By Shawkat Hammoudeh and Robert Kaufmann
Several decades of research indicate that natural gas markets are regionalized, while oil markets are globalized. Morris Adelman of MIT advanced the notion that the different grades of crude oil belong to “one great pool.” This view is important for the price discovery process. Once an economic, political or weather shock strikes, some prices will lead while others follow suit to equilibrate with the leader, leaving some room for price differentiation in terms of transportation cost and grade quality (ie, sulfur content and API gravity). The leaders are considered ‘gateways' through which price shocks enter the market and spread to other crude oils. But in the oil market, spot and futures prices also have their individual determinants. Moreover, crude oils are produced in different regions and shocks may start in one region and then propagate to other regions. There are different views on where a shock enters the oil markets and how it spreads.
Distinguishing between leaders and followers on spot and futures markets has implications that may help us understand how oil prices exceeded $147/B in July 2008. Was the rise caused by fundamentals or speculators? If spot prices move futures prices, fundamentals probably play an important role in moving shocks through the market. For example, the strong demand for oil that originated in China, India and the Middle East since 2004 may have contributed significantly to the acceleration in oil prices. Alternatively, if futures prices dominate, then speculators may be largely responsible for the price increase. There could also be a mix of both, as speculators along the road ride on the fundamentals' wagon.
The literature is divided over where shocks enter the system and how they spread. Some economists such as Weiner 1 and Quan 2 believe that shocks hit spot prices and then unidirectionally move to futures prices. Others such as Schwarz and Szakmary 3 , Gulen 4 , and Bachmeier and Griffin 5 have the opposite view that innovations (shocks) impact futures prices through expectation formation and then move to spot prices. A third view starts with the notion that futures prices affect spot prices, but this relationship can change over time due to structural events such as the 1997 Asian crisis and the 2003 Iraq war. A fourth view takes geography as an important confounding factor in determining whether shocks initially affect spot or futures prices. Nor are these explanations mutually exclusive. A structural break hypothesis combines the first and third views, arguing that the surge in oil prices starts with fundamentals and accelerates as the speculators enter an overvalued market with the expectation that prices will continue to rise.
Dubai Fateh ‘Gateway'
In terms of geography, Kaufmann and Ullman 6 assert that shocks first appear in the spot price for Dubai Fateh crude and then spread to both spot and futures prices in other regions such as North America, Europe, Africa and East Asia. In this case, Dubai Fateh is considered a ‘gateway' crude oil. The Dubai benchmark represents medium, sour crudes that have traded spreads with WTI and Brent. This benchmark crude is currently traded at the Dubai Mercantile Exchange (DME) and London's Intercontinental Exchange (ICE). The presence of DME and the supplementing of Dubai crude with Oman crude may result in the Dubai benchmark becoming more liquid, more actively traded and being one to watch for in the near future. DME should work on creating more financially settled futures contracts to boost liquidity, which usually attracts more liquidity. Most of the Middle East oil is represented by this medium benchmark, whether in terms of oil exports or reserves. A large fraction of the crude oil shipped to Asian nations from the Middle East (more than 10mn b/d) uses the spot price for Dubai Fateh as a benchmark. As such, shocks in the spot price for Dubai Fateh may reflect increasing demand in Asian countries such as China and India. Moreover, this oil is produced in an area that is home to two important wars, lengthy embargos, and chronic political conflicts, which make the price for local crude oils ultra-sensitive to political shocks.
Research also views the spot price for Mayan crude (Mexico) to be a follower or a dead-end in the sense that it receives shocks from other crude oils but does not affect the price for any of the other crude oils. Maya is a heavy, sour crude and sells at a significant discount to WTI and Brent. It is worth noting that Maya is illiquid because it is not actively traded on any oil futures market.
Kaufmann and Ullman also contend that other shocks initially appear in WTI futures prices and spread to other trading centers and contracts of different maturity. The effect of such shocks may be amplified by asymmetry in the causal relationships in the futures market, which favor price increases over price decreases. Those authors also find empirical evidence that the long-run causal relationship from futures to spot is weak and the strong surge in demand for commodities starting in 2004 may have altered this relationship. In sum, they believe that the fundamental factors and not the speculators were primarily behind the steady increase in oil prices over the period 2004-07, but speculators made the prices skyrocket since 2007. Among crude types in different regions, Hammoudeh and Li 7 assert that WTI spot or futures move first and then the shock spreads to Brent before it moves to other regions. Among gasoline geographical types, these two authors contend that shocks first appear in the spot price on Nymex and then spread to the spot prices the US Gulf coast, Rotterdam, and Singapore.
In 2008, most economists attributed the surge in oil prices to fundamental factors and minimized the role of speculators. The lay observer blamed the speculators. Politicians such as Barack Obama, John McCain, Joseph Lieberman and Bart Stupak found it expedient to blame speculators. Some wanted to introduce new legislation to bring back cheap oil. Now cheap oil is on its way without new legislation. Did the fundamentals or the speculators bring it cheap to us? No one is accusing speculators of bringing cheap oil now!
References:
1. R J Weiner, 1991, ‘Is the World Oil Market ‘One Great Pool'?', The Energy Journal 12(3), 95-107.
2. J Quan, 1992, ‘Two-Step Testing Procedure for Price Discovery Role of Futures Prices', The Journal of Futures Markets 12(2):139-149.
3. T V Schwarz and A C Szakmary, 1994, ‘Price Discovery in Petroleum Markets: Arbitrage, Cointegration, and the Time Interval of Analysis', The Journal of Futures Markets 14(2):147-167.
4. S G Gulen, 1999, ‘Regionalization in the World Crude Oil Market: Further Evidence', The Energy Journal , 20(1):125-139.
5. L J Bachmeier and J M Griffin, 2006, ‘Testing for Market Integration Crude Oil, Coal, and Natural Gas', The Energy Journal 27(2):55-71.
6. R K Kaufmann and B Ullman, 2008, ‘Oil Prices, Speculation, and Fundamentals: Interpreting Causal Relations Among Spot and Futures Prices', Working Paper, Boston University.
7. S Hammoudeh, H Li, and B Jeon, 2004, ‘Causality and Volatility Spillovers Among Petroleum Prices of WTI, Gasoline and Heating Oil in Different Locations', North American Journal of Economics and Finance , 14 (1), 89-114.
Shawkat Hammoudeh is Professor of Economics and International Business at Drexel University, and Robert Kaufmann is Professor in the Center for Energy and Environmental Studies, Boston University. Petroleumworld does not necessarily share these views.
Editor's
note:
This commentary was published by Middle East Economic Survey (MEES), VOL. LI, No 46,17-Nov-2008 Petroleumworld reprint this article in the interest of our readers. Petroleumworld reprint this article in the interest of our readers.
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