Why the Oil Futures Market did not Contribute to High Oil Prices

A recent study by Luciana Juvenal and Ivan Petrella suggests that the financialization of oil futures markets contributed significantly to the surge in oil prices after 2003. Lutz Kilian, Professor of Economics at the University of Michigan, questions their analysis and highlights that their paper actually does not shed any light on the role of Wall Street speculation.

The question of how much speculative pressures contributed to the surge in the real price of oil between 2003 and mid-2008 continues to be hotly debated in policy circles. A common view among policy makers is that excessive speculation driven by the financialization of oil futures markets played a key role in causing oil prices to peak at unprecedented levels in mid-2008. This interpretation has been driving recent policy efforts to tighten the regulation of oil derivatives markets in the U.S. as well as abroad. In sharp contrast, the academic literature on this subject is virtually unanimous that financial speculation played no independent role in this episode. One of the rare studies claiming some success in pinning down the effects of financial speculation has been a working paper by Luciana Juvenal and Ivan Petrella (2012) originally published by the St. Louis Fed in 2011. This study has received considerable media attention, but what does it really show and how were its surprising conclusions arrived at?

Based on estimates of a structural vector autoregressive (VAR) model of the global market for crude oil, Juvenal and Petrella (2012) report that, overall, financial speculation (as captured by what I will refer to as the "hybrid speculative shock" and what they call somewhat imprecisely the "speculative shock") accounts for about 15% of the surge in the real price of oil from 2003 to mid-2008. This compares with 9% attributed to oil supply disruptions (or "flow supply shocks") and with 58% attributed to oil demand shocks associated with global business cycle fluctuations (or "flow demand shocks") - not 40% as has been widely, but incorrectly reported in the media on the basis of the Juvenal-Petrella study (see Figure 1 below).

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The guest post was written by. Lutz Kilian