Fundamentals, non‐fundamentals and the oil price changes in 2007–2009 and 2014–2015

• Date: 01 June 2016
• Author: Carola Vallejo,Afshin Javan
• Published date: 01 June 2016
• DOI: http://doi.org/10.1111/opec.12071

Fundamentals, non-fundamentals and the oil

price changes in 2007–2009 and 2014–2015

Afshin Javan* and Carola Vallejo**

*OPEC/PSD/Modelling and Forecasting Analyst, Helferstorferstrasse 17, OPEC, Vienna, Austria. Email:

ajavan@opec.org

**Master’s Student, People’s Friendship University of Russia, Miklujo-Maklaya, 15, Moscow, Russia

117198. Email: vallejo.carola@gmail.com

Abstract

The fast increase in oil prices in the past 15 years and the spectacular fall in 2008 and in 2014 has led

to the rethinking of supply and demand as the only determinant price. It has been observed in the last

decade that large financial institutions, hedge funds, index funds and other investment funds invest

billions of dollars in the futures market benefiting from the changes in oil prices. We considered the

net long position of each trader category in the New York Mercantile Exchange to estimate, through

the Vector Error Correction Model (VECM), the impact of each category on oil price and on

volatility. Similarly, we also consider quarterly world oil demand, supply, inventories and industrial

production from 1993 and 2015. The results show that fundamental variables have a strong and long-

lasting relationship with oil price. Unlike the fundamental variables, the non-fundamental variables

very quickly became stable and react in a different way when the prices of oil rise and fall. The results

show that the main factor for the increase of the price in 2008 was the higher than expected demand.

For the 2014 decline the VECM shows that supply is the main force behind it. The non-fundamental

variables together can explain almost 11 per cent of the variations of the price in 2008–2009.

However, for the 2014–2015 period, the non-fundamental combined explained only 5 per cent. The

non-fundamental have low share in the changes in oil price despite having a strong effect on volatility.

1. Introduction

The fast increase of oil prices in the last 15 years and the spectacular fall in 2008 and in

2014 has led to the rethinking of supply and demand as the only factors that determine

the oil price. At first sight, these two factors do not seem enough to explain the recent

changes in oil price. The dramatic changes in oil price captured public attention and put

the spotlight on the high volatility of the oil prices and its consequences for the

economic, political and social sphere in consumer and producer countries as there is a

widespread concern that a high volatility in the price of oil is harmful to the economies

and to economic growth. In this regard, determining the cause of this high volatility in

oil prices is relevant from a policy standpoint.

JEL classification: C32, C58, O16, Q31 (or Q41).

©2016 Organization of the Petroleum Exporting Countries. Published by John Wiley & Sons Ltd, 9600 Garsington

Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

125

In the last decade, large financial institutions, hedge funds, index funds and other

investment funds have invested billions of dollars in the futures market benefiting from

the changes in oil prices. This has provided a new dynamic to the market. Some analysts

believe that the input of these financial investors has deformed the price of oil. This has

carried out policy efforts by the G20 and other bodies to establish an international

regulatory framework on derivatives market (G20 Leaders Statement: The Pittsburgh

Summit).

1

These regulations are aimed at boosting paper market transparency, minimise

market concentration, reduce the trading potential for market manipulation in each of the

G-20 members as well as have a coordinate politics regarding the regulatory framework.

According to the Pittsburgh Summit Statement of the G-20: ‘They took steps to fix the

broken regulatory system and started to implement sweeping reforms to reduce the risk

that financial excesses will again destabilise the global economy’.

The main objective of this study was to determine if indeed the increase in the oil

paper market trade has played a key role in the changes in oil price in 2008 and 2014.

We seek to compare the weight of the speculation and the fundamentals factors in the

price of oil in these two shocks. Due to weakness in the financial data before 2006 and in

order to take full advantage of the existing one, this research offers three different

approaches. The first one is focused in the financial market and its impact on the price of

oil. The second approach looks to measure the wage that the fundamentals factors such

as production, supply, demand and inventories have on oil price. The third considered

the effect of the non-fundamental variables on oil price volatility. This research will

address this matter using a Vector Error Correction Model (VECM) method.

The paper is organised as follows. Section 2 reviews the historical importance of the

increase and fall of the oil price in 2008, the decline in 2014 and also looks into the

genesis of the speculation theory. Section 3 briefly summarises the results of the main

studies that have approached this problem through vector autoregression (VAR) models.

Section 4 describes the data used. Section 5 makes a brief summary of the method

applied. Section 6 shows the results of the model, divided in the effects of the

fundamental and non-fundamental in oil price and oil price volatility. Section 7 is for the

conclusion and remarks and Section 8 for references.

2. Historical view

The price of oil has been characterised mostly by fluctuations related to supply and

demand. Fo r the past 30 years, as show in Graphic n°1, the oil price has steadily

increased, with few disruptive events in 1986, 1990 and 1998. All of these events related

to variations in demand or supply. From 2003, this increase has been faster than before,

especially after 2006. The oil price even saw an increase that tripled the real price by the

middle of 2007. At the beginning of that year, the price from $54 per barrel steepened

OPEC Energy Review June 2016 ©2016 Organization of the Petroleum Exporting Countries

126 Afshin Javan and Carola Vallejo