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Oil price formation: Fundamentals versus financial markets approach. Some ideas.

Published on

September 4, 2019

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Article by

Hermes Pérez

In the next lines, we will study the relationship between the formation of oil prices and the increasing impact that financial markets have had on the formation of prices of commodities markets and, in particular, crude oil.

Content

  1. Introduction
  2. Deregulation of financial derivatives and energy derivatives.
  3. Evolution of the financial operations of crude oil.
  4. Relationship between physical demand and the financial demand. Financialization of oil.
  5. Impact of financial markets on oil prices. Anecdotal evidence.
  6. The position of some institutions on the subject.
  7. Petroleum Intelligence Weekly (PIW) and its opinion on the subject.
  8. Some final ideas.

1. Introduction

The daily volume of oil trade in 2017 was equal to:

5 million barrels per day (MBD) in the physical markets(1).
1,609.3 MBD in the financial markets(2).

This last figure was equivalent to more than 16 times the value of what was negotiated in the physical markets.

In this regard, it seems difficult to discard the idea that the higher oil volumes traded in the financial markets had nothing to do with the determination of their price(3).

In this sense, it can be affirmed that some commodities began to undergo fundamental changes in the determination of their prices(4) since the rise of the financial markets in 2001.

Thus, there seems to be statistical evidence, anecdotal and common sense, which suggests that the determination of oil prices also depends on the decisions made in the financial markets of the world and not in the oil market exclusively.

On the other hand, there was an almost exponential expansion of the financial markets of commodities, which started at the end of 2001. This, due to the deregulation of this market, financial innovations and the entry of new participants.

This transformation could support the hypothesis that structural changes occurred in the process of price formation in some commodities and in particular the oil market.

Therefore, in the following lines we will analyze how the process of deregulation that registered the market of financial derivatives in 2001, and in particular energy, led to an explosive increase in this activity. We will see how financial crude oil operations grew exponentially after deregulation and financial innovations.

In addition, we will analyze how it has been the numerical relationship between purchases of physical crude oil and purchases of crude oil in financial markets, the latter being immensely greater than the former. We will present some anecdotal examples of measures in the money markets that affected the financial markets of crude oil and its prices. In the same way, we will comment what is the opinion of some important institutions on the subject and we will finish with some final ideas.

2. Deregulation of financial derivatives and energy derivatives.

The Commodity Futures Modernization Act of 2000 (CFMA) was enacted in December 2000, in which most of the derivatives were no longer regulated. The CFMA exempted from any regulation by the Commodity Futures Trading Commission (Commission or CFTC) to energy derivative contracts. These exceptions are known as The Enron Loophole (Jickling, M., 2008).

The CFMA established three categories of instruments subject to various degrees of regulation.

  1. The financiers. With little regulation.
  2. The agricultural. They were totally prohibited.
  3. The exempt ones (Metals and energy).

The liberalization led to the volume of financial contracts of some commodities growing amid 5 and 7 times between 2000 and 2009. In addition, the number and variety of agreements negotiated rose close to 7 times and many of these increased their complexity (CFTC, 2010).

3. Evolution of the financial operations of crude oil.

The oil financial operations began in New York in 1986, with an average of 74,000 contracts per week. In March 1995, the purchase and sale of oil options began with 58 contracts per week.

In 2017, an average of 7.265 million contracts were negotiated weekly, which was equivalent to an approximate volume of $ 19.248 billion. It should be noted that a single contract is equivalent to 1,000 barrels of oil. This meant that crude oil contracts negotiated in the financial markets accounted for more than 16 times the value of the physical supply of crude oil in the world in 2017.

In 2018, the average number of negotiated contracts of oil stood at 8.056 million weekly.

• The operations of crude oil in the financial markets expanded at an average annual rate of 14.6% between 1995 and 2001. Its boom began in 2002, registering an annual growth of 54% until 2017.

4. Relationship between physical demand and the financial demand. Financialization of oil.

It seems difficult to discard that higher volumes traded in the oil financial markets have nothing to do with their price. In this sense, it can be affirmed that some commodities began to undergo fundamental changes in the determination of their prices since the rise of the financial markets, at the end of 2001.

• The index of financialization of oil reveals the growing importance of financial elements in this market, particularly since 2002.

 

5. Impact of financial markets on oil prices. Anecdotal evidence.

The price of oil was around USD 90 between 2009 and 2014. Then, it went down 70% between June 20, 2014 and February 11, 2016.

The fall in oil prices started after the Federal Reserve (FED) announced the rise in the official interest rate (06/18/14), which signaled the start of the normalization phase of monetary policy. This induced the appreciation of the dollar and encouraged the restructuring of portfolios in the financial markets.

In 2017, Bloomberg reported several times that the volume of West Texas Intermediate options reached historical highs in this year and surpassed an amount equivalent to more than 500 million barrels per day. This data did not include futures or other synthetic oil operations such as swaps.

6. The position of some institutions on the subject.

In this regard, Organization of the Petroleum Exporting Countries (OPEC) the International Energy Agency (IEA) and The U.S Energy Information Administration (EIA) include fixed segments in their periodic reports on the financial markets of oil.

For example, the IEA developed a supplement dedicated to the subject of derivatives. “Special Supplement. The mechanics of the derivatives markets. What they are and how they function“. April 2011.

In the same way, the EIA acknowledged that one of the preponderant elements in the determination of oil prices is associated with financial markets. U.S Energy Information Administration (2016). “What drives crude oil prices?. May 10, 2016. Washington, DC.

 

The Federal Reserve of New York, includes in one of its models of estimation of oil prices variables associated with financial markets. Groen, J., et Al (2013). “A new approach for identifying demand and supply shocks in the oil market”.

7. Petroleum Intelligence Weekly (PIW) and its opinion on the subject.

PIW® June 12, 2017. Market Mayhem
“NEW YORK — High-frequency and algorithmic traders are having a ball with oil futures. Supercharged computers pushed trading volumes to new records on electronic exchanges, turning the oil price focus from fundamentals to nanoseconds. US West Texas Intermediate (WTI) last week traded a record of 37,000 contracts on the Nymex that whacked oil down $1.30 per barrel in a single minute after disappointing US inventory data was released.

Combined, exchanges now trade close to 3 million crude contracts per day, more than 30 times global daily fuel consumption. The question is whether this maelstrom of machine power is distorting the oil price or just adding to liquidity. Price volatility invites more traders to market that have an appetite for such wild swings. Traders say the market is now highly focused on technical analysis, which is programmed into many of the computers that execute trades without human intervention.

High-frequency trading is not new to the oil market. What is new is that, seemingly at random, flash trades generate volumes of 5,000 contracts or more per minute — a rarity even a few months ago, only seen on Wednesday mornings 10:30 AM New York time when the US government releases weekly petroleum data. These trades whack around the oil price. Opec must cringe. It gave the market unprecedented long-term guidance by extending its 1.2 million barrels per day output cut another nine months for the explicit purpose of creating price stability and a floor (PIWMay29’17)”.

8. Some final ideas.

It seems to be clear that the fundamentals associated with the oil market do not completely explain the evolution of oil prices as of 2002.

In particular, they find it difficult to interpret their movement between 2007 and until mid-2008, and the trend observed as of the second half of 2014, just to mention a couple of cases.

In this regard, there is abundant evidence, statistics, anecdotal and common sense that supports the thesis that financial markets have a large impact on oil markets.
Therefore, if we consider the exposed results, it must be affirmed that the emergence of financial markets has played an important role in this market.
For these reasons, the financial variables must be taken into the consideration when evaluating the oil market variables.

 

Bibliography

• Baffes, John, et Al (2015). “The Great Plunge in Oil Prices: Causes, Consequences, and Policy Responses”. World Bank Group. Policy Research Note. March 2015. PNR/15/01.
• Beidas-Strong, S., and Andrea Pescatori (2014). “Oil price volatility and the role of speculation”. December 2014. IMF Working Paper WP/14/218.
• Büyüksahim, B., et Al (2008). “Fundamental, trader activity and derivative pricing”. Commodity Futures Trading Commission.
• Chevalier, Julien (2013). “Price relationships in crude oil futures: new evidence from CFTC disaggregated data”. Journal of Environmental Economics and Policy Studies. (2013) 15:133-170.
• Fawaz , K., Jamie Webster (2015). “Money flows matter: The expanding role of financial markets in oil price setting”. IHS Energy. Global Oil Markets. March 2015.
• Hannesson, R. (2012). “Does de Speculation drive the price of oil?” OPEC Energy Review 2012.
• Jee-Hoon, L. (2007). “Causes and future of surging oil prices”. Samsung Economic Research Institute.
• Jickling, Mark (2008). “The Enron loophole”. CRS Report for Congress. July.
• Juvental, L., and Ivan Petrella (2012). “Speculation in the oil market”. Federal Reserve Bank of S. Louis. Working Paper Series 2011-027E.
• Lombardi, M., and Ine V. Robays (2011). “Do financial investors destabilize the oil prices?” European Central Bank. Working papers series, No. 1346. June.
• Turner A., et Al (2011). “The oil trading markets, 2003-2010: Analysis of market behavior and possible policy responses”. The Oxford Institute for Energy Studies. April, WPM-42.
• United States Senate (2006). “The role of market speculation in rising oil and gas prices”. Staff Report. Permanent Subcommittee on Investigations. June.
• U.S Energy Information Administration (2016). “What drives crude oil prices?. May 10, 2016. Washington, DC.


1 / According to Oil Market Intelligence.
2 / Own calculations.
3 / Baffes, John, et al (2015); BIS (2015); Beidas-Strong, S., and Andrea Pescatori (2014); Büyüksahim, B., et al (2008); Chevalier, Julien (2013); Fawaz , K., Jamie Webster (2015); Hannesson, R.(2012); Jee-Hoon, L. (2007); Juvental, L., and Ivan Petrella (2012); Lombardi, M., and Ine V. Robays (2011); Turner A., et al (2011); US Senate (2006) y US EIA (2016).
4 / Anzuini, Alessio, et al (2010); Henderson, Brian j., et Al (2014); BIS (2015); Büyüksahim, B., Michel A. Robe (2011) y Xiong, Wei and Ing-Han Cheng (2014).

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