London, 6 July 2011

The weight of the evidence indicates that macroeconomic fundamentals can explain the 2003–08 increase in the price of oil, according to  new report – The Role of Financial Speculation in Driving the Price of Crude Oil – by Ron Alquist and Olivier Gervais at the International Economic Analysis Department of the Bank of Canada.

Financial speculation seems to have played a modest role. "Our own analysis suggests that there is no empirical evidence to suggest a strong relationship between the positions of speculators and price changes. Although there is debate about the appropriate way to estimate demand and supply elasticities in the global crude oil market, this technical discussion should not distract us from the fact that global macroeconomic conditions are capable of accounting for the persistent increase in oil prices. Overall, the available evidence points to global demand and supply conditions rather than financial speculation as an explanation for the surge in the price of oil between 2003 and 2008," say the authors.

Over the past 10 years, financial firms have increased the size of their positions in the oil futures market. At the same time, oil prices have increased dramatically. The conjunction of these developments has led some observers to argue that financial speculation caused the run-up in oil prices. Yet several arguments cast doubt on the validity of this claim according to the Report.

First, although the stock of open futures contracts is many times larger than the flow of oil consumption in the United States, comparing these two statistics is misleading. Stocks are not measured with respect to a specific unit of time but flows are, so the two are not directly comparable. Second, empirical analysis shows that changes in financial firms’ positions do not predict oil-price changes, but that oil-price changes predict changes in positions. Third, the evidence indicates that financial firms’ positions did not cause the market to expect persistent price increases during 2007/08.

Other explanations for the increase in oil prices include macroeconomic fundamentals, such as interest rates and increased demand from emerging Asia. Of these two explanations, the one that seems most consistent with the facts explains oil-price fluctuations in terms of large and persistent demand shocks related to growth in global real activity in the presence of supply constraints.

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Bank of Canada Role of Financial Speculation in Oil Prices July 2011.pdf

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