What is going on in the oil market?

In this article, we propose a consistent view on the recent oil-price history based on fundamental data and economic theory. We sum up: After the turn of the century three major stylized shocks have hit market. First, the demand curve has shifted fight outwards, mainly driven, as extensively reported in the media, by sustained growth in China and other Asian Countries. Second, supply disruptions in countries with low extraction costs (Iraq and Venezuela) have shifted the supply curve to the left. Third, we show that speculators adjust their inventories in order to take advantage of predictable price fluctuations and play themselves a major role in the price formation. Optimal storage theory implies that aggregate inventories are negatively related to the oil price and positively to the volatility of supply and demand shocks.

We provide evidence that the political events in the last years have increased volatility and induced the inventory curve to shift right outwards. We analyze in a graphical framework the interaction of all these shocks and conclude that speculators have caused the oil price to overshoot in the short run its long-run fundamental value. However, this is not at all attributable to market failure or the harmfulness of speculators. In fact, the opposite is true. Speculators have in general a dampening effect on the oil price. The record oil price in the very recent history is partly a consequence of speculators maintaining or building-up inventories to cope with the supply and demand shocks to come. Hence, high prices represent a short-term toll for future price stability.

It follows from our analysis that the oil price is expected to fall towards its long-term mean, provided that no further shocks hit the economy and, critically, the oil supply. As we saw, this prediction is consistent with the observed prices in the futures markets. Also in terms of future price volatility, the outlook is rather upbeat. The increased inventory levels held by speculators will cushion the spot market against fluctuations in natural supply and demand and limit the degree to which the currently high underlying volatility will translate into higher price volatility.