Houston, March 2010

Craig Pirrong, Professor of Finance, Energy Markets Director, Global Energy Management Institute, Bauer College of Business, University of Houston – Summary and Conclusions: The financial crisis of 2008‐2009 had a pronounced effect on the behavior of oil prices, and the performances of the two primary price benchmarks, WTI futures, and Brent futures. The crisis was associated with a dramatic increase in price volatility; a widening of spreads; an increase in the volatility of these spreads; and a decline in hedging effectiveness.

These effects were evident for front month and second month WTI and Brent, but were most pronounced for front month WTI, especially within a few days of contract expiration. The financial crisis was also associated with an unprecedented spike in oil inventories in the United States and around the world, and at the WTI delivery point of Cushing, Oklahoma. The economic theory of storable commodity pricing, and the data, strongly suggest that this phenomenon is connected with the behavior of price benchmarks during the financial crisis.

Specifically, in an efficiently operating market, a sharp demand decline like that caused by the financial crisis should lead to a large increase in inventory. This large accumulation can cause stocks to approach capacity constraints at a point like Cushing. Although storage at Cushing was less than nominal capacity there even when inventories peaked, the data suggest that Cushing was effectively constrained, and that as a result, the supply of storage was extremely inelastic. Since (a) in a market with large storage nearby‐deferred spreads price the marginal cost of storage, and (b) when the marginal cost of storage is highly inelastic, small fundamental shocks have large effects on this marginal cost, then (c) such fundamental shocks will have large effects on spreads. Moreover, the dramatic increase in uncertainty and an increase in the demand for storage likely increased transactions costs, and the dispersion and volatility of negotiated storage rates at Cushing.

Thus, the behavior of pricing benchmarks during the period of the financial crisis was driven by the extraordinary circumstances of that period, and are not a harbinger of performance under more normal circumstances.

It should be emphasized that these effects were concentrated during the period of severe worldwide economic contraction and extreme volatility in the autumn of 2008 and the winter of 2008‐2009. The performance of the pricing benchmarks had largely returned to pre‐crisis levels by early‐spring, 2009.

For both WTI and Brent, there is evidence that technical factors associated with expiration inject additional volatility into the price in the expiring future.

These problems were more severe for WTI during the period of the financial crisis, likely due to the fact that the aforementioned constraints at Cushing exacerbated the effects of expiration‐driven technical features. The similar behavior of WTS suggests that this phenomenon was caused by fundamental conditions in the Midcontinent market, rather than factors specific to the NYMEX WTI futures contract. Although not immaterial, the importance of this is diminished by the fact that most interest has rolled to the next‐expiring contract well before these effects become manifest.

Even during the height of the financial crisis, WTI pricing relationships continued to co‐vary with fundamentals as predicted by economic theory. In particular, spreads widened as inventories (US and Cushing) declined (and vice versa), although this relation was weaker than that observed prior to the crisis. In contrast, in a reversal from pre‐crisis behavior, during the crisis, Brent spreads exhibited a negative correlation with inventories (US and Cushing); this is opposite from what one would expected to observe in a competitive market that accurately reflects fundamentals. This suggests that any divergences between the hedging performance of WTI and Brent are not clearly attributable to the latter reflecting fundamentals and the former not. In fact, the stock‐spread relation suggests that the opposite is the case.

Ends --

By Craig Pirrong, Professor of Finance, Energy Markets Director, Global Energy Management Institute, Bauer College of Business, University of Houston.

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Pirrong: Oil Trading Report

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