The recent run-up in oil price and other energy products between
2003 and 2008, and then their subsequent steep collapse within a
few months, to many economists appears to be a huge bubble that was
meant to burst (Eckaus, 2008). These developments in the price of
oil and in other energy markets have been mainly attributed to the
positions taken by financial investors on the futures markets, such
as pension funds, hedge funds, investment banks etc. These peculiar
dynamics of oil, and most of the energy commodities, have
transformed them into financial assets, and as such, they are
subject to speculative bubbles.
As Caballero et al. (2008) argue, the financial collapse of 2007
led investors into a search for an alternative asset class that has
diversification properties able to deliver positive returns during
a market downturn, and they found it in energy commodities and more
specifically in oil. According to them, it is this huge inflow of
capital towards energy commodities that created this huge rise in
oil prices towards the end of 2008, leading to a speculative bubble
that burst only a few months later. As Shleifer and Summers (1990)
point out, investors' reactions to common signals or their
overreaction to recent news can cause herding behaviour. However,
in the case of the oil futures markets, Boyd et al. (2009) and
Buyuksahin and Harris (2009) conclude that, during recent years,
herding among hedge funds did not destabilise the futures markets
because of its countercyclical nature. Moreover, in their study on
the performance of various hedge funds and commodity fund
investment styles during periods of bullish and bearish stock
markets, Edwards and Caglayan (2001) find that commodity funds
provide greater downside protection than hedge funds do.
There is also a number of researchers and economists that are
more sceptic as to whether the oil price spike was a bubble (see
Krugman, 2008; Pirrong, 2008; Smith, 2009), basing their argument
on the missing stockpiles of oil. In their opinion, betting in
higher future prices for oil and energy products, financial
speculators would have increased stockpiling where possible. In the
absence of stockpiling in oil and other energy products, their
argument states that physical markets could not have been affected
by speculation in the futures markets. On the other hand, above
ground storage and the creation of stockpiles, in the case of
energy markets is a very short-term concern as it is a very
expensive solution, when it is even physically applicable; only a
very low level of inventories relative to total production is
maintained at any given time. Based on the assumption of economic
equilibrium, Pierru and Babusiaux (2010) take on the view that an
increase in oil prices would reduce demand for oil, resulting in
any quantity of the non-consumed supply being stored. Based on this
economic viewpoint, any accumulation of stocks, even minimal, would
imply that the price of oil is driven by speculation above the
level set by market fundamentals. As Parsons (2010) states, during
the 2003-2008 period no such stockpiling occurred. Adding to the
later finding, Hamilton (2009b) argues that crude oil inventories
in 2007 and early 2008 were significantly lower than historical
levels. Even when investors expect that the long-term price of
energy products will remain high, it makes no economic sense for
them to increase their production levels in order to store any
excesses in facilities above ground until the time of sale. Thus,
the argument that the lack of stockpiling should support the belief
that the recent increase in energy prices was not a bubble can no
longer be considered valid.
Krugman (2008) and Smith (2009) argue that the price spike of
2007-2008 can be attributed purely to supply and demand factors. As
Hamilton (2009a, 2009b) and Kilian (2009) suggest, supply and
demand fundamentals can explain the recent price spikes, caused by
stagnant production and strong demand for energy products, which in
turn led the short-term elasticity of oil to historically low
levels. During the past decade, there has been a big swift in
market fundamentals, mostly caused by strong economic growth in the
developing countries like China, India, and Brazil, which was not
only rapid but at the same times persistent for a long period of
time, increasing demand for oil and other energy products. At the
same time, supply of oil and other energy products has been very
slow in adapting to the demand, because of falling supply rates
from mature and depleted oil fields, and because of the big time
lag between new investments in oil and energy production and actual
delivery of the projects. Thus, the aforementioned imbalance
between supply and demand can be attributed as the major factor for
the sharp price increase.
Nevertheless, as sound as the previous argument appears to be,
the recent transformation of the paper energy markets due to
increased investor appetite for alternative asset classes, which
can be very influential, is overlooked. According to Parsons
(2010), financial innovations made it possible for paper oil and
energy contracts to be considered as a pure financial asset, thus
making it very similar to equities in this regard, opening the way
for the development of a speculative bubble. Based on data reported
by the Bank for International Settlements (BIS, 2009) the notional
amounts outstanding and the gross market values of commodity
derivative contracts traded over-the-counter, including energy
contracts, in mid-2008 were $13 trillion and $2.2 trillion,
respectively. A big portion of these funds has been directed into
commodities' index funds or index trading, since investors can buy
into a commodity index much as they would buy into a mutual
Bank for International Settlements, 2009. Semi-annual OTC
Derivatives Statistics At End-June 2008, table 19,
Boyd, N., Buyuksahin, B., Haigh, M.S., Harris, J.H., 2009. The
impact of herding on futures prices, CFTC Working Paper.
Buyuksahin, B. and Harris, J.H., 2009. The role of speculators
in the crude oil futures market, Working paper.
Caballero, R.J., Farhi, E., Gourinchas, P.O., 2008. Financial
crash, commodity prices and global imbalances, Brookings Papers on
Economic Activity, Fall, 1-55.
Eckaus, R., 2008. The oil price really is a speculative bubble,
MIT Center for Energy and Environmental Policy, Research Working
Edwards, F.R., and Caglayan, M.O., 2001. Hedge fund and
commodity fund investment styles in bull and bear markets, Journal
of Portfolio Management, 27 (4), 97-108.
Hamilton, J.D., 2009a. Understanding crude oil prices, Energy
Journal, 30, 179-206.
Hamilton, J.D., 2009b. Causes and consequences of the oil shock
of 2007-08. Working Paper, University of California San Diego
Kilian, L., 2009. Not all oil price shocks are alike:
Disentangling demand and supply shocks in the crude oil market,
American Economic Review, 99 (3), 1053-1069.
Krugman, P., 2008. The oil non-bubble, The New York Times, http://www.nytimes.com/2008/05/12/opinion/12krugman.html.
Parsons, J.E., 2010. Black gold & Fool's gold: Speculation
in the oil futures market. Economia, 10 (2), 81-116.
Pierru, A., and Babusiaux, D., 2010. Speculation without oil
stockpiling as a signature: a dynamic perspective. OPEC Energy
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Pirrong, C., 2008. Stochastic fundamental volatiltiy,
speculation, and commodity storage, Working Paper, University of
Shleifer, A., Summers, L., 1990. The noise trader approach to
finance, The Journal of Economic Perspectives, 4, 19-33.
Smith, J.L., 2009. World oil: market or mayhem? Journal of
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