To Oil or Not to Oil: Part One

Joy Pathak

As someone who has worked in the oil industry I have always been truly fascinated by 'black gold'. The recent oil spill gave me the idea to possibly talk a bit about crude oil futures. In addition, I am currently working on a crude oil futures forecasting research paper as part of an independent study. I have broken up the articles into 5 parts. The parts will follow my research basically. The first two parts will be introductions and literature review and thereafter will focus on what my contributions will be as part of the research paper. I am keeping it very brief here. My paper will have much detailed descriptions. I am keeping this post more of a blog post oriented (for citations) format rather than a research article, so don't fret, as the research paper will be articulated in a much better way. I will upload my paper once its done. Here is Part One.

Petroleum... is basically a mixture of a range of hydrocarbons. The most common hydrocarbons are alkanes, cycloalkanes, asphaltenes. Each variety of petroleum has a unique mixture of these molecules which define its physical and chemical properties. To a chemist this is just a murky liquid with a range of interesting flammable properties;To an oil corporation this is a a few trillion dollars in liquid form; To a financial investor this is a great way to hedge. To me, it is the fuel that gets me from A to B, also.

Everyday, basically 24 hours, on average 600,000 contracts of Light Sweet Crude Oil (WTI) are traded which is equal to approximately 600 million barrels of oil. Whether they are traded through the new CME Globex electronic trading platform or on the trading floor in New York, WTI futures and its options represent key price risk management opportunities for a range of customers.

A plethora of investment funds have recently been injected into the commodity markets. The total holdings have risen from $13 billion in 2003 to mid-2008 in $260 billion in mid-2008. During this period as can be expected the prices of crude oil and other commodities rose significantly leading to the much heated debate that speculation in the commodities market has led to the rise in prices. To give an idea, the price of WTI crude oil rose by over 170% between January 2007 and June 2008. The impact of oil price changes on the world economy is large. According to Morris Adelman, ‘‘Oil is so significant in the international economy that forecasts of economic growth are routinely qualified with the caveat: “provided there is no oil shock.’’

But...this was not always the case.

For many decades, only commercial operators were allowed to buy almost close to unlimited amounts of oil. Oil prices did not fluctuate much before 1973. A few large U.S. oil companies known as the Seven Sisters stabilized the price through price and production controls during much of the 20th century. After the Yom Kippur War started on October 6, 1973, control over crude oil prices passed from the United States to OPEC. It can be seen that since then oil prices started to behave similarly like other financial instruments. In addition, to possibly further drive up the volatility, in 1991, the Commodity Futures Trading Commision (CFTC) passed a ruling to allow financial institutions to have similar privileges as the oil suppliers/producers to trade oil futures. So began the modern day oil trading in which even Joe Schmoe speculating in his basement can buy oil related financial instruments for trading purposes.

West Texas Intermediate (WTI) is the benchmark for crude oil prices. WTI comprises a blend of several U.S. domestic streams of light sweet crude oil. The delivery point in Cushing, Oklahoma, is the key transport hub, with many intersecting pipelines and storage facilities and easy access to refiners and suppliers. Crude oil flows inbound to Cushing from all directions and outbound through dozens of pipelines. There are three types of WTI that one can trade. There is the Light Sweet Crude Oil (CL), Light Crude Oil - Financial (WS), and E-mini Light sweet crude oil (QM). The first one is for physical delivery whereas the other two require financial settlements. There are other types of oil futures that are traded also, like Gulf Sour Oil and Brent oil futures.

Prices of oil and its characterisation usually depend on two important characteristics: sulphur content and density. Oil that has low sulphur content (referred to as sweet) and low density (referred to as light) is cheaper to process than oil that has high sulphur content (referred to as sour) and high density (referred to as heavy). For instance, the price of West Texas Intermediate is generally higher than Brent oil as it is sweeter and lighter than Brent oil. Of the total world oil consumption of 70–80 million barrels a day(might be old numbers now), Brent oil serves as a benchmark for between 40 and 50 million barrels a day, West Texas Intermediate for 12–15 million barrels a day, and others for around 10–15 million barrels a day. Spot markets exist for different qualities and for different regions (for instance, Rotterdam/Northwest Europe, New York Harbour/U.S. Northeast, Chicago/U.S. Midwest, Singapore/South East Asia, and Cushing, Oklahoma/ U.S. Gulf Coast). Some of the most active spot markets have forward physical markets, but most focus on prompt delivery of readily available volumes. The oil sands produces Light Sweet Crude Oil.

As I mentioned in the previous paragraphs it can be seen that as the oil futures became readily available for trading the volatility and prices of oil instruments rose drastically. Oil supply is quite inelastic. The price is mostly influenced by excess demand shifts that arrive from the two sets of traders mentioned above. The growing presence of financial operators in the oil markets has led to the diffusion of trading techniques based on extrapolative expectations where trends can be used to speculate. One side of the table has said that from the research out there has been no clear cut justification behind the notion of speculation driving up the prices. CFTC put out a report in July 2008 that concluded that speculators were NOT systematically driving oil prices. A few days later, quite the contradiction was published in which it was shown that just four swap dealers held 49% of all the NYMEX oil contracts, and were betting oil price increasing. This provided a decent amount of evidence of the concentration of power in the market. Obviously, as many would suggest, it can be difficult to distinguish between ‘pure speculation’ and commercial trading. It is quite hard to conduct a direct study of how speculation affects oil prices due to lack of reliable data on who is speculative and who isn’t, but it is possible to attain an idea of the role of speculators through an indirect method through the use of heterogeneous agent models, based on the interaction between two stylised types of trade; fundamentals and noise/feedback chartists. More information on this can be found in the links provided.

Oil price movements are often linked to both stock market and exchange rate behaviour. A number of studies, based on different data and estimation procedures, find a negative financial linkage between oil and stock prices i.e. a large negative covariance risk between oil and a widely diversified portfolio of assets. This link was studied by Amano and Van Norder (1998). They used two non-stational variables and used a VECM approach for data between 1972-1993 to show that the variables are co integrated. Moreover, the long-run level of the exchange rate seems to adjust to the price of oil, but not vice-versa. Specifically, a one percent increase in the commodity price would lead to a 0.51 percent appreciation of the dollar in the long run.

A substantial body of literature, however, claims that there is a real linkage between the value of equities and oil via production and the business cycle, expansionary periods (in turn related to stock price increases) being closely associated with oil price rises. As for the dollar, it has traditionally influenced the price of oil and other commodities, including gold and base metals, which are mostly priced in the green currency. In a really interesting paper on the Canadian oil and gas industry returns, Sadorsky(2001) used monthly data and a multifactor market model to find that the industry is affected by returns on market index, oil price, interest rate and exchange rate. Stock price returns showed a positive relationship with the market and oil price factors whereas a negative relationship was seen with interest rate and exchange rate returns.

Oil is an important commodity if I have not insinuated that yet. It is an area that of high importance and will be growing more as the demand grows in the developing countries. I wanted to keep it a bit simple in my first comment on oil with this post. In the next post I will discuss some forecasting related methods. To give a preview, one of the methods used for forecasting is the use of neural networks. I will talk about an empirical mode decomposition based neural network ensemble learning paradigm for crude oil spot price forecasting. I will also talk about an innovative method to measure uncertainty and oil price volatility that I recently read in a working paper. I will discuss oil price movement as driven by levy processes of generalised hyperbolic distribution compared to Normal Inverse Gaussian Distribution as some academicians have suggested. Feel free to read some of the papers I have mentioned below.
To be continued...

Some interesting papers/books: (Many excerpts in the above article have been taken from these papers/books)
Black, Fischer. 1976. The pricing of commodity contracts. Journal of Financial Economics 3, no. 1-2 (January): 167-179.
Gibson, R., and E. S. Schwartz. 1990. Stochastic convenience yield and the pricing of oil contingent claims. Journal of Finance 45, no. 3: 959-976.
Adelman, M.A., 1993. The Economics of Petroleum Supply: Papers 1962–1993. Massachusetts Institute of Technology, p. 537.
International Monetary Fund, 2000. The impact of higher oil prices on the global economy. Research Department. /
Hamilton, J.D., 2003. What is an oil shock? Journal of Econometrics 113 (2), 363–398.
International Energy Agency (IEA), 2004. Analysis of the impact of high oil prices on the global economy. /
Manning, N. (1991), “ The UK oil industry: some inferences from the efficient market hypothesis”, Scottish Journal of Political Economy, 38, 324-334
Sadorsky, P. (2001), “Risk factors in stock returns of Canadian oil and gas companies”, Energy Economics, 22, 253-266
Amano, A. and S. van Norden (1998), “Oil prices and the rise and fall of the US real exchange rate”, Journal of International Money and Finance, 17, 299-316.
Good post bro. This reading gave me a head start to my commodity trading research. Also this is a good one because it has all intricate details dished out with light and sweet oil. :D