Is the argument over who caused crude prices to spike – speculators or market supply-and-demand fundamentals – too simplistic? The Oxford Energy Studies Institute has published a lengthy paper by Bassam Fattouh arguing that it is. The paper is for the meeting of the world’s energy ministers taking place in Cancun in March, but all 60-odd pages are available online now.
Fattouh notes that despite numerous attempts, there’s little conclusive evidence on the culpability of speculators on crude prices. He points also to problems in the physical market, which he says is relatively illiquid, lacking in transparency and dominated by a few players. The futures markets meanwhile are “more transparent, highly liquid and characterised by a large number of players with diverse expectations”. He writes:
An important question that demands deeper research is whether greater transparency in the physical market, and the creation of multiple benchmarks based on more liquid markets, would help reduce volatility by revealing more accurate information about the fundamentals in the physical market.
Here is his description of what happened between 2002 and 2008:
As oil prices rose sharply during the boom years in the 2000s, uncertainty about the existence of and timing of feedbacks from prices to oil supply and demand increased markedly. The perception of strong feedbacks in the oil market was replaced by the perception of limited feedbacks. Key feedbacks absent during this period were a) the perception that high oil prices would trigger a rise in global inflation rates and a subsequent recession, tempering growth in the demand for oil; b) that high oil prices would induce strong growth in non-OPEC supply; and c) that OPEC would increase its oil supply to prevent oil prices from rising to high levels as high and volatile oil prices may result in the long-term destruction of oil demand.
Those doubts about the existence of feedbacks heightened in the first half of 2008, he writes, which meant a wide range of public information signals were influencing prices, sometimes having a disproportionate effect.
So what was it that led to the these doubts in feedback existence? Fattouh explains that some of the long-held assumptions about oil market characteristics were challenged as it became clear that the supply and demand interaction in oil markets has some particular complexities — such as weak short-term price sensitivity, high income response. The idea that high oil prices would always hurt economic growth was also damaged by the fact that inflationary expectations failed to rise along with oil prices in 2002 – 2008.
As for the specific events and signals that led to the price run-up to mid-2008, Fattouh lists a few things: Non-Opec supply growth rates themselves are volatile and they operate with almost no spare capacity. Decline rates are rising, and the easy oil is gone. And more complexities of the Opec cartel have emerged: “Specifically, the latest boom has shown that a key objective of OPEC is to avoid oil prices from falling below some level deemed unacceptable by its members.”
Fattouh identifies specific signals that then led to the crude price fall from its peak in July 2008 as originally coming from the June 2008 Jeddah meeting, and then the financial crisis. The climbing of prices by the second quarter of 2009 was due to perceptions that a quick global recovery might be underway, and that a supply crunch caused by under-investment was looming.
Financial reforms in the wake of the recent crisis, he writes, are aimed at reducing risk-taking behaviour by financial institutions; whereas the goal in energy markets is to reduce price volatility.
Furthermore, if the main objective of proposed regulations is to tackle sharp rises in commodity prices, then authorities should widen the policy options to include the role of monetary policy (for instance by making asset price stability a target for monetary policy), prudential regulation, or even fiscal policy (by reducing overall demand).
Reader Q&A with Dr Fatih Birol (FT Energy Source)
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