Projects
September 2010 / December 2015

Financial Speculation in the Oil Market

Financial trading and speculation in the oil market are relatively recent and well-documented phenomena. Theory suggests that the creation of a financial demand for a specific commodity (e.g. oil) can have a relevant impact on the determination of the spot price for that commodity. Commodities, which, in absence of a financial demand, should be traditionally evaluated as pure commodity using the equilibrium price between demand and supply (physical price), share today the features of financial assets, whose value is determined by the discounted expected value of fundamentals and speculative movements (financial price).

Financial trading and speculation in the oil market are relatively recent and well-documented phenomena. Theory suggests that the creation of a financial demand for a specific commodity (e.g. oil) can have a relevant impact on the determination of the spot price for that commodity. Commodities, which, in absence of a financial demand, should be traditionally evaluated as pure commodity using the equilibrium price between demand and supply (physical price), share today the features of financial assets, whose value is determined by the discounted expected value of fundamentals and speculative movements (financial price). The actual price of that commodity corresponds to the maximum between the physical and the financial price. As a consequence, it is extremely important to study the behaviour of financial trading and speculation in the oil market and to analyze the effects on producers and investors, in order to answer to relevant questions, such as: Is it possible to identify a long-run equilibrium oil price? Are the correlations between the price of oil and relevant macroeconomic variables (exchange rates, interest rates, stock market indices) stable? Is it possible to define and measure speculation? Is speculation correlated to oil futures price dynamics and volatility?

The project is articulated in four parts:

  • Descriptive analysis of the role of speculation in the oil derivatives market over the period 1990-2010. This part discusses some stylized facts on: the financialization of the oil market; the role and definition of speculation; the impact of speculation on spot and futures oil prices; the impact of speculation on oil price volatility.
  • Modelling the relationship between financial trading activity and futures price volatility in energy markets. In this part of the project reduced-form econometric models are used to investigate the relationship between financial trading and oil price volatility. In particular, the relationship between volume and volatility is tested using different definitions of volatility (e.g. absolute returns, squared range, etc.) and different empirical strategies (e.g. short- vs long-memory approaches), coupled with estimates of the market depth and evaluation of position limits. The relationship between open interest and volatility distinguishes between aggregate data and the CFTC’s classification of traders. The long-run causes of volatility of the energy prices are also investigated.
  • Exploring the relationship between risk premium in energy and non-energy commodities futures prices and financial speculation. This part of the project focuses on the following research question: how speculation and macroeconomic variables affect futures price returns of energy and non-energy commodities? The econometric analysis is conducted using univariate as well as multivariate GARCH models over the period 1986-2010, using daily, weekly and monthly data on the futures prices of 4 energy commodities (oil, gasoline, heating oil, natural gas) and 9 non-energy commodities (cocoa, coffee, corn, cotton, oats, soybean oil, soybeans, sugar, wheat) .
  • Explaining the determinants of the price of oil with a large-scale macroeconometric model. This model allows to: compute the contribution of each structural shock to the oil price forecast error variance; analyze the transmission mechanism through which structural shocks affect the oil price, as well as the effects of an oil price shock on the global economy; reconstruct the historical evolution of the “fundamental” oil price, as well as its decomposition in the various fundamental components; evaluate the effects of speculative shocks on the actual oil price.
Main Results and Outputs

The main goals of the projects are:

  • To provide the Research Centre, eni with a thorough vision of the most recent research frontier on oil and commodities markets. As a consequence, eni will be able to internalize the econometric and market-analysis skills and to apply appropriate quantitative techniques to analyze relevant economic questions.
  • To allow FEEM to consolidate its internal research competence on energy markets, by strengthening its links with leading international researchers and building up a team of junior researchers with strong quantitative skills, who will be able to promote autonomous research activities in the field.
  • To organize an international conference, which will bring together top-level academics and analysts of the oil market to present and discuss recent methodological approaches and results on the role of financial speculation in the oil market. This conference will be held at the premises of FEEM-Milan, around in mid January 2012.
  • To organize a permanent observatory on the dynamics of the price of oil as well as the price of other relevant commodities. The observatory would draw upon a selected number of econometric models and the systematic study of the available market data. Both econometric models and market data would be monitored and improved periodically and would allow FEEM and eni to critically analyze the evolution of the oil market.
Project team

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