Living in an Era when Market Fundamentals Determine Crude Oil Price.

• Author: Perifanis, Theodosios

1. INTRODUCTION

   The crude oil price has shown considerable fuctuations over the last ten years. There is a long-standing debate concerning the fundamentals of the crude oil price dynamics. The global economic activity, the OPEC's strategy, the shale oil revolution, geopolitical tensions in the region of Middle East and North Africa (MENA), as well also in other regions, raise the attention of researchers and decision makers, concerning their influence on crude oil prices. The crude oil price now seems to follow a course mainly driven by economic and market fundamentals, rather than by geopolitical developments. Although political instability and disruptions were evident in many oil producing regions over the last three years leading to the evolution of wars in MENA region, the crude oil prices remained at relatively low levels.

   There is a long-standing debate on which are the fundamental drivers of crude oil price. The main question concerns on which factors, market fundamentals, economic, (geo)political or other prevail on the formation of crude oil price. The dominant role of OPEC has been identified in previous decades (Reza, 1984; Wood et. al., 2016). However, over the last years, the sharp penetration of shale oil producers, the sharp decreases of crude oil prices, the significant losses in balance sheets of OPEC members challenge the dominant role of OPEC and their potential to affect the crude oil prices. A recent paper (Pierru et. al., 2018) unveils the role of spare capacity in assessing the OPEC's impact on crude oil price volatility. When Loutia et. al. (2016) conclude that OPEC decisions affect changes over time and depend on production decisions and oil prices, while OPEC is less influential when prices are high and unconventional resources are viable. This can be partly explained by its recent statement. The 170 (th) (Extraordinary) Meeting of the OPEC Conference made the public statement: "Based on the above observations and analysis, OPEC Member Countries have decided to conduct a serious and constructive dialogue with non-member producing countries, with the objective to stabilize the oil market and avoid the adverse impacts in the short- and medium-term." (OPEC, 2016). This is enhanced by the fact that other economies, such as the Russian economy, are also oil dependent (Perifanis and Dagoumas, 2017).

   The agreement to cut production to rebalance the market initially showed results, as oil prices increased by 8% in the first quarter of 2017. (1) The price averaged at 52.9$/barrel, but a sharp decline followed in the second week of March, as shale production rebounded and inventories showed a persistent durability. World oil demand continued to increase but this was not enough to augment the pressure on the price, as this was at a slower pace than the previous years. Even if OPEC agreed to contract production by 1.2 Million barrels/day, in order to curtail any surpluses, the small shale producers seemed to have increased their drilling efficiency and be ready to exploit at low exploration costs. However, over the last weeks we notice a considerable increase in crude oil price, possibly related to the increasing tensions in Middle East, which might be not proved long-term lasting. West Texas Intermediate (WTI) and Brent indices were priced at 70.70$/bbl and 77.12$/bbl on 11th of May 2018.

   There is an extended literature review on oil prices and their main drivers. The research field incorporates a vast variety of variables. Most of the research includes macroeconomic variables, as MacAvoy (1982), who reached the conclusion that oil price can be explained by economic and market fundamentals. Ewing and Thompson (2007) include macroeconomic factors as the industrial production. They suggested that prices are procyclical. Dees et al. (2007) distinguishes oil prices in relation with demand and inventories, and OPEC's behaviour as with quotas and capacity. Kaufmann et al. (2004) propose that OECD stocks, capacity utilisation, production quotas and real production over the quotas explain oil price fuctuations. Kaufmann et al. (2008) highlights refining shortages to increase prices. Kaufmann and Ullman (2009) suggested that oil price responds to fundamentals and are magnified by financial speculation. On the contrary, Kaufmann (2011) justifes price's increase during the second half of 2010 to oil disruptions. Cifarelli and Paladino (2010) argue on oil price drivers, and suggested that speculation justifes better the prices than fundamentals. Les Coleman (2012) argues that oil price fuctuations can be explained by supply, demand, political, financial and shock components.

   In addition, Hamilton (1983) and Hamilton (2003) suggest price shocks have a significant economic negative effect. Especially Hamilton (2003) proposes that price shocks have asymmetrical effects, with price spikes to have much more powerful consequences than plummets. Hamilton (2005) suggests that as we extent the research period the less oil prices influence GDP growth. Mory (1993) proposes that the elasticity of GNP to oil price is low, at the level of -0.0551. Hooker (1996) argues that oil price is not a powerful determinant of economic activity as it was in the past, suggesting a structural break in 1975. Since then, unemployment and GDP cannot be explained by oil prices. Bernanke et al. (1997) argue that energy costs are a small fraction of the total production costs, and as a consequence the monetary policies to deal with oil price spikes harmed the output. Gault (2011) suggests that a 10$/barrel price increase, during the period when the price was around 100$/barrel, would increase consumer's price index decreasing the disposable income. If gasoline demand was decreased, then this would deepen GDP decrease, as reduced income in this sector of the economy would lower spending in others. Kim and Jung (2018) unveil the dependence structure between crude oil prices, exchange rates, and the United States interest rates. Barunik et. al. (2015) examine the volatility spillovers across petroleum markets.

   Considerable fuctuations were present as crude oil prices spiked to a peak of more than $145 per barrel in 2008 to a nadir of $32 per barrel in early 2009, in the heart of the global financial crisis. Then, crude oil prices increased sharply to more than 100$ per barrel in early 2011, remaining at those levels for more than 3 years, followed by a sharp decrease below the 40$ per barrel in late 2014, while prices were at levels of 50$ per barrel until June 2017. Since then prices follow an uptrend course. Although political tensions are evident in this period, those fuctuations are not strongly related to them. Economic and market factors, such as the economic activity, oil demand, OPEC and shale oil production are the key parameters in the literature review. Kisswani (2016), using monthly data from 1994 to 2014, examines whether OPEC acts as a cartel, and therefore affects crude oil prices. The findings of the paper show no evidence of cointegration between each member's production and that of OPEC indicating no cartel behavior at all exists. Moreover, the results show that OPEC production does not cause oil prices; rather it is the other way around. Okullo and Reynes, (2016) examined the imperfect cartelization of OPEC, by applying a model of global oil production. OPEC's supply strategy, although observed to be substantially more restrictive than that of a Cournot-Nash oligopoly, is found to still be more accommodative than that of a perfect cartel. The paper provides evidence that OPEC's ability to mark up the oil price is limited.

   The shale oil revolution proved to be a game changer, that raised attention in literature. Behar and Ritz (2017) developed a simple equilibrium model, examining fundamental market factors, aiming to rationalize a "regime switch" by OPEC to a market-share strategy, due to the evolution of a competent shale oil production. Khalifa et al. (2017) examines the role of oil rigs, finding a non-linear relationship between oil prices and oil rigs counts. The paper provides evidence that non-linearity has softened during the most recent years, where the relationship between the variables has been stabilized. Another factor examined in the literature is the effect of announcements and news on the crude oil prices. Loutia et. al., (2016), using an EGARCH model to capture some features characterizing oil prices volatility examined the effect of OPEC announcements, concluding that OPEC decisions' effect changes over time and depends on production decisions and oil prices. Ewing and Malik (2017) using an asymmetric GARCH model, suggest that it is best to include both asymmetric effects and structural breaks in a GARCH model to accurately estimate oil price volatility dynamics. The paper finds that both good and bad news have significantly more impact on volatility, if structural breaks are accounted for in a model. Few studies focus on quantifying the influence of political and geopolitical factors. Les Coleman (2012) uses fundamental and market parameters that cover financial markets, global economic growth, demand and supply of oil, geopolitical measures as well as dummies for terrorist activity and major industry events. Although, the analysis is holistic, the considered variables are for the period 1984-2007.

   Many researchers suggest that oil prices are infated or defated asymmetrically to market conditions by increased speculation. The phenomenon is referred as "paper oil", as it has not a physical substance. Kilian and Murphy (2010) argue that further trading regulation will not isolate price from demand, and as a matter of fact as soon as economy recovers, oil price will surge again.

   They add that the speculative demand played an important role in 1979, 1986, and 1999, and not between 2003 and mid-2008. Sornette et. al. (2009) found evidence of speculation on the crude oil prices bubble during the...