1. 1
Are fundamentals the maindrivers of volatility in crude oil prices and
how might they explain – or not – the 2001-2009 price cycle.
Oil markets today are of great importance to all of us. “Black Gold” as it is sometimes
known is used in nearly everything we do. Extreme volatility, known as “shocks” in
the price have been blamed for recessions, excessive inflation, reduced productivity
and lower economic growth. Significant research has been undertaken to try and
understand these extreme price volatilities.
There have been many oil price shocks and they have not just been a recent
phenomenon. The increase in volatility during the last price cycle has raised the
possibility of speculation playing a more critical role than previously thought. The
research in this area focuses on two differing views of what caused this dramatic
boom and bust scenario. Some researchers claim that recent price movements have
been caused by the emergence of money managers in the commodity market to
support the theory of financialization leading to speculation. The opposing view is
that financialiazation has little or no impact on recent oil price dynamics and it is
totally down to fundamentals through supply and demand. Oil markets are also
affected by political factors including the Organisation of Petroleum Exporting
Countries (OPEC) and these may have had an impact during the recent price shock.
Oil supply has been studied at length focusing on crude oil production and its direct
effect on price. Hamilton (2009) focused on hurricanes in the Gulf of Mexico in
September 2005 and trouble in Nigeria and Iraq which disrupted the supply chain
and caused shocks. However, global oil production remained relatively stable from
2000 to 2010. On the other hand there was a failure to increase production by the
required amount as prices rose during 2007-08. Hamilton (2009) points to this
being due to the oil exporting giant of Saudi Arabia, which has deliberately had a
high volatility of oil production. This was a strategy tostabilize prices, which is also a
strategy of OPEC to be discussed later. An example of the price stabilization strategy
was the kingdom’s decision to increase output in 1990 when there was a price shock,
leading to the price increase being very short lived. As this had historically been the
case analyst’s assumed this would continue. Between 2007 and 2010 Saudi Arabia’s
oil production feel by 850,000 barrels a day. This has led to a big change in pricing
dynamics with the loss of Saudis’ assumed willingness to adjust production to
maintain constant prices. Other research played down the impact of supply on oil
price shocks. Kilian (2008) concluded that supply shock measures alone do not
explain the majority of oil prices due to the large amount of precautionary storage of
oil. This is supported by Kilian and Murphy (2010) who found that supply shocks
only account for 4% of the variation in the real price of oil. So supply as a key part of
fundamentals can be seen to have had little impact on volatility. This research also
suggests supply had little impact on the 2001-2009 price cycle. This is compared

2. 2
with 11% due to speculative demand shocks and 85% being attributed to demand side
shocks.
Demand for Oil around the world has been growing throughout the last century as
we have found many new uses for it; and has led to our total dependence on this
commodity. To understand short run oil price volatility the most important fact is
that economic output leading to increased incomes is the key element of quantity
demanded not price. This is because as a country gets richer there is an increase in
cars, travel, eating of meat and clothing which all increase demand for oil. Hamilton
(2009) shows this as over the last 60 years in the US, even with huge variations in
the relative price of oil, petroleum consumption has followed economic and income
growth throughout. The recent price shock of 2007-08 was during a period where
production remained flat but there had been one key change in demand coming from
increased consumption of 870,000 extra barrels per day from China. This led to
other countries finding alternatives to oil as the price of oil grew. Alternatives like
hydrogen and wind had been struggled from lack of investment but the higher oil
prices made some of these projects viable. This research and development in
renewable areas should have positive social and environmental impacts going
forward as the length of time we can continue to rely on oil is still unknown.
According to the International Monetary Fund, real gross world product grew by 9.4
percent in 2004 and 2005. World petroleum production increased by 6 percent
between 2004 and 2005. It is reasonable to see this 6 percent increase in oil
consumption causing a shift in the demand curve triggered by the growth in world
income. Over 2006 and 2007, real world gross product grew 10.1 percent. If oil had
stayed at its 2005 price of $55 a barrel there
would have been an increase of 5 million
barrels a day demanded by December 2007.
Economic growth in 2008 slowed but there
still was enough growth to add 500,000
barrels a day. So we can assume that the
price rise between 2005 and the first half of
2008 had to be by an amount that would
reduce quantity demanded by 5 million
barrels a day, to 85.5 million barrels a day
(See chart). Hamilton 2009 and Gately and
Huntington 2002 believe the income
elasticity of petroleum demand in developed
countries is currently around 0.5, while
recently industrialized countries it is likely
to be above 1. This research suggests that
demand play’s a leading role in the volatility of oil prices and in the price shock of
2007-08. This supports earlier research discussed with the supply playing a limited
role in oil price shocks but demand plays a very central role. The growth of China and
the world’s increased demand for oil does have wider implications with drilling
having permanent damage to the landscape and the burning of fossil fuels also

3. 3
having a great impact on global warming and rising sea levels. Demand for oil is also
growing in developing countries such as India and so looking forward this type of
demand side shock could happen again.
Many of the researchers mentioned already, including Hamilton, believe that the
story of the oil price shock of 2007-08 can be fully explained by fundamentals.
However, the extreme nature of this episode has led to an alternative hypothesis
being proposed. This alternative denotes a speculative price bubble that burst. A lot
of studies have looked at the possibility that speculators engaged in what is known as
positive feedback trading in oil futures, which moves price away from fundamentals.
Positive feedback relates to the speculation model developed by Delong et al. (1990).
In regard to oil prices it’s proposed to have worked through speculators buying
futures as the price is rising with no reference to changing fundamental value of
crude oil. This is based on the rational that the price is rising and it will continue to
do so making profits for speculators. Cifarelli and Paladino (2010) investigated the
positive feedback trading strategies using heterogeneous agent models, based on the
interaction between two stylized types of traders. Through the GARCH-M model
estimation they used weekly data from 6 October 1992 to 24 June 2008. They found
that speculation played a substantial role in crude oil market in 2008 through
positive feedback ideology and that speculatively driven high prices can persist for a
significant time period before fundamentals bring them down to a fairer value.
However, speculation is hard to prove in oil markets as it often happens when there
are large changes in fundamentals also acting on the price.
Parsons (2010) also agreed that the oil spike of 2003-08 definitely looks like a typical
financial asset bubble caused by speculation in the oil futures market. Parsons (2010)
used a two-factor model with one factor being short term, transient factor and the
other a long term, lasting factor. He found that in the short run supply and demand
had an impact but in the long term random walk was observed and so he also
supported the argument that demand as well as speculation played an integral part
in the price of oil especially over the 2005-2008 period. Parsons also supported this
augment through evidence that other commodity prices were also rising radically
during this period. Commodities such as iron, steel, fabricated products and cement
are not traded through futures exchanges and so cannot form speculative bubbles in
the same manor. On the other hand this increase in many commodities may have
been caused by the increase in commodity index funds which is discussed later. In
these types of funds a large basket of commodities is invested in to spread the risk
however not many are purely oil. This assumed speculation of the oil market in 2008
has led to Congress to request position limits after airlines, trucking firms and
consumer groups who blamed speculators for the price shock of 2008. The
Commodity Futures Trading Commission has since approved new limits after
reducing the limits on speculative positions throughout the nineties when lobbied by
major financial institutions including Goldman Sachs. The evidence to support
speculation in the oil market is strong, however, it is not possible to say it was the
overriding factor. There is evidence to support its joint effect after increased demand

4. 4
was observed so fundamentals still play the driving role. The models used in this area
also have many weaknesses most importantly the ability to totally remove the effects
of fundamentals to observe speculative demand. The fundamental analysis is based
on figures making its impact clearer.
The relationship between futures and spot oil markets is very important with futures
contracts originally having the main purpose of providing hedging opportunities for
producers and consumers in the oil spot market. This was examined by Kaufmann
and Ullman (2009) were they studied the relationship between spot oil price and
crude oil futures. Using a two-step error correction model which over come’s the
problem of integrated time series variables also being cointegrated. They also used
full information maximum likelihood estimate for vector error correlation model.
They used daily price data for crude oils traded on spot and futures markets and
found that in the oil market, futures prices converge to spot prices in physical
markets because of the arbitrage process. This is what would be expected as the idea
is that spot price is naturally fixed by real economic factors including opportunity
costs and the cost of carry. If someone in the futures market bids well over the odds
they will lose money and eventually be wiped out as the arbitrager on the other side
makes profits and the high bidding stops. However this is not what happened as the
fundamentals may have shown increased price in the future this was continually
pushed up by speculators in particular index funds which could not take short
positions so forced the price up. Cifarelli and Paladino (2010) found that the impact
of the lagged rate of change of the futures oil prices was positive concluding that
futures price changes led to spot price variations and provides a threefold increase to
the value of the feedback trading.
The growth of global commodities under management was astronomical from $13
billion in 2003 to $260 billion in mid-2008 Cifarelli and Paladino (2010). This was
fuelled after the equity market crash of 2000 when it was found that there was a
small negative correlation between commodity returns and stock returns. This led to
investors trying to diversify their portfolios and lower their exposure tostocks by
investing in commodities. This allowed indexers to market commodity futures as a
new asset class for investors through the use of commodity index funds K Tang, W
Xiong (2010). The developments in diversification were used by pension funds who
sought protection against inflation. When oil performed so badly at the end of 2008
this had wider social impacts on pensioner’s long term future income and so a
negative social impact. The trading activities of index funds were in the virtual “paper
barrel” market as they have no need for delivery of the commodity making them
purely speculators. Between 2001 and 2008 the increasing use of commodities in
portfolios triggered a fundamental process of financialization amongst commodities
markets, through which oil prices grew into becoming more correlated with financial
assets K Tang, W Xiong 2010. The financialization of the oil market and improved
accessibility greatly increased oils use in portfolios through index funds increasing
the similarities between oil financial assets. This made the possibility of a speculative
bubble in the oil markets possible. This recent change in how the market operates is

5. 5
something that is hard to measure but clearly had an impact allowing more
participants into the market which links with the increased demand.
That market for oil has a unique combination of factors affecting its price. One key
difference between oil and other markets is the legal cartel that operates within it.
This organization is OPEC and it operates as a cartel of nations of the largest
petroleum exporting countries in the world producing around 40% of the world’s oil.
OPEC is not a classic cartel as it is run by politicians not firms. These politicians
pursue political and economic objectives. OPEC is a price maker which aims to
“coordinate their oil production policies in order to help stabilize the oil market”
(OPEC, 2008). There is a view that through OPECs anticipation of higher oil prices
held back production from 2001, through the use of oil below ground inventories,
Hamilton (2009). This is disputed as Kilian and Murphy (2010) tested this
hypothesis through a structural vector autoregressive model and found no evidence
to support this notion. This structural model was different to many of the others as it
included the role of oil inventories which is a key part of the oil market which most
countries holding some degree of reserves in case of supply disruption as seen in the
past.
With the increased volatility in the oil market since 2001 it may be inferred that
OPECs goals have not been achieved. However, M Rodetzki (2012) concluded that
the primary cause of price movements over the last 40 years was due to politics, not
economics. Rodetzki found OPEC collaboration has had some impact on oil prices,
however longer run oil price was caused by inadequate growth of production
capacity, caused by
nationalized oil enterprises
as well as greedy
governments that left oil
firms without investment
resources. This is an example
of the cobweb theory which
explains why prices might
have periodic fluctuations.
This theory is based on the
time lag between supply and
demand and happens in
markets where the quantity
produced is chosen before
prices can be observed. When
prices are high, investment in oil is profitable and is encouraged which leads to
increased supply. Increased supply leads to lower prices, which causes a fall in
investment. This in turn prompts the price to rise as the fall in investment leads to
shortages. This may have been why production didn’t keep up with demand between
2001-2008. The impact of OPEC has a direct effect on fundamentals. There has been
limited research into OPECs policy decisions during the 2001-2009 but we can see

6. 6
from the chart production was stable. This does not justify the price shock and
supports earlier supply side conclusions.
The main drivers of volatility in crude oil prices have been discussed with a focus on
the 2001-2009 price cycle. The fundamentals of supply and demand have been
shown to impact oil price volatility in varying degrees. Supply has had a minimal
impact on price movements as evidenced by the analysis of numerous supply shocks
in this period, both caused by market activity and OPEC intervention. On the other
hand, demand has played a crucial role in price volatility, with the price spiking
whenever demand increased. The increase in demand and improvement in access to
the oil market through financialization gave speculators and index funds the
opportunity to enter the market and they affected the price accordingly. This created
a perfect storm where demand for the commodity was increasing at the same time as
a new asset class was created that was much easier to get exposure tothrough the use
of financial products. Therefore demand side fundamentals are the main drivers of
volatility in crude oil prices and help explain the 2001-2009 price cycle.

7. 7
References
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De Long, J., Positive Feedback Investment Strategies and Destabilizing Rational
Speculation.
Hamilton, J., 2009. Causes and Consequences of the Oil Shock of 2007–08.
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Huntington, G. & Gately, D., 2002. The Asymmetric Effects of Changes in Price and
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