Research & Analysis on Financial Factors for Price Formation of Crude Oil

Transcription

1 Research & Analysis on Financial Factors for Price Formation of Crude Oil March 2009 Mitsubishi UFJ Research and Consulting

2 Introduction Regarding factors for excessive volatility in crude oil prices, various arguments have been presented by individual countries at a series of international forums. While some people argue that both financial and supply-demand factors contribute to the volatility, there are views that financial factors do not have any impact on price formation. As such, it is important to conduct a theoretical analysis from a policy-making perspective. In order to analyze the factors for the price formation of crude oil, first we need to understand the features of crude oil markets. Accordingly, in Part I of this report, we look at flow and stock aspects of the crude oil market and analyze the features of each aspect. Taking into account the analysis, we refer to a bubble analysis of the crude oil market. In Part II, we explain changes in financial factors in the crude oil market, using actual data, in view of the market entry status of financial players and entry incentives for the commodity and crude oil markets. In Part III, we attempt to explain, hypothetically, the recent trend of excessive volatility in crude oil prices by both supply-demand factors and financial factors, based on the results of research and study as shown in Part I and Part II. Finally, in Part IV, we set out possible policy directions based on the results as studied in Part I through to Part III. 1

3 Part I Factor Analysis on Price Formation of Crude Oil In analyzing factors for price formation in the crude oil market, first, an understanding of crude oil as a commodity is necessary. Although crude oil price formation is sometimes discussed only in terms of supply-demand factors, it is considered that we are now in circumstances where these factors alone cannot explain the price formation. Therefore, in analyzing the price formation, it is important to understand that crude oil possesses features of stock goods as well as features of flow goods. Based on this recognition, we analyze the factors for crude oil price formation in the paragraphs below. 1 Flow-Analysis of crude oil market Crude oil is an important flow-good widely utilized in daily economic activities as an energy resource or raw material. In addition, both supply and demand of crude oil have low price-elasticity in the short-term. Not only does the low price-elasticity of supply and demand have a larger impact on the global economy during major price fluctuations, but also it may be one factor that causes difficulty in making a judgment on appropriate pricing, because it is difficult to observe changes in supply-demand balance even if it is affected by price fluctuations. In this section, we discuss the flow aspects of crude oil referring mainly to an empirical analysis on the low price elasticity of demand and the presence of OPEC and its influence on supply. (1) Features of Crude oil as a Flow Good In daily economic and industrial activities, oil products are widely used as energy resources and raw materials, and the primary material of these oil products is crude oil. The global consumption of crude oil occupies 4% of GDP (Crude oil price is assumed to be some 70 dollars for calculations), and crude oil is a type of flow good that holds greater influence over the whole economy, compared with other commodities, such as metals and agricultural commodities. Below, the features of crude oil as a flow good are shown from supply and demand aspects. 2

4 Figure Consumption Scale of Major Commodities Dollars in 100 Consumption (unit: Price (unit) GDP ratio (%) million thousand tons /year; except for crude oil) Global GDP Approx.546,000 Crude Oil 22,477 85,130(thousand 72.34($/barrel) 4.1 barrels /day) Steel 8,099 1,343,500(thousand 603($/ton) 1.48 tons /year) Copper 1,275 17,964(thousand 7,097($/ton) 0.23 tons /year) Aluminum ,518(thousand 2,663($/ton) 0.18 tons /year) Nickel 512 1,418(thousand 36,108($/ton) 0.09 tons /year) Zinc ,074(thousand 3,242($/ton) 0.07 tons /year) Lead 209 8,205(thousand 2,553($/ton) 0.04 tons /year) Tin (thousand tons 14,508($/ton) 0.01 /year) Wheat 1, million tons 638( /bushel) 0.27 /year Corn 1, million tons 374( /bushel) 0.21 /year Soy beans million tons 864( /bushel) 0.14 /year) Note: The figures above are for Prices are averages of NYMEX, LME and CBOT. Steel prices are from HR in US. Volumes are production amounts. Sources: BP, IISI, WMS and Bloomberg (2) Demand features of Crude Oil The demand function of crude oil is estimated in this section to show empirically that the price elasticity of crude oil is low 20. (i) Outline Calculations are made to estimate the degree of short-term change in crude oil demand relative to crude oil price fluctuations. In the analysis, the demand function is estimated by using the quarterly data of OECD Crude Oil Demand and on the precondition that profit shall be maximized by economic activities The present analysis in this section refers to Kensuke Miyazawa (2009) 2 The subject for analysis is the OECD because quarterly data for global GDP is not available. If we add new emerging countries with increasing oil demand that are undergoing structural change, there is the disadvantage that the estimated demand function of crude oil would be unstable. Further, it is considered that there would be no major difference between the marginal productivity of OECD crude oil and that of global crude oil if free trade is conducted and there is sufficient free competition in the market. It should be noted that similar results were obtained from an analysis using US GDP construing WTI as US crude oil. 3

5 According to the results of the analysis, the price elasticity is shown to be so low that the demand would be down only 0.3% in the case of the price increasing by 10%. Whilst the estimations of the demand function shown in the present chapter are based on data for the period between 1989 and 2003, it is suggested that the price elasticity for demand would not undergo major change during periods of volatile price fluctuations, even in 2004 or thereafter. It should be noted that the estimation is expected to capture short-term ups and downs in consumer demand when the price of crude oil changes and long-term impacts of structural changes are not considered. (ii) Details of the model and mathematical expressions We explicitly consider labor, capital, crude oil, and technology for the use of crude oil (i.e. efficiency) as production elements required for production activities concerning goods other than crude oil. It is also assumed that economic activities are conducted in order to maximize profit, using a CES-type production function for which the relationships between these elements are constant. This shall be expressed in mathematical equations, as in (1) and (2) below: In the equation above, Y t is the entire demand quantity of the economy, V t is the injected quantity of goods other than crude oil, O t is the injected quantity of crude oil, A t is the efficiency of the use of crude oil, p t is the level of prices in the entire economy, p v,t is the price of goods other than crude oil, and p o,t is the price of crude oil. By varying the injected quantity of crude oil, the profit maximization behavior can be described as in (3) and (4) 3. Therefore, the price elasticity for crude oil demand, ν, shall be as in (5), the reciprocal of ρ. (iii) Details of data and method of estimation 3 First order conditions for O t. 4

6 In the estimation, quarterly data is used as shown below. We take into consideration some insufficiencies in the data on the demand for crude oil: it would not be appropriate to analyze the impact on demand due to price fluctuations as new demand for crude oil tends to occur in emerging countries as a result of economic development, and the accuracy of the data is possibly deficient. Our analysis employs quarterly data because we use GTP data as a variable for indicating the level of economic activities. It is expected that technological development of alternative energy and energy conservation is captured as A t, the efficiency of the use of crude oil, and that the estimate will capture short-term ups and downs in demand due to such behaviors as consumers refraining from buying gasoline and transportation companies canceling fuel purchases during times of crude oil price hikes 4. The data of Kilian s supply shock is used as an operational variable because we aim to make more accurate estimation of the price elasticity of demand 5. Y t : GDP of OECD (OECD stat) O t : Consumption of OECD (IEA Estimation, seasonally adjusted) P ot : WTI Spot Price P t : U.S. CPI Operational Variable: Kilian supply shock - Considering improving developments in energy conservation and the use of alternative energy, it is assumed that the efficiency of crude oil use, A t shall rise at a constant rate as shown in (8) 6. 4 It is considered that the current estimation would not reflect such influences as movement toward fuel efficient cars, reorganization of the distribution network and so on spanning a long period of several years or more. The present analysis aims, as a matter of course, to estimate the short-term price-elasticity of crude oil demand. 5 The current estimation employs Kilian supply shock from the term 0 to term 3 lag, and the length of lag only has a small impact on the results of the estimation. 6 The method of the current estimation is based on the GMM (General Moment Method), which is considered to have a small bias in estimated values. Note that C* ρ* ln α 5

7 Figure Y/O and A (Y 2000 /O 2000 = 1.00) Ratio of Crude Oil Consumption to GDP (Y/O) Efficiency of Use of Crude Oil (A) (iv) The Results of Estimation and their Interpretation As a result of the estimation, we find ρ 33.2 and ν 0.03 (v is the reciprocal of ρ, i.e. price elasticity). This means that in spite of a 10% rise in crude oil price, crude oil demand would decline by only 0.3%, indicating that price elasticity is extremely low (in other words the inclination of the demand curve is very steep). The above are the results of the estimate based on the data up to the year 2003, for which Kilian supply shock can be used. The theoretical value of marginal productivity of crude oil for the years from 2004 to 2008 can be calculated by applying parameters obtained here, such as ρ (ρ 33.2). It can be shown that the theoretical value of marginal productivity of crude oil moves similarly to the actual price of crude oil. This result is considered to suggest that this estimation model is valid 7, that obtained parameters are correct, and that there is no big change between the demand function of the period from 1998 to 2003 and that of 2004 and thereafter 8. Figure Results of Estimation (parameters in equation (6)) Parameter Value Standard Deviation ρ * C * (Note) For ρ * and C * refer to the main text of the prior page and the footnotes 7 Under the profit maximization behavior in the current chapter, it is assumed that economic activities are conducted so as to ensure that the marginal productivity of crude oil is identical with crude oil price. 8 The results of extrapolation tests made from 2004 onward are consistent with the situation that later occurred, and the validity of the model and parameters is maintained 6

8 Figure Substantial Prices of Crude Oil and Theoretical Values of Marginal Productivity of Crude Oil 4.0 (Y 2000 /O 2000 = 1.00) 3.0 Substantial Prices of Crude Oil Theoretical Values Even though these results appear to support the explanation that the crude oil price rose due to fundamentals factors (i.e. due to enhanced marginal productivity of crude oil), this is not necessarily the case. The framework of our analysis is a partial equilibrium model where crude oil users make decisions 9, and it does not exclude possibilities of price fluctuations, which could occur through a mechanism by which enterprises and other economic agents store crude oil for asset-related or preparatory purposes instead of consuming it 10. The analysis shows that repercussions on demand for crude oil relative to price fluctuations are limited in the short-term. In this way, the results of the analysis in this section do not specify the causes for price fluctuations of crude oil. However, on the other hand, they suggest the possibility that price fluctuations are large in response to such factors as supply side shocks due to extremely steep inclinations of the demand curve. (3) The features of Crude Oil Supply In this section, we focus on the characteristics of OPEC (Organization of the Petroleum Exporting Countries), which wields power over crude oil supply, and argue that the price elasticity of crude oil supply is also low. 9 The data in the current analysis is consumption quantity excluding fluctuations in inventory. 10 Even if this sort of mechanism causes the price to fluctuate, the results would not contradict those of the current analysis because the actual consumption sector of crude oil would behave so that the price would be identical to marginal productivity. 7

9 (i) Outline Crude oil produced in a certain area of the world partially competes with that produced in all other parts of the world, and producers of such crude oil are considered to be competitors with each other in the global oil market. However, it is difficult to increase supply beyond the present spare production capacity on a large-scale in the short-term because developing an oil field requires long-term investment. Many people have the view that OPEC (or part of OPEC) has a dominant position in crude oil supply. In fact, actions of OPEC do have a large influence on the supply volume of the entire world and this is considered to be a factor that makes it difficult for supply to change elastically in response to price fluctuations. (ii) Presence of OPEC Although there are alternatives to crude oil in the long-term, such as natural gas, coal, nuclear power, water power and bio-fuel, considering the low price elasticity of crude oil in the short-term, it could be said that there are not yet any goods that could sufficiently replace crude oil. However, on the other hand, even crude oil comes in various forms with different origins of production and different qualities, such as WTI, Brent Oil, Arabian Light and Ural Oil, and each type has its counterparty competitor. It could also be said that there are circumstances under which producers of each type of crude oil are largely influenced by behaviors of other producers. However, it is generally viewed that crude oil supply is a dominant rather than competitive factor. This is because it is OPEC that makes production adjustments internationally. OPEC s share of the world production declined from 60 percent in the 1970 s to 30 percent in the mid 1980 s, but since then, the share has tended to rise and in recent years the share percentage has ranged in the 40s. (iii) Function of OPEC According to OPEC, its mission is to, among other matters, (1) coordinate and unify the petroleum policies of Member Countries and determine the best method for protecting the interests of Member Countries, (2) ensure the stabilization of oil prices in international markets, and (3) secure an efficient, economic and regular supply of petroleum to consumer countries and a steady income to producers. In March 2000, OPEC determined to introduce a Price Band System with target prices at 22 to 28 dollars per barrel for OPEC crude oil baskets in order to sustain the prices. Under the system, when crude oil prices deviated from the target price range, a production increase or decrease of 500,000 barrels a day would automatically be implemented. In 2001 after the collapse of the IT Bubble, the crude oil price dropped to ten dollars. However, the crude oil price showed a clear upward tendency, and upon the price entering the 40-dollar range, it was announced at the general meeting in May 2005 that the price band system would be suspended. Although the framework for the production agreement was maintained, the 8

10 purpose of the framework has become obscure. Considering the statements issued by OPEC, it is presumed that it focuses on the levels and changes of crude oil inventories or the trends in the crude oil market. (iv) Trends in Crude Oil Supply Presumably, when the price stays high for a certain time, new oil fields, even high cost fields, would be further developed due to expectations for profitability. On the other hand, the supply would decrease if the price stays low because production capacity for the existing oil fields gradually declines and oil field development will stagnate. Therefore, if we look along a time axis spanning a period of five to ten years, in which trends in oil field development are influential factors, crude oil supply would likely be elastically responsive to price changes. On the contrary, if we look along a time axis spanning only two to three years, the supply would not be elastically responsive to prices because it is difficult to additionally provide new sources for supply through oil field development. Meanwhile, OPEC makes prompt production adjustments at several-month intervals, as observed in their action to respond to seasonal demand (reduction of production quota in the second quarter). (v) OPEC Market Control Power There is no unified view as to how we should consider the market control power of OPEC, which constitutes an important factor in considering crude oil supply. (Ayed Al-Qahtani, Edward Balistreri, Carol Dahl, Literature Review on Oil Market Modeling and OPEC s Behavior, 2008). However, many have the view that OPEC conducts monopoly-like activities with market control power of a certain level. (vi) Sources of OPEC s Market Control Power Crude oil suppliers are categorized into two groups, OPEC members, which determine oil production volume based on mutual production agreement, and non-opec oil producing countries, which conduct production according to their own discretionary judgment. Non-OPEC oil producing countries are conducting production close to the maximum capacity of production and they have only a little leeway to change the supply volume in response to ups and downs in demand and to price fluctuations 11, and their production is non-elastic. On the other hand, OPEC can change the production volume so as to fill the gap between global demand and the supply provided by non-opec production. 11 In particular they have little leeway to increase production when the price rises, and even if the price falls they are likely to anticipate a decrease in OPEC production and so would not decrease production themselves. The same tendency also exists within OPEC, particularly in non-gulf State regions. 9

11 In other words, the source of OPEC s market control power lies in the fact that it has spare production capacity sufficient enough to fill the gap between global demand and production by non-opec countries. From a long-term perspective, since OPEC has large potential power for oil field development, given that around 80% of identified oil reserves are concentrated in OPEC countries, its actions tend to have an impact on the market. It should be noted that when OPEC conducts production activities that function like a control valve, the production volume of OPEC changes depending on the difference between global demand and non-opec production volume, and thus OPEC production volume has no direct relationship with price fluctuations. Therefore, the entire supply of crude oil could possibly be non-elastic in response to price fluctuations in the sense that OPEC production has a weak co-relationship with prices 12. It is observed that for the short-term, the presence of an OPEC production quota makes supply non-elastic. In other words, when the crude oil price rises, the presence of the quota would not allow a discretionary increase of production even when there is a surplus in production capacity, whereas when the price declines, because the production quota is preserved as a vested right, production would continue, and thus supply is kept inflexible 13. On the other hand, there is the opposing view that OPEC does not have power over the market. According to this view, it is noted, the entire global production capacity of crude oil is not large enough compared with the volume of global demand, and this is a factor that lowers the price-elasticity of supply in response to price fluctuations 14. (4) Non-elasticity of Supply & Demand of Crude Oil in response to Price Fluctuations As discussed so far, both the supply and demand of crude oil show a tendency of non-elasticity in response to price fluctuations. In the case of goods whose elasticity in terms of supply and demand is large enough, for example, when the price rises to a certain point (P 1 ) well over the equilibrium price (P 0 ) at which supply and demand are balanced, demand will fall below supply, leading to an increase in inventory (Figure 1-1-5, left part). However, in the case of goods which have no elasticity in terms of supply and/or demand, it would be difficult to observe an increase in inventory. Inventory fluctuations are paid attention to as indications of supply and demand, and some people regard the fact that a large increase of inventory is not observed as indicating that the crude 12 This means that even if the price rises or falls, there will be little influence on supply. 13 There is also the possibility that production would not decrease even upon the price declining, because the price is set higher than the marginal production cost. 14 There is another possible view that the marginal cost is sufficiently high, taking into consideration the political cost accrued on the part of an oil producing country even with spare capacity in supply if the country produces at a level higher than that agreed by the production agreement. There is a further view that risk premium would be enhanced as spare supply capacity decreases. 10

12 oil price does not deviate much from the appropriate price level. However, in reality, the supply and demand of crude oil are non-elastic in response to price fluctuations and thus there are conditions under which it is difficult to observe inventory fluctuations, even if the crude oil price fluctuates on a large scale Price Figure Difference in Price Elasticity and Supply-Demand Gap Size Price Quantity In the case of large price elasticity Quantity In the case of small price elasticity 2. Stock Analysis on Crude Oil Market Transactions of crude oil can be analyzed from two aspects, one as transactions of flow goods reflecting the consuming aspect, and the other as transactions of stock goods reflecting the asset aspect. The flow goods features of crude oil were mentioned in the previous section, whereas in this section, we pay attention to the stock goods features of crude oil. We present ideas for the Asset Approach that constitute prerequisites for a fundamental understanding of the price formation of stock goods, and make an empirical analysis based on the idea that the crude oil price is formed by the fundamentals of supply and demand. (1) Stock Features of Crude Oil In View of Data First we will analyze the stock features of the crude oil price by looking at data. We also compare the futures price system with other commodities to evaluate the stock features. 15 It is possible that the demand curve has repeatedly shifted to the right due to the increase of crude oil demand in emerging countries. Thus, decline in demand for crude oil due to price hikes in developed countries etc. has been offset and it may be difficult to observe a global increase in inventory. 16 On the other hand, if we reverse the relationship of quantities to prices, price fluctuations tend to be larger in the case of supply-demand quantities changing. In other words, it is suggested that even a small amount of change in supply and/or demand could easily lead to a large fluctuation in price. 11

13 (i) Stock Good Features Crude oil is a commodity that meets the needs of a wide range of fields and can be stored, therefore it has stock features, like financial products, as a means to store value. Meanwhile, there is a notion called the Safe Asset, which has the highest value storage features and is a highly exchangeable asset 17 The Safe Asset also has interest rates, and futures prices are formed in relation to such interest rates. The Safe Asset is compared below with the futures prices of various commodities, assuming the futures price of the Safe Asset is obtained by investing in US Federal Funds 18. One method for evaluating the stock features of a commodity could be established by using price data on futures markets to observe whether a price system similar to that of the Safe Asset is formed. For example, if the commodity of crude oil has certain liquidity and value storage features that are similar to those of the Safe Asset, it is considered that the futures prices of crude oil are similar to those of the Safe Asset. (ii) Commodity Features of Crude Oil in comparison with other commodities The Safety level of an asset is defined as the degree of correspondence of the futures price of the subject commodity to that of the currency (i.e. investing at a rate of return in the Safe Asset). We consider this safety level of the asset as the strength of the features as a stock good. For example, looking at the status of futures prices as of the end of August 2007, as shown in Figure 1-2-1, it is possible to identify certain commodities, such as dollar deposits, stocks, gold and silver, as assets whose futures prices are similar to those of the Safe Asset. There are deviations from the Safe Asset Price System for certain commodities, including crude oil, copper, corn, live cattle and sugar. Deviations from the Safe Asset futures prices for each commodity could be quantified by measuring the distance between the prices. Figure shows trends in the degree of deviation. The analysis for the years from the 1990s onwards, in terms of deviations from the Safe Asset shown in Figure 1-2-2, shows that crude oil is a safer asset than such commodities as agricultural products, although it is less safe than term deposits, stock and gold. In the period from 2005 through to the first half of 2008 in particular, crude oil continued to be very safe. It is also understood that crude oil is not as safe an asset as it has been in the past, although the safety level has varied over time. In other words, we could consider that crude oil has had commodity features with a certain degree of safety. The general trend of the 2000s, as shown in Figure 1-2-3, has been an improvement in the 17 There is a small risk concerning value preservation and exchange. 18 Federal Funds are cash deposits contributed by city banks to US Federal Reserve Bank and the funds are regarded as assets for which it is difficult to presume future deterioration in both value and exchangeability 12

14 Asset Safety level (1 minus the deviation from the Safe Asset) of crude oil. (iii) Deviation from Safe Asset Nonetheless, the futures price system as of February 2009 (February 10) in Figure shows that crude oil is increasingly deviating from the Safe Asset, even compared with the other commodities. Figure also confirms that deviations of crude oil from the Safe Asset have reached a historically high level. This reflects a market view that the sharp decline in crude oil demand, due to the economic slowdown over the period up to February 2009, has strengthened concerns about inventory surplus. In this way, as shown in Figure 1-1-1, crude oil is a commodity subject to large consumption for daily economic activities, and the storage and transportation of crude oil is accompanied by cost. We stress again that crude oil has these strong features of flow goods, which provides an indispensable point of view for understanding the commodity nature of crude oil. (iv) Relation to Financial Assets On the other hand, if crude oil possesses stock features, it is also important to make a relative evaluation with stock goods other than Safe Assets such as shares 19. Comparing the price fluctuations of crude oil and shares shown in Figure reveals that crude oil risks (price fluctuations) are greater than those of shares. Implied volatility that reflects the formation of market participants expectations in the options market shows very similar results. Market participants recognize that crude oil has the characteristic of great price fluctuation. However, as we mention later, since around 2004, there have been stronger market movements, in which such commodities as crude oil, metals and agricultural products became regarded as alternative investments for shares or bonds. Looking at Figure 1-2-5, commodities in general are closely linked to the dollar market (weak dollar/strong commodity, or strong dollar/weak commodity) and crude oil in particular has the strongest sensitivity It is considered that the price of higher risk stock goods would settle at a level where the expected rate of return is higher than that of the Safe Asset. 20 There is a market tendency for the crude oil price to go up by almost 2.5% in response to a 1% decrease in the dollar. 13

15 Figure Safe Asset (investing in Federal Funds (FF)) and Futures Prices of Commodities Future prices of commodities (with 100 in the first contract month As of end of August 2007 FF Dollar deposits Gold Shares (S&P500) Silver Copper Crude oil Heating oil Live cattle Corn Sugar Future prices of commodities (with 100 in the first contract month As of end of August 2008 FF Dollar deposits Gold Shares (S&P500) Silver Copper Crude oil Heating oil Live cattle Corn Sugar Future prices of commodities (with 100 in the first contract month As of end of February 2008 FF Dollar deposits Gold Shares (S&P500) Silver Copper Crude oil Heating oil Live cattle Corn Sugar Contract months Future prices of commodities (with 100 in the first contract month As of February 10, 2009 FF Dollar deposits Gold Shares (S&P500) Silver Copper Crude oil Heating oil Live cattle Corn Sugar Contract months Contract months Contract months 14

16 Figure Deviation of Commodities from Safe Asset Safe Asset and Deviation Dollar Deposits Stocks Gold Silver (Monthly) Copper Heating oil Live Cattle Crude Oil Corn Sugar (Monthly) (Note) Log differences between futures prices of each commodity and those of the Safe Asset (invested at FF interest rates) are powered by 2 and the total of their sum is square-rooted. (One-month forward is set as the bench-mark and calculations are made for two- through to seven-month forward contracts.) Calculations are made from the average in the middle of the month in US markets (CBOT, CME, NYMEX) (Sources) Bloomberg 15

17 Figure Safeness of Asset of Each Commodity Points Dollar deposits Gold Stocks (S&P500) Silver Copper Crude oil Heating oil Live cattle Corn Sugar Note log differences between futures prices of each commodity and those of the Safe Asset (invested at FF interest rates) are powered by 2 and the total of their sum is square-rooted. (One-month forward is set as the bench-mark and calculations are made for two- through to seven-month forward contracts) Calculation for Safety level of Asset = 100 Deviation from Safe Asset * 100 By using the averages of the middle of the month in US markets (CBOT, CME, NYMEX) deviations of each month are calculated and the average is taken for each term. (Sources) Bloomberg Figure Crude Oil Price Fluctuation Characteristics (Standard Deviation) by GARCH (1,1) Model Share Price Fluctuations Characteristics Crude Oil Fluctuations Characteristics (Annual, weekly data) 16

18 <Note>GARCH model is a method which simultaneously estimates the price change rate and its variance (variability) on the hypothesis of heteroscedasticity. Specifically, the following model is assumed. P t (Crude oil price) = C (Constant) + ε t (Current term error) σ t 2 (Variance of crude oil) = ω (Constant) + α σ t-1 2 +β ε t

19 Figure Correlation between commodities and foreign exchange rate or share prices (Elasticity of each commodity against the dollar exchange rate or share prices) Crude Oil Copper Constant Against dollar Against share price Constant Against dollar Against share price Natural Gas Gold Constant Against dollar Against share price Constant Against dollar Against share price Corn Wheat Constant Against dollar Against share price Constant Against dollar Against share price Soy Beans 10-year Government Bond Yield Constant Against dollar Against share price Constant Against dollar Against share price (Note) Price (logarithmic difference)=c (Constant term α Foreign exchange rate (logarithmic difference) β (Coefficient) Share price (logarithmic difference) Transitions of C, α and β are the successive estimates since January 4, 2000 Exchange rate is effective rate of the dollar (Euro, yen, Pound, Canadian Dollar, Swedish Krona and Swiss Franc). Share prices are S&P500 and commodities prices are U.S. market figures. 18

20 (2) Asset Approach We have mentioned that crude oil has stock features, and this section covers the Asset Approach, which is a basic idea concerning the price determination of stock goods. While the Asset Approach has been applied to determine foreign exchange rates, crude oil, in light of its commodity features, is also considered to be suited to the Asset Approach. We discuss Asset Approach ideas concerning crude oil and foreign exchange, contrasting flow transactions and asset transactions. (i) Similarities between Foreign Exchange Rate and Crude Oil Price The price is determined both by spot transactions (flow) and by financial asset transactions (asset). In foreign exchange transactions it is considered that (a) flow = the supply and demand of foreign currency accompanied with international trade (current transactions), and (b) asset = the supply and demand of foreign currency based on financial asset transactions. In crude oil transactions, it is considered that (a) flow = the supply and demand of crude oil as a consumer good (raw material), and (b) asset = the supply and demand of crude oil based on transactions as an asset. Further, also in explaining the mechanism of price formation, both have in common such key words as future expectation, speculation, and bubble. (ii) Three Ideas on Foreign Exchange Rates There are three typical ideas concerning price formation in the foreign exchange market: 1) the Purchasing Power Parity theory, 2) the Flow Approach, and 3) the Asset Approach. Of the three, 1) and 2) can be described as theories for the long-term, and 3) for the short-term, or, to put it another way, 1) and 2) are for the absolute value of the foreign exchange rate, and 3) for the rate of change. 1) Purchasing Power Parity theory This is the argument that the foreign exchange rate should be determined so as to equate the purchasing power of each currency (one price for one item). For long-term fluctuations spanning several decades, or even for short-term fluctuations of currencies in countries suffering from hyperinflation, the actual fluctuations of the foreign exchange rate are almost consistent with the Purchasing Power Parity Theory. 2) Flow Approach This approach attaches importance to the supply and demand of foreign currency accompanied with spot transactions. This is the argument that the foreign exchange rate should be determined so as to balance international accounts (current accounts). Attention has been paid to the 19

21 theory that foreign exchange fluctuations have impacts on exports or imports along a time axis spanning several years and thus bring equilibrium to international accounts. In reality, it has been evident that under the floating market system, foreign exchange fluctuations do not necessarily function to balance current accounts. However, there is also the view that the function becomes effective when asset transactions slow down. It is also possible that the argument that the function of foreign exchange is to balance current accounts has benchmark characteristics to some extent. 3) Asset Approach This approach is based on the argument that the foreign exchange rate is determined by the supply and demand of foreign currency incurred by financial asset transactions denominated in two foreign currencies. The foreign exchange rate is adjusted so that the expected rate of return, both on domestic and foreign financial assets, will be identical. Statistically, this approach will lead to an idea called Interest Rate Parity. Interest Rate Parity is the concept that the difference between the predicted future foreign exchange rate and the present foreign exchange rate is equal to the difference in interest rates. (Simple Example) Current foreign exchange rate: 100 yen / dollar Predicted foreign exchange rate at a date one-year in the future: 100-X yen/dollar Japanese Interest Rates: 5%, US Interest Rates: 10% Investing in Yen assets: from 100 yen to 105 yen Investing in Dollar assets: from 1 dollar (= 100 Yen) to 1.1dollars (=1.1 (100-X) yen) X = (10-5) = 5: By 5% yen appreciation, the rate of return for the two assets will be identical Interest rate parity requires 5% yen appreciation Attention was once paid to the Asset Approach as a theory to determine the foreign exchange rate for a shorter-term time axis, whereas the Purchasing Power Parity Theory and the Flow Approach were considered to be theories for a long-term time axis spanning several years and decades. However, more importantly, the idea that interest rate arbitrage works at different points of time in the present and the future provides basic ideas on price formation of not only the foreign exchange market but of all other types of assets. Under the Asset Approach, which considers that the foreign exchange rate fluctuates most in response to change in expectations of economic fundamentals, such as interest rates, a problem arises as to the difficulty of explaining well the actual large-scale fluctuations of the foreign exchange rate, and it should be noted that research is being conducted on various ideas, such as how 20

22 expectation should be formed and the behavioral principles of market participants 21. 4) Inter-relationship among the three approaches Which of the three approaches above has the ability to explain the actual fluctuations depends on such economic conditions as how freely international capital transactions can be conducted, the extent to which foreign currency transactions are liberalized, and the length of time lags before prices for goods are adjusted. Much empirical research has been attempted on foreign exchange, and the validity of the three approaches has been tested. In summary, it is the standard view that while super-short-term determination of the foreign exchange rate is subject to influence by speculative transactions not based on investors expectations or fundamentals, the Asset Approach based on fundamentals is useful, for the short- and medium-term. On the other hand, it is recognized that the Purchasing Power Parity Theory and the Flow Approach, where asset aspects are not taken into consideration, can not sufficiently explain the foreign exchange rate in the short- and medium-term. Taking into account the similarities between crude oil and foreign exchange, even in the crude oil market, it could be argued that while super-short-term determination of crude oil price is subject to influence by speculative transactions not based on investors expectations or fundamentals, the Asset Approach based on fundamentals is useful, for the short- and medium-term. (iii) Complement by Long-term Theories The Asset Approach only explains the rate of change in the foreign exchange rate (i.e. a motion equation) and can not answer the question as to how the absolute levels of the foreign exchange rate are determined at present or at a future point of time. This initial question is answered by such long-term theories as the Purchasing Power Parity Theory and the Flow Approach, which apparently can not sufficiently explain short-term determination of foreign exchange. The fundamentals pre-determine the (expected) level of foreign exchange in the remote future, and the future level of the rate is linked to the present foreign exchange rate by interest rate parity. Changes in news regarding fundamentals or in investors expectations, which influence future rates, make the foreign exchange rate jump. In the crude oil market, too, it is often observed that news or expectations of future demand and supply bring large price jumps. These price fluctuations cannot be captured well by the Flow Approach, which focuses only on the spot market of crude oil supply and demand. These fluctuations could be understood only by the Asset Approach, under which future prices and present prices are mutually affected through arbitrage behavior. 21 This point is addressed later. 21

23 (iv) Application of Asset Approach to Crude Oil Price Determination It follows, from an analogy of interest rate parity in foreign exchange, that crude oil prices are adjusted so that the rate of return of crude oil assets is identical to that of other financial assets. This is a motion equation in the crude oil market. In this case, the rate of return of crude oil is the difference between the present and future prices of crude oil. Assuming storage cost is negligible, this price difference would be determined so as to correspond to the rate of return of financial assets. In reality, since we cannot ignore the storage cost, there are inventories of spot crude oil lying idle, and also extreme shortages could occur in areas where crude oil transportation is difficult. Compared to other financial assets, the price of crude oil has a stronger tendency to be formed through channels whereby spot price fluctuations affect futures prices. On the other hand, it is considered that the crude oil price in the remote future, which is an initial condition, is determined by fundamentals based on the real demand in the same manner as long-term foreign exchange theories. This expected future price could change, depending on news concerning expectations of future supply and demand or investors expectations. (v) Noteworthy Points of Asset Approach According to the Asset Approach, when the price deviates from the fundamentals, pressures are exerted through speculative arbitrage transactions in order for the price to become closer to the fundamentals. On the other hand, the approach leaves out speculations that cause deviation from the fundamentals. Further, according to the approach, the expected price is shaped by the fundamentals and, as a result, no distinction is made regarding impact on price whether by real-demand-based transactions or by speculative transactions (arbitrage transactions). News concerning fundamentals is immediately reflected and the crude oil price jumps 22. In actual cases, concerning speculation, it is important to distinguish speculation in the Asset Approach and speculation that deviates from the fundamentals. However, in the following section, we see to what extent the approach can explain fluctuations in the crude oil price This refers to shock as explained by empirical verification 23 Speculation that deviates from fundamentals is addressed later 22

24 Figure Price Determination Mechanism of Crude Oil using Asset Approach Price Price Volume Spot Market (Current term) Volume Spot Market (Future) (Notes on Price Determination Mechanism of Crude Oil using Asset Approach) The price that brings equilibrium to supply and demand for the current term is P * and the price that brings equilibrium to supply and demand for the future is P 1. In this case, having taken future expectation into account, the price based on the fundamentals, P F1 lies between P * and P 1. When the price that brings equilibrium to the future supply and demand is low, at a level of P, the price based on the fundamentals is determined between P * and P 2. When D and S are almost vertical lines, even a small amount of change in supply or demand could cause large fluctuations in the value of P. In cases where the Flow Approach is applicable, the price for the current term is P * and at a point of time in the future, the price sharply rises to P 1 or declines to P 2. On the other hand, the prices for the current term or the future are either P 1 or P 2, in cases where the Asset Approach is applicable 24. In other words, it is important to note that it can be suggested that if sufficient speculation (arbitrage behavior) looking ahead to future supply and demand is made, it could have a price stabilizing effect 25. (3) Factor Breakdown Analysis for Crude Oil Price Formation In this section, empirical verification is made as to how far crude oil fluctuation could be explained individually by each of the two approaches, i.e. the Flow Approach, which demonstrates 24 Strictly speaking, the price fluctuates in response to interest rates, various risk factors and so on, but it is considered that such fluctuation evens out as time passes. 25 However, as will be explained later, it should be noted that in cases where asymmetry of information exists, or only one-way transactions tend to occur (for example, in cases where there are restrictions on the selling futures), the probability of bubbles occurring increases. 23

25 that price is determined by supply and demand in flow, and the Asset Approach, which demonstrates that price is determined by the process where rational investors form future expectations based on available information 26. (i) Outline of the Model Estimation is made by the structural VAR model with the following structure. Variable X is a vector consisting of the log level value of the global crude oil supply volume, that of the global crude oil demand volume, and that of the substantial price of crude oil. Under the model, the expected future price is formed by price fluctuations due to flow features caused by supply and demand changes for each term, and to change in real supply and demand and information so far obtained. Unexpected ups and downs in demand would appear as demand shock, unexpected change in supply as supply shock, and price change as price shock due to matters other than these. In other words, it is construed that price is formed through the process where fundamentals are reflected on both of the two aspects of flow and stock. (ii) Data and Details on Estimation Methods To begin with, subject data from the first quarter of 1995 through to the fourth quarter of 2008 is used. As for demand and supply volumes, publicly disclosed IEA data with seasonal adjustment 27 are used. Substantial crude oil prices are not seasonally adjusted 28. Meanwhile, the substantial crude oil price is deflated by the US consumer price index, and then noise due to the foreign exchange rate is removed by the substantial and effective foreign exchange rate 29. As for the lag number of the VAR model, number one (1), which is supported by the Baze information standard, is adopted. It is construed that unexpected shock for the crude oil supply volume is supply shock, unexpected shock for demand is demand shock, and unexpected shock for price is formed by other shocks. It is considered that other shocks include such speculative factors as irrational behavior, and supposition on future supply and demand not based on supply and demand data. As an assumption for distinguishing shocks under structural VAR, standard recursive restrictions are used. In other words, the following three assumptions are made: a) unexpected shock 26 The results of analysis in the current section refers to Nutahara Kengo (2009) 27 The result is robust even in cases where seasonal dummy variables are used 28 Because seasonal characteristics are not observed according to adjustment method X11 of the US Census Bureau 29 Main results are robust even for date deflated by the CPI. 24

26 for demand volume for the current term does not affect the supply volume for the current term, b) unexpected shock for the crude oil price for the current term does not affect the supply volume for the current term, and c) unexpected shock for the crude oil price for the current term does not affect the demand volume for the current term. (iii) Results of Factor Breakdown Analysis of Price Formation by Analysis of Historical Factors The factor analysis of crude oil price formation based on the above model is as follows. First, the crude oil price shows a moderate tendency of change in terms of trends and this tendency has a relatively small impact. More specifically, the trends of the substantial crude oil price corresponding to change in trends of demand and supply show that the price has increased 240 percent from 1995 through to Furthermore, comparison between the bottom level in the period from October to December 1998 and the peak level in the period from April through to June 2008 shows that the peak value is more than eight times more than the bottom value, which means that the majority of the fluctuations are due to factors other than trends. Figure illustrates factors that cause the crude oil price to deviate from the trend during the period from 2004 to The overview shows that demand shock plays a relatively small role whereas other shocks play a greater role as factors that push up the crude oil price from the trend over the period from 2005 to around On the other hand, supply shock became negative, reflecting increasing production. During this period, OPEC spare production capacity diminished, and though some people think that restrictions on production may be a factor that pushed prices up, it should be construed that reduction in spare production capacity is due to demand increase. As for price hikes of crude oil over the period from the latter half of 2007 to the middle of 2008, while both demand and supply shocks contributed to the price hikes, the influence of other shocks is especially large. In addition, in the fourth quarter of 2008, a large negative impact is observed due to other shocks. Thus, it can be understood that for excessive volatility in crude oil prices in recent years, a large influence is exerted by other shocks, which are not shown in the observable data on demand and supply. 25

27 Figure Factor Breakdown of Crude Oil Price (2004 and on) Factor breakdown of deviation from trend of crude oil prices Supply shock effect Demand shock effect Other shock effect Crude oil prices (after removing trend) (Note) Rate of deviation from trend is indicated (Figures are based on logarithmic difference). Factors are broken down using the structural VAR model shown in this chapter. For the subject period under analysis in this section (i.e. from 1995 to 2008), we look at how other shocks fluctuate. Other shocks contributed to upward crude oil price movements from 1995 to 1997, downward movements from 1998 to 1999, downward movements in the latter half of the period from 2001 to 2002, upward movements from 2004 to 2006, downward movements from the fall of 2006 to the beginning of 2007 and upward movements from 2007 to The COT (Commitment of Traders) report released by the CFTC recognizes that these trends of other shocks are linked to net positions (long positions minus short positions), and it suggests that speculative sources possibly influenced price fluctuations. Possible specific factors that underlie the background where speculative sources acted for selling and buying are as follows: it is possible that in the period from 1995 to 1997, when other shocks showed an upward swing, advanced nations, such as the US, were in the process of financial deregulation and market feeling eased toward demand recovery. In the period from 1998 to 1999, it is possible that, due to the Asian currency crisis or the Japanese financial crisis, the market tended to anticipate supply/demand mitigation. During the downswing in the period from the latter half of 26

28 2001 to 2002, demand, suffering from the IT bubble collapse, was stagnant and there were multiple terrorist attacks (September 2001), thus creating possible expectation for supply/demand mitigation. On the other hand, during the Iraq war (March 2003), market concern regarding tight supply/demand was not very strong, as Saudi Arabia and other countries increased production. However, during the upward swing from 2004 to 2006, market expectation for a demand increase in China or the US was strong. During the downswing from the fall of 2006 to the beginning of 2007, the housing loan issue was recognized and market uncertainty regarding the future economy arose. During the upward swing from 2007 to 2008, commodities, including crude oil, were attracting attention as investment targets while stocks and dollars were weak. In the same way, as a factor that can explain other shocks, we could point out a change in speculation by market participants due to factors that do not appear in the observed data on the demand or supply of crude oil. These factors are fundamental factors in the sense that they affect the supply and demand of crude oil at the present time and in the future. However, it is hard to judge to what extent other shocks could be explained by the factors mentioned above. Especially, given the fact that other shocks have been exerting influence on price formation in the same direction over a certain period of time, it is suggested that prices remained at a level that deviated sharply from the fundamentals for a certain period, which indicates that bubbles possibly occurred. Figure Factor Analysis on Crude Oil Price (over the whole period) Factor breakdown of deviation from trend of crude oil prices Supply shock effect Demand shock effect Other shock effect Crude oil prices (after removing trend) (Note) Rate of deviation from trend is indicated (Figures are based on logarithmic difference). Factors are broken down using the structural VAR model shown in this chapter. 27

29 (4) Limitations of Flow Approach and Asset Approach If the Flow Approach is effective as a price determination model, the approach should be able to sufficiently explain the price trends based on the demand and supply of crude oil. In other words, under the approach, most of the price fluctuations could be explained by trends or shocks in demand and supply, and the influence of other shocks should not be large. However, according to the empirical analysis in this section, such influence is actually large and it is suggested that the Flow Approach is not sufficient as a price determination model for crude oil. On the other hand, if the Asset Approach is effective as a price determination model, the present crude oil price should be determined by the supply and demand of crude oil at the present time and over periods in the remote future. It was mentioned earlier that if there is no major change on a short-term basis in the view on future prospects held by rational investors or oil traders, prices could be stabilized by allowing sufficient speculative transactions. In reality, prices underwent large fluctuations and other shocks are shown to be a factor that has exerted major influence. The influence of other shocks appears to have lasted for a certain period of time, rather than appearing at random 30, and we cannot eliminate the possibility that the crude oil price has deviated from the fundamentals and that bubbles have developed. Although under the Asset Approach, it is assumed that information prevails throughout the market and investors follow rational behavior, such an assumption is not valid in the actual crude oil market. 3. Bubble Analysis of Crude Oil Market As mentioned in the previous section, the price hikes until the summer of 2008 suggest the possibility that the actual conditions were different from those assumed as a prerequisite for the Asset Approach, and this in turn suggests the possibility that bubbles occurred as prices were influenced by factors other than the fundamentals. We introduce recent studies concerning asset bubbles and refer to them in considering the price hikes up to the summer of Theories on asset bubbles are categorized into the following typical models. Though we cannot discuss which model of the four is correct or not, we explain the outline of each model. Figure Typical Models of theories on Asset Bubbles No asymmetry of information Asymmetry of information 30 If other shocks are random, in general, the price determination mechanism of the Asset Approach is considered to be effective. 28

30 Rational Investors only Rational bubble Herding Irrational Investors exist Noise traders Psychological Bias (1) Models (rational bubble / rational expectation) where only rational investors exist (i) In the case of Symmetrical Information Under this model, all investors receive the same information and behave based on rational expectations. The information is not biased and the existence of a bubble becomes part of common knowledge among all the investors. There is a model showing the process where a slump is likely to occur following a bubble that temporarily existed. (Blanchard and Watson, 1982) Under the model, it is difficult to show that the bubble continues to exist 31. For example, there should be no possible bubbles for such assets as loans or bonds that have maturities and a fixed ceiling over the asset prices. In other words, it is considered that there are no factors that cause bubbles at maturity, and no factors in the middle of the term either, when the price of the asset is calculated by discounting future prices 32. (ii) In case of Asymmetrical Information Under the model, it is assumed that each investor forms rational expectations based on the information received, but it should be noted that only some of the investors are aware of the existence of the bubble. It appears at first glance that the difference in the information received by each investor would immediately lead to speculative transactions. But it is considered that information is transmitted through investors actions (or asset prices). Under this model, although it may appear otherwise, it is in fact very difficult to show how bubbles develop or speculations occur (no trade theorem) 33. The important issue in considering whether the bubble could continue is whether asymmetry in information would continue to exist even after each investor obtains publicly disclosed information such as market transactions or prices (Allen, Morris and Postlewaite, 1993). It should be noted that, as in the case of symmetrical information, if investors share the knowledge that the initial resource allocation is efficient (Interim Pareto Efficient), no bubbles would develop in a general equilibrium model. Herding (crowd behavior, following in footsteps) is suggested as an example of models based on asymmetrical information. 31 If investors share the common knowledge that the initial resource allocation is efficient (Interim Pareto Efficient), no bubbles would develop in a general equilibrium model. (Tirole, 1982) 32 Even securities with no maturities, if the transversality condition is met, would not cause bubbles. 33 Some investors, looking at other investors actions, in order to update information, can learn the fundamentals price. Therefore, as a result, opportunities for transactions would be lost instantaneously. 29

31 Various explanations from the point of view of economics are possible for the Herding Model as follows: (a) In cases where all the people face the same issue in decision-making, the optimal solution should be the same and as a result Herding is observed. (b) In cases where direct satisfaction is obtained by taking the same action as others, Herding is naturally observed. (c) In cases where it is advantageous to take the same action as others for strategic reasons, Herding occurs as an equilibrium action. (d) In cases where the information obtained indirectly through others actions is useful, it would be advantageous to disregard one s own information and join the Herd. We focus on (d). These cases are called Rational Herds, Information Cascades, Observational Learning or Social Learning. The theory considers investors patterns of actions in the following light: an investor who obtains private information on fundamentals will take time when taking actions, by observing actions of investors who moved earlier, other investors will update their information. 34 It is known that this sort of Herding could occur under very general conditions. In such a case, most of the information market participants have may not be reflected in their market actions. Namely, the market price could deviate from the fundamentals because information on the fundamentals is not released. The trigger for this situation is the fact that each market participant does not act to improve the entire efficiency but rather only acts to pursue his or her own profits, thereby useful information that could otherwise bring external positive values cannot be transmitted to others. Meanwhile, Herding tends to occur for insignificant reasons, Herding could suddenly stop for various reasons, or Herding in the reverse direction could occur. Another indication is that in cases where preferences are different among investors, it is difficult to gauge others actions (it is difficult to distinguish whether the received information is correctly reflected or the difference is caused by the difference in preferences ) and, therefore, it is pointed out that information is not easily reflected in the market (Smith and Sorensen, 2000). 34 As a specific example, consider the selection of restaurants. Customers visit two restaurants facing street A and B in turn. Each customer has inaccurate information of his or her own regarding as to which restaurant serves better dishes and he or she intends to select a restaurant by obtaining more information. The information received by the first customer would be clarified through the restaurant selected. The second customer compares his or her own information with the first customer s information and therefore partially his or her own information is reflected. However if the two customers in a row select the same restaurant, a third customer and so on would neglect his or her own information, and it becomes advantageous to select the same restaurant ( they are highly satisfied at this point in time). In this way, the information of the third customer and so on is not reflected at all in the entire actions. (Information Cascade) 30

32 (2) Model which includes Irrational (Behavioral) Investors (i) In case of Symmetrical Information Under these models, it is a precondition that rational and irrational investors (noise traders) are mixed. It should be noted that the introduction of noise traders itself and transactions between the two would not immediately cause bubbles 35. In order for bubbles to develop, it is necessary that there are restrictions on rational investors arbitrage actions. Risk avoidance (fundamentals risk and noise trader risk) and Synchronization Risk are known 36 as internal factors that restrict arbitrage by rational investors. Under the traditional model, bubbles occur simply as a direct consequence of this insufficient arbitrage and no consideration was given to a model where rational investors would expect higher prices and make speculation in the narrow sense. Below, we show two recent examples of research concerned with bubbles in cases of symmetrical information where rational investors are actively involved in the creation of a bubble. <Abreu-Brunnermeier (2003) Model> Under this model, it is a precondition that an investor independently spends time acquiring information, gradually beginning to notice the existence of the bubble and yet there will be no common knowledge shared among investors on the existence of the bubble. Under the circumstances, the model explains how rational investors ride bubbles while being aware of the existence of bubbles and that securities even with maturities could cause bubbles to develop (Finite Horizon Bubble). The model further points out, regarding bubble collapse, that news which has even a weak relationship with the fundamentals, coupled with synchronization with investors actions, could cause large price fluctuations (slumps). <Matsushima (2009) Model> Under this model, it is demonstrated that if there are irrational (behavioral) investors who believe in continuing price hikes and who never end up selling assets, even if the probability of such irrational investors existing is very small, bubbles could develop. This model could explain bubble occurrence even when the existence of bubbles becomes common knowledge among investors at the initial stage, and in this respect it is different from the Abreu-Brunnermeier model (2003). Further, if the point in time at which the bubble collapses is delayed, a bubble of a longer-term and larger size could be produced, according to the model. 35 Hypothesis of Efficient Market, namely, rational investors would conduct arbitrage and so bubbles would vanish. 36 External restrictions on transactions could be implemented 31

33 (ii) In case of Asymmetrical Information Under this model, it is assumed that views held by investors are varied due to factors such as psychological bias. In this case, investors are aware that they disagree with each other on the fundamentals, and speculative transactions can be made (even without noise traders). Even in this case, in order for bubbles to occur, restrictions on short selling are necessary (bubbles would not occur unless restriction is made on the influence of investors who have pessimistic expectations). Specifically, buys by optimistic investors expecting future price hikes cannot be balanced by sells by pessimistic investors expecting future price drops, and thus bubbles would occur with upward price swings. (Miller, 1977) With no common prior knowledge held by investors at the initial point of time, even if all information is shared, speculative transactions will occur due to psychological bias 37. Under the dynamic model, there are cases where the asset price would go up to a level even higher than prices expected by optimistic investors 38. We also studied models with irrational investors and asymmetrical information as preconditions, and here we introduce one example. <Scheinkman and Xiong (2003) Model> First, in cases where each investor is so overconfident as to believe that the information he or she has is more accurate than other investors information, speculative transactions could be made at a price higher than that based on the fundamentals. One typical feature of the model is that it can explain the phenomena where the price goes up with an increasing volume of transactions that are empirically suggested. As for the model s implications, it is pointed out that bubble size and price fluctuation would stay almost unchanged in cases where transaction cost goes up due to external factors, including asset transaction tax (Tobin Tax), although speculative transactions would decrease dramatically. In other words, the model suggests that it has a large disadvantage because an increase in transaction cost would restrict speculative activities based on arbitrage in a broad sense This is because the No Trade Theorem does not apply. 38 This is because of possibilities that more optimistic investors will appear in the market. 39 This is consistent with the fact that bubbles occur in the real estate market, where transaction cost is large. 32

34 Part 2 Changes in Financial Factors in Crude Oil Market Part 2 deals with the expansion of financial players presence in the crude oil futures market and the relationship between financial markets and crude oil prices based on observed data. 1. Financial Players Participation in Crude Oil Market First, we will analyze the expansion of financial players presence in the crude oil futures market, based on NYMEX futures market data 40. (1) Changes in Crude Oil Futures Open Interest and Trading Turnover Figure indicates that open interest on the New York crude oil futures market has increased since This means massive funds have flown into the crude oil market. Daily turnover has also expanded substantially since around Figure Changes in Crude Oil Futures Open Interest (on NYMEX) (1,000 contracts) (1,000 contracts) Open interest Turnover Note: One contract represents 1,000 barrels. Open interest is of the end of each month. Turnover is the monthly average of daily turnover. Source: Commodity Futures Trading Commission (CFTC) 40 The light, sweet crude oil brand (usually, West Texas Intermediate) listed on NYMEX represents the largest listed crude oil futures market, on which relatively more data from the U.S. Commodity Futures Trading Commission (CFTC) and other sources are released. 41 Long and short futures contracts are equal. On the basis of a gap between buying and selling, therefore, no fund inflow is seen into the market. But both long and short futures contracts have swollen. 42 The turnover expansion may indicate the presence of overconfident investors. It also indicates that a rising number of commodity traders have provided individual investors with investment tools leading transactions to be repeated in accordance with certain algorithms and that investment styles have been developed for daily trading based on investment by prop houses. 33

35 (2) Diversification of Crude Oil Futures Market Participants The expansion of crude oil futures open interest leads us to suppose that traditional market participants have increased open interest or that new players have participated in the crude oil futures market. Table compares a breakdown of crude oil futures open interest by market participant category in 1998 with that in In 1998, commercial hedgers accounted for more than 80% of open interest, traditional speculators for less than 10% and index investors for slightly more than 10%. In 2008, however, commercial hedgers reduced their share substantially to 60%. Conversely, index investors expanded their share to 30%, with traditional speculators still accounting for 10%. When commercial hedgers open interest increased, speculators and investors open interest expanded even faster. Particularly, index investors scored a remarkable increase in their open interest, which indicates that index funds and other new investors have become new participants in the crude oil futures market. In fact, a report that the CFTC published in 2008 said index investments in net notional value increased from $146 billion in December 2007 to $200 billion in June (Table 2-1-3). Crude oil accounts for large shares of major commodity indexes, indicating that an increase in commodity index investments can lead to a rise in crude oil futures open interest (Table 2-1-4). In fact, NYMEX crude oil index notional value increased from $39 billion at the end of 2007 to $51 billion at the end of June 2008 (Table 2-1-5). Index investors include various players, indicating their growing diversification (Figure 2-1-6). 43 The table indicates estimates made by Michael Masters. Data are estimates, lacking accuracy in some cases. For example, the traditional investors share of 4% in 1998 may have been an underestimation. Since investors business categories can change, it may not be sufficient to classify all investors other than index investors as traditional speculators. Nevertheless, the estimates may indicate an overall trend. 44 Based on real data covered and defined by the CFTC. 34

36 Table Changes in Commodity-by-Commodity Shares of Commodity Futures Market (1998) (2008) Commercial hedgers Traditional speculators Index investors Commercial hedgers Traditional speculators Index investors Cocoa 89% 9% 2% Cocoa 33% 48% 19% Coffee 81% 18% 2% Coffee 26% 35% 39% Corn 87% 9% 4% Corn 41% 24% 35% Cotton 84% 14% 2% Cotton 32% 27% 41% Soybean 73% 27% 0% Soybean 46% 22% 32% oil oil Soybeans 87% 11% 2% Soybeans 30% 28% 42% Sugar 87% 9% 3% Sugar 38% 19% 43% Wheat 88% 21% 11% Wheat 17% 20% 64% Kansas 86% 5% 8% Kansas 37% 32% 31% wheat wheat Feeder 52% 37% 10% Feeder 17% 53% 30% cattle cattle Lean hogs 57% 28% 16% Lean hogs 18% 20% 63% Live cattle 88% 24% 9% Live cattle 13% 24% 63% WTI crude 84% 4% 12% WTI crude 59% 10% 31% oil oil Heating oil 88% 2% 10% Heating oil 37% 16% 47% Gasoline 80% 4% 16% Gasoline 41% 20% 39% Natural 90% 3% 7% Natural 62% 10% 28% Gas Gas Average 79% 14% 7% Average 34% 26% 40% Source: Testimony of Michael Masters before the Committee on Homeland Security and Government Affairs, United States Senate Table Changes in NYMEX Crude Oil Index Notional Value Item Unit Date December 31, 2007 March 31, 2008 June 30, 2008 Index investments in net notional value ($1 billion) US exchanges only ($1 billion) NYMEX crude oil index funds NYMEX crude oil index notional ($1 billion) value Crude oil index values measured in (1 million futures equivalents barrels) Share of NYMEX open interest (%) NYMEX open interest (gross) (1 million 2,509 2,885 2,837 barrels) NYMEX crude oil price WTI $/barrel Note 1: Net notional value means net short and long positions. The NYMEX open interest (gross) covers futures and options positions on NYMEX. Note 2: Tables and cover CFTC-compiled data that do not necessarily match estimates by Michael Master for Table Source: CFTC Staff Report on Commodity Swap Dealers & Index Traders with Commission Recommendations, September

37 Table Commodity-by-Commodity Breakdown of Major Commodity Indexes (2009) Energy Industrial metals Crude Petroleum Natural Aluminum Copper Nickel Zinc Others oil products gas S&P GSCI DJ-AIG RICI Precious metals Farm products Dairy Others products Gold Others Wheat Corn Soybeans Other S&P GSCI DJ-AIG RICI Note: S&P GSCI: September 2009 DJ-AIG: January 2009 RICI: No rebalancing Table Comparison of Futures Market and Index Fund Sizes for Major Commodities Commodity Futures market size Index investments in net notional value ($1 billion) ($1 billion) (Percentage share) 33 US exchange-traded markets (17) NYMEXT crude oil (13) CBOT wheat 19 9 (47) CBOT corn (18) ICE cotton 13 3 (23) Note: Data as of June 30, Source: CFTC Staff Report on Commodity Swap Dealers & Index Traders with Commission Recommendations, September

38 Figure Types of Index Investors Index funds Institutional investors Sovereign wealth funds Others Note: Data as of June 30, Source: CFTC Staff Report on Commodity Swap Dealers & Index Traders with Commission Recommendations, September 2008 Table Features of Commercial and Financial Players Investment Behaviors Features of Investment Behaviors Commercial - Commercial hedgers hold futures and other positions to hedge against risks hedgers involving cash transactions. Companies that conduct commercial transactions may take speculative actions. Hedge funds - Hedge funds repeat short-term transactions to earn profit without considering (traditional cash transactions. speculators) - They utilize short selling and other tactics to earn profit on both price hikes and drops, taking flexible positions while anticipating future developments. Index - While keeping away from cash transactions, index investors conduct futures investors rollovers (buy front-month contracts, sell them just before their expiration and buy new front-month contracts) to effectively hold long positions over a long term to earn long-term investment profit. - Instead of short selling, they conduct long buying over a short term and conduct selling to fix profit after holding positions for a long term, based on long-term fixed strategies rather than trend-following and flexible strategies. - Pension funds give priority to diversifying investment portfolios to disperse risks, rather than maximizing profit. They try to avoid inflation risks and view inflation-linked financial instruments as attractive investment targets, given that these instruments have little correlation with traditional assets. Source: MURC prepared the table based on Akira Ishii, Another Oil Crisis, Nikkei BP (October 2007). 37

39 (3) Financial Players Participation Historically, outstanding commodity index investment 45 has been increasing since around 2004 (Figure 2-1-8). One apparent factor behind the increase is an expansion in commodity market investment by pension funds and the like. For example, the California Public Employees' Retirement System (CalPERS), the largest US pension fund, started considering commodity investment in 2006 and launched such investment in 2007 (Table 2-1-9). As commodity indexes have declined since the second half of 2008 (Figure 2-1-9), trend-following traditional investors may have unwound long positions or shifted to short positions (Table ). Meanwhile, commodity index investment by pension funds and the like may have caused market value to decline on price drops. However, it seems withdrawal of investment has occurred only to a limited extent 46. Figure Commodity Index Investment Compared to S&P GSCI Spot Price Commodity Index Source: Testimony of Michael Masters before the Committee on Homeland Security and Government Affairs, United States Senate 45 Quoted from the Congressional testimony of Michael Masters. 46 Given that pension funds and the like may have limited their withdrawal from commodity market investment and that NYMEX open interest has remained high, index fund open interest is expected to avoid any substantial decline. 38

40 Table Commodity Investment by Institutional Investors PME Fund (Dutch machinery industry): The fund initiated commodity investment in 2004 (with the initial investment size at 750 million euros). It raised the commodities share of its overall investment portfolio from 6% in 2005 to 8% in It has invested in a fund linked to a 24-commodity index covering crude oil, precious metals, grains and other commodities. It decided to increase commodity investment after achieving a double-digit return for 2004 and BT Fund (British Telecom): In January 2006, the fund reduced stock investment and allocated 3%, or 1 billion pounds (about 210 billion yen), of its overall investment portfolio to commodity investment. PGGM (Dutch pension fund): The fund initiated commodity investment in 2000 and increased the commodities weight of its investment portfolio from 2004 to Its commodity investment return stood at 27% in Its portfolio totaled some 12 trillion yen at the end of September 2006, of which stocks accounted for 44.7%, bonds for 29.5%, private equities for 5.4%, real estate for 13.4% and portfolio strategies (apparent hedge funds) for 2.7%. Commodity investment accounted for 4.3% (some 560 billion yen). The fund presumes an expected return on commodity investment at 14.8%, higher than 8.5% on stocks. NEMA (Irish state pension fund): The fund decided to invest in commodities in 2006, allocating 1-3%, or 270 million euros, of its investment portfolio to commodities. California Public Employees' Retirement System (CalPERS): The fund officially approved its commodity investment in November 2006 and launched such investment in In February 2008, it released a plan to invest up to 3% (some $7.2 billion) of its total portfolio in commodity markets. (It plans to reduce the stocks share of the portfolio from 60% to 56% in two to three years and increase shares in crude oil, gold and other international commodities, and real estate. Investment in international commodities will expand up to $7.2 billion, a 16-fold increase from the latest level.) Its investment portfolio totaled $260.6 billion in February Illinois Teachers Retirement System: The fund launched international commodity investment in It canceled part of investment linked to US and other stock market indexes and commissioned investment managers to invest $600 million in commodities. Oklahoma Firefighters Pension and Retirement System: The fund initiated investment in real estate and international commodities in Pennsylvania State Employees Pension Fund: The fund s outstanding investment linked to international commodity prices stood at $2.6 billion at the end of 2007, up some 30% from a year earlier. Fonds de Reserve pour les Retraites (FRR) The fund experimentally launched commodity investment in 2007 and achieved high investment returns. It plans to use 2 billion euros for commodity investment. <Other moves> ABP, Netherlands: since 2001, 2.5% of assets 4,500m Ontario Teachers: since 1997, 3.5% of assets $3,000m Harvard Endowment: >10years, 13% in real assets $3.000m PIMCO (Commodity Fund): since 2001 >$3,000m Hermes (Commodity Fund): since 2006 > 1,000m BGI (Commodity Fund): since 2004 > 500m PME, Netherlands: since m Bedfordshire CC PF, UK : allocating in 2005/6 75m NZ Superannuation Fund, NZ: 5% of assets 260 Sources: MURC prepared the table based on newspaper reports, Sumitomo Capital Management Commodity Market Comment (Macro & Crude Oil) (November 28, 2007), etc. 39

41 Figure Changes in CRB Commodity Futures Index Note: Reuters/Jefferies-CRB Index (1967=100) Source: Thomson Reuters Figure Changes in Speculators Positions ($/barrel) (1,000 contracts) WTI crude oil price (front-month contract) Long positions Short positions Net positions of speculators (non-commercial and non-reportable) (right scale) (Yearly, weekly) Note 1: Latest positions are for March 10. The WTI crude oil price is a March average. Note 2: Noncommercial investors are reportable speculators, excluding end-users. Non-reportable investors are market participants who are not required to make trading reports. Most of these investors apparently engage in speculative actions. Source: CFTC 40

42 2. Reasons for Participation in Commodity Markets The following can be considered as reasons for these funds focus on energy commodity investment. (1) Excessive Liquidity Since stock markets slumped after the IT bubble burst in 2000, the US Federal Funds rate target had been gradually lowered. Following the US monetary easing, Europe also cut policy interest rates. Japan was already under the zero interest rate policy. Therefore, industrial countries as a whole had low interest rates then, leading to a global excess of liquidity 47. Later, the world economy recovered, and interest rates were raised gradually. As the US subprime mortgage problem emerged in the second half of 2007, however, the United States and other major countries lowered interest rates again. This contributed to increasing the global excessive liquidity 48. Furthermore, growing oil money and trade surpluses in emerging economies added fuel to the global excessive liquidity. This means that China and oil-producing countries expanded purchases of US and European government securities, bringing about their higher prices and lower yields 49. This reduced the attractiveness of bond investment, leading to difficulties in finding investment targets. 47 The excess liquidity has not been defined clearly or quantified. Here, it means a situation where investment returns deteriorate on interest rate drops, leading investors to have difficulties in finding investment targets, and look for new targets. Under such a situation, low interest rates may make fundraising easier, prompting some investors to take advantage of higher leverages to achieve higher investment returns. 48 While investment performance deterioration prompts investors to look for new investment targets, declines in the value of assets subject to investment can reduce investors risk tolerance to cause their withdrawal of investment funds. 49 Asian and oil-producing countries have tended to expand investment in U.S. government securities. This may have contributed to lowering U.S. government securities yields. 41

43 Figure Changes in Japanese, US and European Policy Interest Rates Europe Japan USA Source: DataStream (Yearly, monthly) While investors looked for new investment opportunities, share prices and the dollar declined with commodity prices rising between the second half of 2007 and the first half of As discussed later, share price falls prompted investors to seek alternative investment targets and the lower dollar led investors to pay attention to crude oil futures as a hedging instrument 50. Figure Changes in Commodity and Financial Market Prices (100 for January 2006) Commodity prices (CRB) Stock prices (S&P 500) Dollar Note: The dollar s value represents an effective exchange rate. Source: Bloomberg (Yearly, monthly) 50 In the second half of 2008, however, the combination of a falling dollar and rising oil prices was reversed. Regarding share prices, however, both the dollar and crude oil prices declined substantially, failing to serve as a hedge against the stock market slump. 42

44 Massive investment in commodity markets can be expected to cause price co-movement among many investment target commodities. In fact, prices of commodities in general, not only crude oil, soared toward the first half of 2008 and declined quickly in the second half. Figure Changes in Commodity Prices (100 for January 2006) Steel prices Nonferrous metal prices Crude oil prices (WTI) Farm produce prices Gold prices (Yearly, monthly) Note: Farm produce covers wheat, soybeans and corn. Nonferrous metal prices are represented by the LME index and steel prices by the HR index. Source: Bloomberg (2) Expectations on Investment Returns Growing expectations of higher returns on commodity investment have been cited as a key factor behind institutional investors massive investment in commodity markets. Such expectations may have grown as a result of actual demand factors, the dollar s depreciation, stock market declines and inflation fears. 1) Anticipation of Higher Prices due to Supply/Demand Factors A crude oil price spike in 2004 may have triggered institutional investors interests in energy commodities, as explained below: In 2004, the crude oil price soared from $33.78 per barrel at the beginning of the year to the then record high of $55.17/bbl on October 22, making a great upward shift from the $20-40/bbl range that had lasted since the 1980s. In this sense, the year can be seen as a turning point leading to the crude oil price spike over the recent years. The spike in the year came on a fast increase in oil demand mainly in China and the United States, and a decline in global spare oil production capacity. The great oil market volatility and growing fears of a tighter supply/demand relationship may have 43

45 stimulated the interests of investors placing funds in global financial markets and enhanced their recognition of energy commodities as investment targets 51. Later forecasts of growing oil demand published by various institutions, including IEA, may have led market participants to become bullish about future energy prices 52. Figure Changes in Global Crude Oil Supply/Demand (1 million barrels per day) Demand Supply Source: IEA Figure Inventory Data (OECD inventories, seasonally adjusted) (Yearly, quarterly) (day) Inventory level (right scale) Number of days covered by inventories (left scale) (1 billion barrels) (Yearly, quarterly) Note: MURC conducted seasonal adjustments under the US Census Bureau Act. Source: IEA 51 An Analytical Survey on Crude Oil Price Spike in Recent Years and Relevant Factors, Institution of Energy Economics, Japan, March A wide range of market participants view the IEA as an objective, reliable forecaster. Analysts who have worked at investment banks have also been considered excellent in transmitting information. 44

46 Figure Changes in OPEC s Surplus Oil Production Capacity (since 2001, monthly) (1 million barrels per day) Surplus production capacity (total OPEC, left scale) Note: Angola has been covered since January 2007 and Ecuador since December Source: IEA (Yearly, monthly) Figure Oil Demand Outlook (from IEA s World Energy Outlook) (billion tons) Totaling 3.2 billion tons Totaling 4 billion tons Totaling 4.5 billion tons Totaling 5.1 billion tons Unknown Africa Middle East Latin America India China Asia (excluding Japan, China, India and South Korea) Russia Eastern Europe and Central Asia Japan USA OECD (excluding Japan and USA) Source: IEA World Energy Outlook

47 2) Relative Improvement of Attractiveness of Commodity Investment Commodity indexes including crude oil futures have achieved better investment performances than stocks and bonds in a greater number of periods. Some people think that commodity markets replace stock markets as the better investment performer every 15 to 20 years 53. Given such view, some investors may have growingly speculated that a period toward the 2010s would be the time for commodity market investment. Stocks rose to high levels on substantial monetary easing from 2002 and were then recognized as riskier investment targets 54, while crude oil futures and other commodity markets, which had been rising since the late 1990s, attracted attention as investment targets expected to rise on supply/demand factors. This may have been a factor behind the improvement of commodity investment s attractiveness. (100 for early 2000) Figure Investment Performances of Stock and Commodity Indexes Stock index (S&P 500) Commodity index (S&P GSCI) Energy index Note: The figure is based on the total return index published by Standard & Poor s. The energy index as part of the index covers crude oil and natural gas. Source: Bloomberg 53 The view may have been attributable to the two oil crises in the 1970s and large-scale wars. Toward the 1990s, monetary tightening amid inflation fears during economic expansion in industrial countries tended to trigger stock market declines. 54 As price-earnings ratios and other share price indicators led investors to view fewer stocks as undervalued, stock investment risks were interpreted as relatively higher than those indicated by returns. 46

48 3) Inflation Hedge Commodity price hikes led to growing inflation fears under general upward pressures on prices. Inflation can lower the currency value and the effective bond value, making government securities investment less attractive. When inflation fears grew globally toward the middle of 2007, the need for commodity investment as an inflation hedging tool increased. For example, the above-mentioned CalPERS reportedly decided in 2007 to increase the portfolio weight to 5% in a few years for inflation-linked assets, including commodities 55. Figure Changes in Inflation in Major Countries Germany Japan Britain USA Source: CEIC (CY) 4) Dollar Decline-Caused Expectations of Higher Commodity Prices The dollar s depreciation has been viewed as a factor behind price hikes for crude oil and other commodities. If crude oil and other commodities remain unchanged in value, the dollar s decline may reasonably boost their dollar-denominated prices. If crude oil and other commodity prices tend to rise on the dollar s depreciation, commodity futures can be viewed as useful for hedging against the dollar fall. Over the recent years, a remarkable negative correlation has been observed between the dollar and commodity prices. This means the dollar s deprecation tended to cause commodity price hikes. 55 Specifically, commodities, infrastructure assets, forests and inflation-indexed Treasury securities were cited as inflation-linked assets. 47

49 Since the second half of 2008, however, the dollar rose substantially against the euro with crude oil prices declining considerably. The negative correlation, though reversed, has continued (Figure ). Figure Changes in Correlation between Commodity Prices and Dollar Value Positive correlation (linked) Negative correlation (linked in reverse)) (Yearly, daily) Note: The commodity price and dollar value move in the same direction when their correlation coefficient is close to 1. They have no relationship if the correlation efficiency is zero. If the correlation coefficient is close to minus 1, the directions of their movements may be different. We tracked the average correlation between commodity prices and the dollar s value over the past year, and here we provide a simple average correlation between commodity and dollar values. Source: Bloomberg Figure Changes in Correlation between Crude Oil Prices and Dollar Value Positive correlation (linked) Negative correlation (linked in reverse)) (Yearly, daily) Note: The commodity price and dollar value move in the same direction when their correlation coefficient is close to 1. They have no relationship if the correlation efficiency is zero. If the correlation coefficient is close to minus 1, the directions of their movements may be different. We tracked the 30-day moving average correlation between crude oil prices and the dollar s value over the past 30 business days, and here we provide a simple average correlation between commodity and dollar values. Source: Bloomberg 48

50 (iii) Effects of Investment Diversification 1) Improvement of Linkage between Traditional Financial Assets Institutional investors have begun to invest funds in commodity markets, as the linkage between traditional financial assets (stocks and bonds) has grown stronger on the progress in the globalization of financing and markets and in information. In fact, since 2000, share prices in the world have moved in the same directions. Japanese, US, German and Hong Kong share prices have always moved up and down in the same direction. Figure indicates the correlation coefficient between US and other share prices. Since 2000, the coefficient has remained close to 1, indicating a growing linkage between US and other share prices. Figure Stock Market Linkage Japanese share prices German share prices Hong Kong share prices (Yearly, monthly) Note: The correlation coefficient for two years is for the monthly stock average. As the coefficient is close to zero, these share prices move in the same direction. If the coefficient is close to minus 1, they may move in opposite directions. Source: Bloomberg 2) Lighter Correlations For the above-mentioned reasons, institutional investors have begun to indicate their interests in commodity market investment. They assume that commodities have less correlation with traditional assets and are suitable as investment targets for the diversification of risks. As indicated by the table below, no stable correlation has been identified between commodity and share prices (Figure ) and between crude oil prices and share prices (Figure ). This indicates that people may be led to believe that commodity markets are suitable for 49

51 investment to disperse risks 56. Figure Changes in Correlation Coefficient between Commodity and Stock Markets Positive correlation (linked) Negative correlation (linked in reverse) (Yearly, daily) Note: Commodity and share prices move in the same direction when their correlation coefficient is close to 1. They have no relationship if the correlation efficient is zero. If the correlation coefficient is close to minus 1, their directions may be different. We tracked the correlation coefficient between commodity and share prices regarding month-to-month changes over the past year, and here we provide a simple average correlation between commodity and share prices. Source: Bloomberg Figure Changes in Correlation Coefficient between Crude Oil and Stock Prices Positive correlation (linked) Negative correlation (linked in reverse) (Yearly, daily) Note: Crude oil and share prices move in the same direction when their correlation coefficient is close to 1. They have no relationship if the correlation efficient is zero. If the correlation coefficient is close to minus 1, their directions may be different. We tracked the correlation coefficient between crude oil and share prices regarding month-to-month changes over the 30 business days, and here we provide a simple average correlation between stock and crude oil prices. Source: Bloomberg 56 Actually, stock and commodity prices declined substantially in the second half of 2008, indicating that the risk-dispersing function of commodity investment cannot necessarily be expected at any time. 50

52 (iv) Presence of Myth A myth spread when bubbles (including land price and IT bubbles in Japan) emerged. During the latest crude oil price spike, growing energy demand in BRICs, the dollar s depreciation leading to higher crude oil prices, and arguments about oil price peaks may have been exaggerated to become a kind of myth. For example, the combination of the dollar s decline and crude oil price spikes came as the dollar declined 30% with the crude oil price nearly doubling (Figure ). There may be no problem if the dollar depreciates 1% on a 1% rise in crude oil prices. In fact, however, crude oil prices soared even more sharply. The dollar s fall may have brought about an excessive rise in crude oil prices 57. Figure Changes in Crude Oil Prices and Dollar Value ($/barrel) (100 for January 1, 2003) Crude oil prices (WTI, left scale) Dollar value (dollar index, right scale) Dollar depreciation Dollar appreciation (Yearly, monthly) Note: The dollar s value represents a weighted average against the euro, yen, pound, Canadian dollar, Swedish krona and Swiss franc. Source: Bloomberg 57 In response to relative crude oil market moves, unreasonable speculations may have worked. 51

53 Part 3 Hypothesis for Mechanism of Large Fluctuations in Crude Oil Prices It is often pointed out that although the surge in crude oil prices over the period from 2004 to the summer of 2008 partly reflected the tightening fundamentals, the reason for the rise after 2007 in particular remains unclear. Meanwhile, the steep fall in crude oil prices since the second half of 2008 appears to signal the collapse of a bubble. The excessive volatility in crude oil prices is believed to have been closely related to the global economic trend. Share and asset prices rose amid the strong growth of the global economy, and prices of crude oil and other commodities also went up, leading to an increase in the volume of leveraged investment funds used in a broad range of sectors of the global economy. Although prices of stocks, real estate and commodities did not rise exactly simultaneously, investors came to underestimate risks involved in the overall global economy while overestimating investment returns as they continued to look for undervalued investment targets and investment targets with potential for a future price rise. It is natural to regard the surge in crude oil prices as part of this trend. 58 This means that investors hoping to secure both relatively high investment returns and risk hedges directed their attention to the crude oil market as a target for investment through commodity index funds. However, as mentioned above, an inflow of funds would not necessarily create a market bubble if adequate information is available for investors and rational investors are allowed to make arbitrage activity without excessive restriction 59. Therefore, it is important to examine inherent market factors that cause excessive volatility in crude oil prices. 60 While there are many possible factors, we would like to present the following hypothesis for the mechanism of excessive volatility in crude oil prices so as to enable comparison with and reference to the aforementioned economic theories and existing data related to the generation of a market bubble, while giving due consideration to the fact that the fundamentals alone cannot fully account for the surge in crude oil prices. (1) A Rise in Crude Oil Prices in 2004 to 2006 Fundamentals May be the Main Driver (i) Tightening of Supply-Demand Balance The crude oil price rise in 2004 is attributable in large part to the tightening of the supply-demand balance due to the strong global economic growth, as indicated by the fact that prices 58 Specific factors were explained in Chapter II. 59 We already mentioned that under the model that allows rational investors to make sufficient arbitrage activity, a bubble is unlikely to arise (1-3. Bubble Analysis of Crude Oil Market). Under the model that assumes the presence of only rational investors (Symmetrical Information (i) and Asymmetrical Information (ii)), a bubble is unlikely to be sustainable, while under the model that assumes the presence of irrational investors as well as rational investors ((i) Symmetrical Information and (ii) Asymmetrical Information), difficulty in conducting short-selling would have to be added as a precondition if a bubble is to occur. 60 Crude oil price movements have a significant impact on the overall economy. 52

54 of commodities other than crude oil and stocks generally rose. The supply-demand balance began to tighten around the end of 2002 due to political instability in Venezuela, Iraq and Nigeria. In addition, demand from countries like China increased sharply in 2004 while supply from non-opec oil-producing countries did not grow sufficiently, further tightening the supply-demand balance and fueling concern over supply. Furthermore, because of a decline in OPEC countries spare production capacity, concern over supply spread rapidly. As a result, despite a slowdown in the growth of demand from China and a moderate recovery in the OPEC countries spare production capacity, crude oil prices continued to rise in 2005 and thereafter as market expectations of a tight supply-demand balance remained unchanged 61. In the second half of 2006, crude oil prices started to drop, falling as low as 50 dollars per barrel at the beginning of 2007, as the pile of crude oil inventories that were built up due to the slowing demand eventually began to be factored into the market. However, as the OPEC countries reduced production around that time, concern over supply spread again, triggering a renewed surge in crude oil prices. (ii) Widespread Expectations of a Sustained Future Rise in Crude Oil Prices Meanwhile, expectations of a sustained future rise in crude oil prices seemed to spread among a broad range of investors over this period. A report on BRICs written by Goldman Sachs and books discussing the peak oil drew much attention, and a number of books encouraging investment in crude oil and other commodity products, such as Hot Commodities by Jim Rogers, were published. In addition, expectations of a sustained rise in crude oil prices grew partly because the IEA and other organizations continued to issue bullish forecasts of crude oil demand. Furthermore, the circulation of attention-grabbing information about the peak oil and the swelling demand from China prompted many investors, including retail investors and pension funds, to pay attention to the crude oil market as an investment target. In addition, as commodity index funds became available, new players gradually began to have a significant influence in the market. 62 This is likely to have been one factor underlying the surge in crude oil prices in the second half of 2007 and thereafter. (2) A Rise in Crude Oil Prices in 2007 to July 2008 Prices May Have Deviated Further from 61 See Figure Indicators Related to Economic Activity and Supply-Demand Balance. 62 This may be because of the phenomenon of Herding, which we mentioned in relation to the model that assumes the presence of only rational investors (Asymmetrical Information (ii)) in 1-3. Bubble Analysis of Crude Oil Market. Herding may have been prompted by news about the entry of influential investors and investment banks into the commodity market and by information concerning fundamentals that was provided by prominent organizations. In addition, if new market participants were looking for additional profit-earning opportunities, they were probably more bullish on the prospects of the market than existing investors and investors staying outside the market. This may explain the presence of overconfident investors, which we mentioned in relation to the model that assumes the presence of irrational investors as well as rational investors ((ii) Asymmetrical Information). 53

55 Fundamentals (i) Spread of Subprime Crisis and Lack of Favorable Investment Targets The deterioration of the U.S. housing market began to become evident around the second half of 2006, and it came to light in June 2007 that hedge funds controlled by Bear Stearns incurred huge losses related to subprime mortgages. As substantial credit easing was implemented amid growing concern over the stability of the financial system, a glut of funds arose. In other words, as share prices slumped while interest rates declined, fund managers faced a lack of favorable investment targets. In addition, excessive liquidity arose because of an increase in funds managed by investors using leverage, which came against the background of the stock and asset price rises that had continued for a long time, lax regulation and lenient risk assessment. Under these circumstances, crude oil and other commodities that had continued to rise since 2004 came to be regarded as relatively favorable investment targets. In the meantime, organizations such as the IEA continued to issue bullish forecasts of demand. Although demand from developed countries was slowing down, that from China, which was enjoying an economic boom ahead of the Olympic Games in Beijing, was expected to continue growing. Furthermore, as the rise in crude oil prices proceeded at the same time as the U.S. economic slowdown, concern over possible stagflation and a depreciation of the dollar spread among investors, prompting moves to use crude oil futures as an effective investment vehicle for the hedging purpose (the crude oil price surge and concerns over possible stagflation (stock and bond market slumps) and the weak dollar fueled each other). As a result, pension and other investment funds that had previously invested mainly in financial products scrambled into the markets for crude oil and other commodities. 63 Therefore, prices of commodities other than crude oil in general were also on an uptrend in the period up to the first half of 2008 (Figure ). (ii) Investment Boom as Represented by Proliferation of Index Funds Meanwhile, U.S. and European investment banks satisfied the needs of investors who started to invest in crude oil and other commodities by developing and expanding sales of mass-market products like commodity index funds. Commodity traders at investment banks had sophisticated expertise in financial products. However, as they were not necessarily adept in the physical side of crude oil trading, which had previously attracted little attention, they may have allowed the price to be formed at a level that was quite disconnected from the actual demand trend The phenomenon of Herding, which we mentioned in relation to the model that assumes the presence of only rational investors (Asymmetrical Information (ii)), may have escalated because the share price slump and the dollar s weakness due to concern over the stability of the financial system created an environment that enabled the markets for crude oil and other commodities to attract attention. 64 They are likely to have actively changed contract-month-spread transactions to inter-commodity spread transactions so as to avoid risks associated with changes in the price level. In contrast, investment banks that held few physical crude oil stocks may have been cautious about building a large short position in the crude oil market in 54

56 In addition, while investment banks limited their own positions in the crude oil market as they judged it risky to build such a large position as to allow their business to be affected by the level of crude oil prices, they apparently helped to increase market liquidity by actively engaging mainly in spread transactions. Major investors, such as pension funds, are generally regarded as rational and sophisticated investors. However, the fact that many market players started investment in commodities through index funds over a short period of time suggests the possibility that the Herding instinct 65 affected their investment behavior 66. These factors apparently led to an increase in noise traders, 67 who participated in the crude oil market without having judgment criteria regarding the actual condition of crude oil trading. (iii) Rapid Increase in Trading Volume Under these circumstances, crude oil prices rose to such high levels as to discourage players with real demand from making long hedges. This, coupled with uncertainty over economic prospects, dampened real demand-related transactions 68. However, crude oil trading heated up due to an escalation of investments based on the assumption that a link existed between high crude oil prices and the weak dollar and low share prices, and transactions focusing on achieving short-term gains by selling out of the market at the right time 69. particular. 65 As we mentioned in explaining the Herding behavior in relation to the model that assumes the presence of only rational investors (Asymmetrical Information (ii)), the Herding may represent either a rational behavior based on the expectation that behaving like others will improve the investment return or an irrational behavior that reflects a sense of security about the act of behaving like others. 66 The entry of major pension funds into the market and investment banks solicitation activities may have encouraged new players to invest in commodity futures with a view to diversifying the scope of investment target assets. However, if the surging crude oil prices had been regarded as an evident sign of a bubble, the crude oil market would have been avoided as an investment target. Actually, many players rushed into the market. It should be noted that although the amount of pension funds invested in crude oil and other commodity futures was less than 10% of the entire size of pension assets, it accounted for a large portion of the crude oil futures market. This may have led to a shortage of sellers in the futures market. 67 A noise trader refers to an investor who makes transactions in an irrational manner or based on inaccurate information. Also classified as noise traders are trend followers as well as investors who enter the market with overly bullish expectations of future prices without sufficient understanding of the product nature of crude oil futures (overconfident investors mentioned in relation to the model that assumes the presence of only rational investors ((ii)asymmetrical Information)). Increased liquidity in the crude oil market may have made it easier for trend followers to make transactions, enabling them to earn huge profits as prices continued to rise, and this may have encouraged them to further expand their positions. 68 Open interest built up by market players with real demand have not been increasing since the second half of 2007 (this is true even if the effects of the discontinuity of the CFTC data since July 2007 are excluded). 69 Trading opportunities may have increased because of the presence of overconfident investors as we explained in relation to the model that assumes the presence of only rational investors ((ii)asymmetrical Information) and also because of differences in expectations about the prospects of the market between investors (Figure shows that trading volume has increased since 2007). 55

57 Some hedge fund traders who were confident that they had trading skills and information gathering capabilities sufficient to enable them to sell out of the market at the right time may have bought into the crude oil market while recognizing that crude oil prices were overvalued, as they considered it an opportunity to earn profits. In particular, investment funds pursuing the trend-follow type investment strategy must have enjoyed good investment performance as the surge in crude oil prices continued, and this is likely to have increased their risk tolerance. (The fact that positions in the OTC market can be expanded easily due to some regulatory loopholes 70 may have served as a background to the fact that self-confident investors did not face liquidity risk 71.) It has been pointed out that the investment behavior of investors with strong confidence in their own judgment leads to a price rise coupled with an increase in trading volume 72. Indeed, crude oil prices surged during this period, accompanied by a remarkable increase in trading volume. (iv) Reason Why Perception of Overvaluation Was Ignored Given the rise in the cost of producing crude oil due to higher equipment and personnel costs and the increased bid expenses needed for the acquisition of mining rights, as well as the growing consciousness of the high costs of alternative energies, such as biofuels, and a surge in prices of metals and agricultural products, it was not correct to assert that crude oil prices alone were extremely high. Nonetheless, many investors and players with real demand must have believed that crude oil was overvalued. However, if investors hold short positions in the crude oil futures market, for example, they would be implicitly obligated contractually to deliver crude oil, an arrangement that puts them at great risk because of the nature of crude oil as a product 73. (In the case of the delivery of WTI crude oil in particular, it is difficult for investors who do not have a tank in Cushing, the delivery point, to honor the delivery obligation.) In addition, crude oil-producing companies did 70 The swap loophole refers to the situation in which positions held by swap dealers at major investment banks that handle commodity index funds are treated in the same way as positions held by commercial sources for the hedging purpose under the CFTC s rules and thus are exempted from the position limits that are normally imposed on speculative transactions. The Enron loophole refers to the situation in which over-the-counter (OTC) transactions are exempted from the CFTC s regulation and oversight. The London loophole refers to the situation in which WTI crude oil futures transactions made on foreign exchanges, including the ICE in London, are exempted from the CFTC s regulation and oversight. (The London loophole was closed in October 2008 through cooperation between the CFTC and the FSA. The Enron loophole was closed by the enactment in May of the Farm Bill (H.R. 2419), which extended the CFTC s regulation and oversight to OTC transactions. In practice, however, the swap loopholes are believed to have a significant influence on both exchange-based transactions and OTC transactions, so the CFTC on February 24 proposed measures to strengthen regulation on commodity index funds (commodity pool operators). 71 Such investors may have used coercive speculative methods, such as by taking advantage of their large positions to induce other investors to cut losses, in order to exercise influence on the price level. 72 This refers to cases in which overconfident investors as referred to in the Scheinkman and Xiong model (2003), which we mentioned in relation to the model that assumes the presence of only rational investors ((ii)asymmetrical Information). 73 Difficulty in conducting short-selling, which is regarded as a precondition for the occurrence of a bubble in the model that assumes the presence of irrational investors as well as rational investors ((i) Symmetrical Information and (ii) Asymmetrical Information) apparently applies to this case. 56

58 not have a significant incentive to enter the market by taking short positions, as they were able to secure adequate profits due to the high crude oil prices 74. (Meanwhile, although some people in oil-producing countries probably regarded a bubble-like price upsurge as undesirable from a long-term perspective, those countries found it difficult to do without the high oil prices after suffering many years of national budget deficits. After all, oil-producing countries did not actively move to curb crude oil prices through a production increase or oil field development.) Thus, we may say that crude oil prices rose to overvalued levels partly because it was easier to enter the market with long positions than with short positions. (3) Period of Crude Oil Price Plunge (2nd Half of 2008) (i) Plunge Suggestive of Bubble Bursting Because of a sharp decline in real demand around the world and the dollar s appreciation, crude oil prices took a sharp downturn. Open interest, particularly that held by commercial traders 75, decreased. Despite the price plunge, we have so far heard of no failure of a major hedge fund. This is presumably because investors investing mainly in the crude oil market are polarized between those focusing on spread transactions and those concentrating on the trend-following strategy. In spread transactions, the possibility of an investment fund incurring huge losses from a change in the level of crude oil prices is limited, while the trend-following strategy may have generated profits because the periods of market upturn and downturn were clearly divided. It should be noted that long positions taken through commodity index funds may have been widely dispersed among investors with low leverage, such as pension funds. (ii) Open Interest may Increase Again in 2009 Since December 2008, we have seen speculative purchases prompted by the perception of undervaluation. However, players with real demand probably remain reluctant to make hedging transactions, because of an expected decline in their own companies sales and the perception of overvaluation of deferred futures (a significant contango). Although pension funds and investors making investments through index funds apparently continue to need diversity of investment targets, they are not active buyers because of the easing of concern about inflation and an erosion of their investment capacity due to a decline in the value of stockholdings. However, now that crude oil prices have dropped steeply, open interest will easily increase if some amount of funds flows into the market. On the other hand, the significant contango that has developed recently may be creating an 74 This may also constitute a reason for a lack of sufficient short-selling. 75 See Figure

59 opportunity for traders capable of stocking physical crude oil to make arbitrage transactions, such as selling futures while holding stocks of physical crude oil, and such sales may be helping to curb a rise in futures prices. 58

60 Figure Indicators Related to Economic Activity and Supply-Demand Balance (Month to month change; Unit: 1,000 people) Changes in the number of non-farm employees (left axis) IMS Manufacturing Report on Business index (right axis) (Source) U.S. Department of Labor, Institute of Supply Management (Annual, monthly) (Year-on-year change, %) Crude oil inventories (right axis) (Year-on-year change, %) Oil product demand (left axis) (Source) U.S. Department of Energy (Dollar/barrel) Crude oil price (WTI) Surplus production volume (right axis) Surplus production capacity (right axis) (Monthly, annual) (Unit: million barrels) 59

61 Figure CFTC Open Interest (Unit: 1,000 contracts) Non-reporters (long) Non-reporters (short) Non-commercial traders (long) Non-commercial traders (short) Non-commercial traders (spreading) Commercial traders (long) Commercial traders (short) 60

62 Figure NYMEX (monthly) (Unit: 1,000 contracts; futures trading volume and open interest) Open interest Trading volume Call Option Trading Volume and Open Interest Open interest Trading volume Put Option Trading Volume and Open Interest Open interest Trading volume (January 2006=100) Share price(s&p500) Crude oil price (WTI) Gold price Effective dollar/yen rate (right axis) (Note) The prices of agricultural commodities are represented by those of wheat, soybeans and corn. Prices of nonferrous metals are represented by LME indexes. Steel prices are represented by HR prices. (Source) Bloomberg 61

63 Figure IEA Statistics; Oil Supply, Demand and Inventories (Unit: one million barrels/day) Global Oil Supply and Demand Demand Supply (Source) IEA (Annual, quarterly) Inventory Level and Inventory Ratio (OECD, original series) (Days) Inventory level (right axis) Day s sales in inventory (left axis) (Unit: billion barrels) (Source) IEA (Annual, quarterly) Inventory Level and Inventory Ratio (OECD, seasonally adjusted series) (Days) Inventory level (right axis) Day s sales in inventory (left axis) (Unit: billion barrels) (Note) Seasonal adjustments were made by MURC based on the method used by the U.S. Census Bureau. (Source) IEA (Annual, quarterly) 62