Paper oil and physical oil: has speculative pressure in oil futures increased volatility in spot oil prices?

• Published date: 01 September 2014
• DOI: http://doi.org/10.1111/opec.12036
• Author: Babajide Fowowe
• Date: 01 September 2014

Paper oil and physical oil: has speculative

pressure in oil futures increased volatility in

spot oil prices?

Babajide Fowowe

Lecturer, Department of Economics, University of Ibadan, Ibadan, Nigeria. Email:

babafowowe@hotmail.com

Abstract

A number of authors have attributed the high and volatile oil prices experienced since the turn of

the 21st century to increased speculative activities arising from a relaxation of regulations in

futures markets. This study examined the effectsof speculative pressure on the volatility of spot oil

prices. I constructed two measures of speculative pressure and modelled the volatility in oil returns

by using the GARCH autoregressive conditional jump intensity model of Chan and Maheu, which

models the effects of extreme news events in returns. Empirical results showed a significant posi-

tive coefficient for speculative pressure, implying that increased speculative pressure has contrib-

uted to volatile oil prices. This result is robust to different GARCH estimators and measures of

speculative pressure.

1. Introduction

The 21st century has been marked by unprecedentedly high and volatile oil prices. In

January 2000, the price of oil was $25/b; it remained relatively stable until September

2003, when it started rising, and this surge continued until it reached a peak of $145/b in

July 2008. The oil price subsequentlyplummeted, and by December 2008, it was less than

$40/b. The onset of the global financial crisis has been identified as the brake on the bull

run that the oil price experienced.

A number of authors have attributed the recent high oil prices to increased speculative

activities in oil futures. Medlock and Jaffe (2009) noted that there has been an increased

number of speculators in the oil futures markets since the 1990s, and not only has their

number increased,but they have accounted for a greater proportion of activity in the US oil

futures markets than physical playersin the oil industry in recent years (p. 3). Medlock and

Jaffe (2009) also noted that the market presence of non-commercial traders increased by

over 15-fold, while the market position of commercial traders doubled, and that this

increase in activities on the futures markets has been identified as a major cause of the high

and volatile oil prices by both industry playersand the academia. This increase in specula-

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tive activities has been largely attributed to the Commodity Futures Modernization Act

(CFMA) of 2000, which relaxed regulation in futures markets in the United States. The

CFMA clarifies that certain over-the-counter (OTC) derivatives transactions (including

those involving oil) are outside of the jurisdiction of the Commodity Futures Trading

Commission (CFTC).1This created a series of ‘loopholes’which created opportunities for

some derivatives transactions (including those involving oil) to be conducted without

regulatory oversight from the CFTC.2The ‘Enron loophole’ arose because the CFMA

stipulated that OTC derivatives trading in some ‘exempt commodities’ would not be

subject to CFTC regulation, with oil being on the ‘exempt’ list. The ‘London loophole’

refers to the case where exchanges outside the United States can offer energy futures con-

tracts in the United States, but are not subject to regulatory oversight by the CFTC. The

specific example relates to ICE Futures Europe, which operates from London and whose

West Texas Intermediate (WTI) futures contract is not subject to CFTC regulation. The

‘Swaps loophole’ arose because the CFMA exempted swaps transactions from position

limits, and institutional investors haveexploited this loophole to take larger positions than

they would be able to do if they traded directly on exchanges, where they might be con-

strained by speculative position limits (Jickling and Cunningham, 2008, p. CRS-8;

Medlock and Jaffe, 2009, p. 9).

The Organization of the PetroleumExpor ting Countries (OPEC) has been a loud voice

blaming the high and volatile oil prices on speculative activity in the oil futures markets.

OPEC (2007) published the findings from a joint EU–OPEC workshopheld in 2006 on the

impact of financial markets on the price of crude oil. The workshop found that while a

number of factors, such as demand growth (especially from China and the United States),

a lack of refining capacity, low investment in crude production and political instability,

were responsible for the recent increase in oil prices, speculation had been the primary

cause of the increased volatility of oil prices (p. 43). OPEC (2009) also reported the con-

clusions from another EU–OPEC workshop held in 2009.The workshop noted the positive

impacts of oil futures on the oil price, such as price discovery, eliminating payment risk,

allowing different expectations and information on participants’ part to be incorporated

into prices, and providing a cost-effective hedge (p. 25). However,the negative effects of

the futures markets on oil prices, which were manifested in increased volatility, were also

enumerated. Such negative consequences of financial markets include the occurrence of

large intraday price volatility, super-spike-type expectationsand price dynamics in futures

markets that exaggerated high price expectations (p. 26). OPEC (2011) maintained that

there was sufficient supplyin the oil market and that the high prices seen in the early part of

2011 of about $100/b represented a risk premium of between $15 and $20, primarily as a

result of speculative activities (p. 7).

This study conducts an empirical analysis of the effects of speculation on the volatility

of oil prices. Oil price dynamics have been shown to exhibit high volatility, jumps

Paper oil and physical oil 357

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