions were not related to expected economic fundamentals, as suggested by Masters (2008), among others, but there is no way of knowing in the context of this model. Hence, Juvenal and Petrella (2012, abstract) overreach when they suggest that their “results support the view that ... the financialization [...] of commodity markets [...] played a role ... in the recent oil price increase”.
Moreover, there are further arguments against their interpretation. One is that closer inspection of Figure 1 reveals that the hybrid speculative shock increased the real price of oil mainly between 2005 and mid-2006. It played essentially no role during the second phase of rising prices, from mid-2006 through mid-2008, when many pundits suspected particularly large speculative pressures, or between late 2008 and the end of 2010 when index fund positions continued to grow by most accounts. The other argument is that the notion that index funds traders were responsible for rising oil futures prices has been decisively rejected by a large number of recent empirical studies based on alternative methodologies. Those findings are consistent with Kilian and Murphy (2011), but inconsistent with Juvenal and Petrella (2012). The reader is referred to the references in Fattouh, Kilian, and Mahadeva (2012) as well as recent work by Hamilton and Wu (2012).
In short, readers of Juvenal and Petrella (2012) should beware that there is nothing in their analysis that sheds light on the quantitative importance of financial speculation or that would justify tighter regulations for oil derivatives markets. Unfortunately, it is precisely those aspects of their study that have generated the most media attention.
This post written by Lutz Kilian.
Posted by Menzie Chinn at July 25, 2012 07:30 AMdigg this | reddit
Thanks for this excellent paper.
I have asked before but would like to ask again. Has there been any study done to see if speculation actually moderated price shocks? Since speculators are looking for extreme moves in markets, it would seem to make sense that their investments would run against the tide when prices, either higher or lower, approach extremes.
I am unaware of any such studies. I am not smart enough to use the Kilian-Murphy study to determine this. Can anyone else?
Posted by: Ricardo at July 25, 2012 08:33 AM
Thanks for this post, well-balanced.
Menzie, pls. care about Europe (guest post would be appreciated v.m.).
Posted by: Johannes at July 25, 2012 08:38 AM
Nice job debunking what appears to be an agenda driven study. The financialization of a financial market. Who da thunk it? Did they coin a new word because my computer does not agree that financialization is an actual word. I wonder if the authors would consider the financialization of their paycheck and calculate the speculative component of the income of the average economist.
Posted by: Hitchhiker at July 25, 2012 08:46 AM
Nice post, Lutz.
Here's my take on the matter, in the European Energy Review:
Posted by: Steven Kopits at July 25, 2012 09:00 AM
From the last paragraph of the afore-mentioned Energy Review article:
But it won't last. Whether China's tolerance is $110 / barrel or $120 / barrel, it is in either case well above that of the US or the other OECD countries. Soft oil prices will allow both China and the advanced countries to catch their breath and rekindle economic growth - and then oil prices will begin to climb again. Over time and just as they have for the last six years, China and the other emerging economies will grind down the OECD countries and force them to yield consumption. Advanced countries may continue to adjust with rapid reductions in oil consumption and increases in efficiency, or the OECD consumer may dig in his heels at some point and fight to keep established consumption levels. But keep in mind, whichever the reaction, these periods - without exception - have historically ended in recessions. We may hope things turn out differently this time.
And yet if we believe ECRI, it won't be different. We seem to be heading into recession. Thus, every time the US has been forced to cede oil consumption, it will have fallen into recession.
Does then oil matter then to GDP? Can we merely shrug off the chronic need to reduce oil consumption whiling maintaining normal economic recovery rates? It doesn't seem so.
If that's the case, then I believe the relationship of oil to GDP should be the focus of research and analysis going forward. It's where we should shine the light next.
Posted by: Steven Kopits at July 25, 2012 09:43 AM
Well, that surprised me. The conclusion is not what I would have expected from the title. Disappointed because I could not go into a long tirade about why the premise was nonsense.
Posted by: Bruce Hall at July 25, 2012 10:45 AM
Regarding Ricardo's comment, there is some work by Dvir and Rogoff (working paper 2010) that studies conditions under which speculation can be stabilizing or destabilizing, although that work does not relate to your question about recent events, but to long-run historical data. There also is a paper by Jacks (2007) in Explorations in Economic History that reviews historical evidence on the relationship between price volatility and commodity futures markets. Finally, Büyükşahin (2011) compares price volatility in exchange traded and non-exchange traded commodity futures markets in recent years. The latter two papers suggest that futures markets did not raise and if anything may have lowered price volatility.
Finally, as to speculators leaning against the tide, the trouble is that sometimes the tide only becomes apparent ex post. Forecasting turning points is difficult. In the Kilian and Murphy model leaning against the tide would have amounted to de-stocking before the mid-2008 price peak (see Figure 2 in that paper). One could argue that there is some evidence of this perhaps, but one has to be careful not to read too much into small changes in the fitted data and overall the effect, if any, seems small.
Posted by: Lutz Kilian at July 25, 2012 10:50 AM
Regarding Hitchhiker's comment, the term "financialization" refers to the fact that oil futures markets, which traditional had been a backwater of financial markets, become fully integrated with other financial markets in recent years. This financial integration occurred after new financial investors such as index funds entered the oil futures market in search of higher returns. For further references see the survey paper by Fattouh et al. on my homepage.
Posted by: Lutz Kilian at July 25, 2012 11:20 AM
Geithner: "I'll tell you my general view on this," Secretary of Treasury Tim Geithner said about the economy in his testimony to Congress. "The economy is not growing fast enough. Unemployment is very high. There's a huge amount of damage left in the housing market. Americans are living with the scars of this crisis."
"The institutions with authority should be doing everything they can to try to make economic growth stronger," Geithner said.
Now, if you think oil is knocking 1-1.5% off the growth rate, then essentially, oil prices are enough by themselves to prevent meaningful re-employment. High oil prices, in the better case, do not mean recession, they mean stagnation. We saw this post-1979, and we see it now.
So what can Congress do? Well, there are four options: i) accelerate drilling and increase access, ii) provide meaningful access to alternative fuels, CNG chief among them (and the reason for the criticality of the current ARPA project), iii) increase the economic viability of non-fossil fuels, primarily by creating a framework to increase the utilization rates of electric vehicles through self-driving technology (a long-term project with near term tasks), and iv) promote i-ii above as a critical component of foreign policy.
But preceding all these policy steps is the notion that oil affects GDP growth rates. Has that been properly demonstrated? Not to my mind.
So here's what we're looking at: If ECRI's right, then the Republicans will sweep the White House and both houses of Congress. That means that the 113th Congress will have effectively carte blanche with energy policy until about this time next year (by which time the Democrats will have collected themselves and the Republicans will have screwed up something).
But the industry--the oil and gas and its lobbying capability--is woefully unprepared. The industry is loath to talk about oil as a supply-constrained resource, and therefore there is little discussion of the impact of oil on the economy. (How could there be, if oil's not a constrained resource?)
Meanwhile, on the left, there is little appetite to investigate the relationship of oil to the economy. A pro-energy policy is viewed as an anti-environemnt policy; thus, the left is inclinded to avoid the issue of whether employment is actually linked to the price of oil.
It's not somewhere they want to go.
However, for those of us who believe oil matters, that prosperity matters, and that prosperity is more important than US carbon reduction, the coming six months are critical.
During this period, we need to show the linkage of oil to the economy, and lay the groundwork for the spring legislative session. That's the battleground today.
Posted by: Steven Kopits at July 25, 2012 12:17 PM
Ricardo, consider that the two primary strategies used in most markets, including oil, are trend-following (momentum) and reversal (contrarian) buying and selling. (Typically, reversal works over days to weeks, then momentum dominates for a month to a year, then reversal again dominates.) I don't know of any studies that show the effects of this buying/selling on moderating (or enhancing) price swings, but there are 100's of momentum papers out there; I'm not familiar with the specific papers mentioned in the 10:50 post.
I'm not sure one can say typical speculators are looking for extreme moves, as opposed to some specific chart pattern, or a fundamental change. But I suppose you might be right, as the big moves tend to get a lot of headlines and might pull in marginal investors that would otherwise stay on the sidelines.
Posted by: Rich at July 25, 2012 12:56 PM
Thank you for the response. I will try to find the papers and review them.
When I use the term "extreme moves" I mean an arbitrage condition where a speculator can make a profit by taking a contrary position. Not just those huge swings that all speculators dream about.
I would say that a momentum trader would probably not be a classical speculator as it is usually defined. Such a trader would be considered more of a normal investor. But I suppose both could be defined as speculators.
Posted by: Ricardo at July 25, 2012 02:10 PM
Agenda driven studies...ha ha ha...look at the poor folks at the CFTC who had a paper concluding that speculation in energy markets was zip, until a change in administrations...paper is yanked...conclusions are wrong...go back do it again until you get it right...
Quite simply, on average speculation greases the wheels. most hedge funds lose money...most retail futures traders lose money...jointly they provide liquidity which helps keep the cost of hedging down....this has been studied ad infinitum...why is it that these stories must be told over and over again....
Once in while a bunch of idiots may be on one side or the other of the market...this will push prices in one direction or another...but kind of hard to see how they profit from this madness...just transfers from one group to another...back and forth...with a haircut...the CME loves it!
Posted by: pete at July 25, 2012 07:41 PM
Nice conclave today.
The outcome and demonstration of Hamilton Wu paper 2012 is to be read as, agriculture index funds are not the sources of pricing of commodities. The same paper does not negate speculation, it is merely demonstrating that the notional value of index funds contracts and volume do not provide for any guidance on the returns on contracts and subsequently on commodities prices. If speculation there is, it is an invitation to look elsewhere. Master report is made short of evidences, as too narrowly focused on commodity index funds.
Cash, bonds, futures, underlying assets, benevolent media or instrumental, publications are to be included in the feasible sets of speculators instruments.
The requirements of prices stabilization (Please see Econbrowser Commodity index funds and agricultural prices and comments) have shown through experience the necessity of controlling assets, inventories flows and worldwide pricing mechanism.
The domain of definition of stocks has to be enlarged to the strategic reserves, it may be found awkward that strategic reserves are reduced before a recession. Should they be strategic, they should either be constant or increased and yet the sinusoidal curves of those strategic reserves management ( IEA on OECD oil strategic reserves) prove otherwise. Should the definition of speculators to be “ anyone buying crude oil not for current consumption and not for future use” then, there is no lack of candidates to the definition “Banks and banks holdings companies have registered a very steady profit growth in aggregated amounts at the chapter commodities trading. When the average quarterly trading revenues since 2000 are a mere 106 million USD with a standard deviation of 166 million USD, they have been skyrocketing at 7906 million USD as of year 2011” OCC derivatives report. There is a nice relationship between the volume in the futures, prices and profits.
A Greek tragedy, when Banks record losses they are doomed, when recording profits the same. There is no one to stand for them, no one to admit their compliances.
Posted by: ppcm at July 26, 2012 12:53 AM
Here is what I don't understand about the "Blame the speculators" belief.
Let's assume, for the sake of argument, that the rascally speculators drove the annual price of Brent crude from $25 in 2002 to $55 in 2005, and then from $55 in 2005 to $111 in 2011 (with a year over year decline in 2009).
Why did we see a large increase in global annual crude oil production, in response to the 2002 to 2005 increase in price, but virtually no increase in global annual crude oil production in response to the 2005 to 2011 increase in price?
Posted by: Jeffrey J. Brown at July 26, 2012 06:00 AM
Sorry for going off topic, but this release is important in the ongoing carbon/oil wars.
Yes, NO EVIDENCE that fracking has caused drinking water pollution in Dimock, PA.
The article says: "Although the families alleged Cabot Oil & Gas Corp. ( COG ) contaminated groundwater to 11 homes, the EPA said the claims were unfounded....
Eleven homes were tested and the results didn't show "levels of contamination that could present a health concern," the EPA said. Federal regulators also found traces of arsenic sodium, methane, chromium or bacteria but those levels were "within safe ranges," it said. Two homes will be retested."
In another article, http://www.washingtontimes.com/news/2012/jul/25/epa-declares-water-dimock-pa-safe-drink-despite-fr/
"n its Wednesday announcement, EPA made clear that the pollutants it identified occur naturally in the area."
Let the fracking continue and the energy resource prices continue to drop!
Posted by: CoRev at July 26, 2012 06:29 AM
From a trader's perspective, here's the thing--
when speculators enter the market (as they did from 2003-08)and buy something like $100+ billion in oil (and hold it for years), who is there to sell it to them at the exact same price as when there weren't massive speculative buyers? And, I suppose as a corollary, why are these sellers willing to unwind their risky positions to accommodate speculators--presumably, once again without demanding price concessions?
Posted by: tinbox at July 26, 2012 11:33 AM
Thank you for the references on papers showing that speculation actually reduces prices rather than driving them up. The paper by Jacks was excellent.
Posted by: Ricardo at July 26, 2012 02:11 PM
Announcement to all readers: I have encountered a technical problem that prevents me from posting new posts, and approving comments to posts.
Posted by: Menzie Chinn at July 26, 2012 03:54 PM
Thanks, Lutz. When are you going to start your own blog?
Posted by: Phil Rothman at July 26, 2012 04:37 PM
Thanks for your interest in our work. I would like to clarify that we do not have an agenda driven study. We have a research agenda, like any other researcher does. Please note that the views expressed in our paper are those of our own and do not necessarily reflect those of the institutions we are affiliated to. There is a disclaimer at the bottom of our paper.
Finally, we have not invented any word. Interestingly, the study of Wei Xiong at Princeton University in collaboration with Ke Tong (available here: http://www.princeton.edu/~wxiong/papers/commodity.pdf) contains the word financialization in the title.
Posted by: Luciana Juvenal at July 27, 2012 03:04 PM
With all due respect, I don't find your rejoinder as having fully or properly addressed Kilian.
Even considering the model you pointed out in Appendix E, I don't think that exactly availed yourself of much criticism from Kilian-- especially when he points out that your speculative variable is a bit... "tacked-on."
I first noticed what he really meant when I was looking at your data. It seemed that the speculative supply movement and the global demand movement (which I believe you graphed in Appendix F?) both appeared to move very nicely together. Almost too nicely. Then I read, and saw that the "sign restriction" you apply to try and restrict your findings is not much of a restriction.
So with that said, you really make it appear as though you simply added some arbitrary ad-hoc assumption to try and tease out some phantom variable which you call speculation.
It's really an assault on your methodology, and I think despite your rejoinder, Kilian's points remain pretty firmly strong.
I'd absolutely love to hear more from you on this, if you feel like it. I understand EconBrowser is giving you some difficulties so I understand if that's a problem for you.
Posted by: CB at August 2, 2012 10:37 AM
surprised at the outcome there speculation actualy makes the price reduce. Lutz do you have a link to your own blog? Or do you just guest post?
Posted by: Dina Trixy at August 7, 2012 05:12 PM
No, I don't have a blog of my own, but I post all my working papers on my homepage.
Posted by: Lutz Kilian at August 8, 2012 10:31 AM