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Guest Contribution: Rejoinder to "Oil Price Spike Exacerbated by Wall Street Speculation?" by Lutz Kilian
Today, we are fortunate to have Luciana Juvenal and Ivan Petrella, as guest contributors. In this post, they respond to Wednesday's guest contribution by Lutz Kilian, entitled Oil Price Spike Exacerbated by Wall Street Speculation?.
Disentangling the main drivers of oil prices is a critical first step for allocating resources and designing good policy.
In our paper, “Speculation in the Oil Market,” we assess the roles of speculation and supply and demand forces as sources of oil price fluctuations.
Our main finding is that global demand has been the primary driver of oil prices.
An expanding global economy increases the demand for raw inputs, including oil, which pushes up prices. Borrowing from our abstract and conclusion our main message is:
“Our results support the view that the recent oil price increase is mainly driven by the strength of global demand but that the financialization process of commodity markets also played a role.”
“Our results highlight a major challenge faced by policymakers in the medium to long-run: Although speculation played a significant role, the high oil prices witnessed in the past decade are mainly due to demand pressures, which are likely to resurge with the recovery of the world economy.”
Our conclusions are thus in line with a large strand of the literature, including Kilian’s own contributions.
Kilian’s blog post presents a misleading interpretation of our study. His comments are partly triggered by how some media have interpreted our paper, which we are naturally unable to control. A non-technical summary of our paper can be found in our Economic Synopses. It turns out that we do not disagree with most of the substantive conclusions that Kilian puts forward and a full reading of our paper should make that clear.
Kilian refers mainly to a report in the Huffington Post, March 20, 2012. He ignores other media reports that have provided an accurate interpretation of our paper. As an example, see Brad Plumer’s post on WonkBlog of the Washington Post. Quoting from that blog: “Indeed, the idea that speculators play a secondary role is essentially what the St. Louis Fed paper, written by Luciana Juvenal and Ivan Petrella concluded. They found that about 44 percent of the price increase between 2004 and 2008 — when oil zoomed up to $140 per barrel — was driven by shifts in global demand. Countries like China, India, and Brazil kept using more oil, while production from countries like Saudi Arabia couldn’t keep up. But an additional 15 percent of the price increase was caused by speculators.”
Aside from highlighting only one, inaccurate media report about our paper, Kilian criticizes our work on various technical issues. We would like to respond to his main criticisms.
- Identification. Kilian notes that we identify speculation as “an exogenous upward shift in oil producers’ expectations of the real price of oil (possibly driven by the financialization of oil futures markets).” Under this condition supply and demand move in opposite directions and we are clear about this mechanism in our paper (see Appendix E). Kilian says that this hypothesis is not an implication from economic theory. However, our paper provides a framework that reconciles our analysis with standard theory of exhaustible resources (Appendix E).
- The 1990 oil shock. Kilian writes that according to our analysis, oil production should have declined after the invasion of Kuwait. In our model, however, this episode is captured by the oil inventory demand shock. As explained in our paper, this shock arises in the presence of uncertainty about future oil supplies, driven, for example, by political instability in key oil-producing countries (as is the case of the invasion of Kuwait). A positive oil inventory demand shock raises demand for inventories, causing the level of inventories and real oil prices to increase. Inventories of crude oil increase so that supply can meet demand in the event of supply shortfalls or unexpected shifts in demand (see Alquist and Kilian, 2010). The increase in the real price of oil provides an incentive for oil producers to increase production. Therefore, our analysis suggests that oil production should increase after the invasion of Kuwait.
- Is the oil inventory demand shock redundant? Kilian writes that adding our speculative shock renders the oil inventory demand shock proposed by Kilian and Murphy (2011) redundant. If, however, this were true we would not be able to separately identify the oil inventory demand shock and the speculative shock. In fact, we use a simple model in Appendix E to inform sign restrictions on the two shocks that distinguish between their effects on supply. We identify speculation as having a negative impact on supply. A shift in the oil inventory demand need be not matched by a contemporaneous shift in supply. For example, any shift of the convenience yield, such as the one modelled in Alquist and Kilian (2010), also implies an increase in total demand (specifically the precautionary demand for oil inventories) but does not imply a contemporaneous shift of the supply curve. Kilian then argues that we claim that the Kilian-Murphy model is wrong. We never write or imply this anywhere in our paper. Quite the opposite, we build on their contribution.
- Differences in approach. Kilian affirms that “One obvious difference is that the original Kilian-Murphy analysis was based on uncontroversial implications of standard economic models rather than ad hoc assumptions without basis in economic theory.” To the best of our knowledge, Kilian and Murphy (2011) do not present any theoretical model to guide their identification strategy. Their reference to theory is Alquist and Kilian (2010) which is nested in the simplified model we propose in our Appendix E.
- Speculation and real economic activity. Kilian describes that our findings indicate that a speculative shock is associated with an increase in real economic activity and suggests that this “would imply that what is needed in today’s economy are more speculators in oil markets.” Our paper does not suggest this. In fact, we do not impose a sign restriction on the response of real economic activity to a speculation shock as there are two forces that operate in opposite directions. In principle, the oil price increase would have a contractionary effect on demand and economic activity. We are not comfortable imposing such a restriction because we do not want to rule out the possibility that an increase of financial speculation is triggered by low real interest rates, as suggested by Frankel (1986 and 2008). As Frankel explains, low interest rates may have a number of effects on commodity markets. On the financial side, lower real rates reduce the cost of "carry trade" in the commodity markets, amplifying the effect of a mismatch between expected future spot prices and futures prices. In the physical side of the market, real rates represent the opportunity cost of holding inventories both above and below ground. This channel would imply a positive effect on real activity (see Frankel and Rose, 2010), therefore we chose to remain agnostic and not impose any restriction. This is also consistent with the framework we provide in Appendix E of our paper.
- Speculation in the last decade. Kilian argues that the fact that the historical decomposition is flat when many pundits suspected particularly large speculative pressures, is puzzling. We disagree with his conclusion. We discuss a simple explanation for this pattern in our paper: “Another feature of interest is that the contribution of speculative shocks to oil price increases becomes flatter from 2007 until 2008. This highlights that the gains from speculation decrease as the oil price goes up.” We give a simple example of why speculation is less likely to be present when prices are higher. Quoted from our paper (footnote 29): “Let us illustrate this claim with a simple example that applies to contango periods like the one observed in 2004-2007. Suppose that the spot price is 30 USD, the 1 year forward price is 60 USD, the interest rate is 10%, and there are no storage costs. An investor would borrow 30 USD, buy oil, wait for delivery and sell it for 60 USD. The total cost for the investor is 33, and the revenue is 27. Now assume that the forward curve shifts upwards, so that the spot price is 100 USD and the forward price is 130 USD. In this case the total cost for the investor is 110 USD, and the revenue is 20 USD.” Moreover, let us add that, according to the dating in Singleton (2011), the oil market was in contango between 2004 and 2007 and backwardation during the spike of 2007-2008.
Overall, we believe that we have more points of agreement with Kilian than disagreement. We encourage the reader to have a look at our paper.
This post written by by Luciana Juvenal and Ivan Petrella
Posted by Menzie Chinn, on 7/26/2012, 3:45PM Pacific