Explosive oil prices, oil eld development and the role of speculation

Explosive oil prices, oil eld development and the role of speculation

Explosive oil prices, oil field development and the role of speculation Marc Gronwald∗ October 2012 Abstract This paper, first, investigates whether or not oil prices are characterized by transitory phases of explosiveness. The application of a recently proposed recursive unit root test shows that phases with explosive behavior were present 1990/1991, 2005/2006 as well as 2007/2008. Second, it is shown that these transitory oil price hikes affect the decision on when to develop an oil field: the profitability of the project increases and, thus, the fields are developed earlier. As this leads to an increase in current oil production, current carbon emissions also increase.

Finally, the underlying causes of oil price hikes are discussed. It is important to note that the effect described here holds irrespective of whether oil price hikes are fundamentally driven or caused by “speculation”. The ongoing debate on oil market speculation, however, yields at least some evidence of speculative influences. Thus, oil market speculation seems indeed to be a harmful, but in a manner which so far appears to have been overlooked.

Keywords: Oil prices, Explosiveness, Uncertainty, Real options, Climate change, Speculation JEL-Classification: C12, C58, D81, Q30 ∗ ifo Institute - Leibniz Institute for Economic Research and CESifo, Poschinger Strasse 5, 81679 Munich, email: gronwald@ifo.de. The author is grateful for the hospitality of the University of California, Berkeley as well as Resources for the Future, Washington, DC, while working on the paper. Financial support by the Fritz Thyssen Foundation for these research visits is gratefully acknowledged.

1 Introduction The global oil market is heavily disrupted on a regular basis.

The two oil crises as well as the OPEC collapse are good examples in this regard. Each of these disruptions attracted considerable attention - from the general public as well as from academia. Most recently, the 2007/2008 oil price hike joined this list of incidents: in July 2008 oil prices reached the record high of more than 140 USD per barrel. Subsequently, a heated debate emerged regarding the causes and the consequences of this oil shock. Whether or not it contributed to the recession observed after 2008 ([4]) as well as whether “speculative” behavior or fundamentals explain it ([2]) are among the themes under discussion.

What is more, there is also a vast literature which is concerned with characterizing the idiosyncratic behavior of oil prices - in both the long-run and the short-run. With regard to the former, it is still subject of debate whether deterministic ([13]; [9]) or stochastic trends ([14]) are present in oil prices. On the short-run behavior front, a number of recent studies deal with jumps in oil prices ([5]; [3]). Among the most prominent candidates for explaining this behavior are low short-run demand and supply elasticities as well as political influences, see e.g. [15]. Finally, the issue of the optimal taxation of exhaustible resources is one of the main fields in the area of resource economics.

The fact that crude oil is a fossil resource and, thus, the usage of which is directly linked to the problem of climate change makes this research even more important. In a nutshell, it does not need much emphasis that these any research effort invested in understanding crude oil prices is more than justified.

Although considerable efforts have already been invested, it appears to be the case that the currently existing models are not able to capture oil price hikes like the one observed 2007/2008. Consulting Figure 1’s plot of daily oil prices from 1983 to 2011 shows that initially more of a horizontal movement is present. After a structural break in the late 1990s, however, oil prices started to increase. This upward movement still seems to be intact and currently oil prices are at about 100 USD per barrel. This visual inspection certainly does not allow one to discard either of the two existing long-run 2

20 40 60 80 100 120 140 160 1985 1990 1995 2000 2005 2010 Oil prices Figure 1: Oil prices descriptions. However, there are temporary phases in which deviations from the long-run behavior are apparent: certainly during the 2007/2008 oil price hike, but also 1990/1991 and in the early 2000s. Motivated by this observation, this paper deals with three issues. First, the idiosyncratic behavior of oil prices by is modeled by testing whether or not oil prices exhibit temporary phases of explosive behavior. The application of a recently proposed recursive application of unit root tests shows that oil prices are indeed marked by temporary phases of explosiveness: 1990/1991, 2005/2006 as well as 2007/2008.

This empirical feature has so far not been discussed in the oil price behavior literature. Second, the paper adds to the literature on the consequences of oil price hikes. However, rather than focussing on macroeconomic impacts, it is concerned with consequences with respect to the decision when to extract the fossil resource oil. Phases with transitory high oil prices like those identified in this paper lead to an increase in the value of undeveloped oil fields. This, in turn, is a strong incentive to begin oil extraction earlier. As this implies that current carbon emissions increase, the current atmospheric concentra- 3

tion of carbon also increases - this has obviously negative impacts for climate change. Third, the underlying causes of transitory oil price hikes are discussed. It is important to note that the effect on the oil field development decision occurs regardless of this cause. This implies in particular that it is not relevant whether the oil price hike is fundamentally driven or caused by “speculation” in oil markets. The heated debate on this issue - see [11], [4], [7] as well as [2] - however, yields at least some evidence that there are speculative influences in the oil market. Thus, there appear to be harmful consequences of speculation which so far seem to have been overlooked.

The empirical strategy of this paper consists of the forward recursive application of an augmented Dickey-Fuller unit root test. In each step, the null of a unit root is tested against the alternative of explosiveness. This procedure yields a sequence of test statistics which is used to identify phases with explosive and non-explosive behavior. Monthly as well as daily oil price data spanning from 1986-2011 and 1982-2010, respectively, is used in this study. This procedure is derived from a test for periodically collapsing bubbles recently proposed by Phillips et al. (2011) as further-development of cointegration-based tests for the existence of bubbles.

The investigation of the consequences of the observed oil price behavior on the resource extraction decision is based a reconsideration of [8]’s study on the relationship between transitory oil price hikes and the development of an offshore oil field. This real option application extends a model on investment under uncertain oil prices discussed in [12]. In the basic version of the model it is assumed that oil prices follow a continuous Brownian motion with drift. Motivated by the oil price hike associated with the Gulf war 1990/91, [8] augment the model by using a jump component and study the effect of non-permanent oil price increases.

They find that also this type of increase leads to development of oil fields, but it needs to be four times as large as a permanent increase in order to have the same effect. [8], however, assume that transitory oil price hikes are associated with wars, occur relatively rarely (every 20 years) and are relatively short (3-6 months). This paper’s empirical findings, however, suggest that they can have var- 4

ious causes, occur much more often and can last longer. In consequence, investment is more responsive to transitory hikes. Thus, there is an increase in current production of crude oil. The consequences have been outlined above. The driving force behind this effect is an increase in the value of an undeveloped oil field. Thus, it emerges regardless of whether or not the observed oil price increase is fundamentally driven. Motivated by the 2008 oil price hike, various papers attempt to shed light on its underlying causes. One important issue is the apparent “financialization” of oil futures markets, see e.g.

[7]. Papers such as [11] provide evidence that capital inflows in the oil futures market affected also oil spot prices and, thus, contributed to the 2008 oil price hike. This finding, however, is not undisputed, see e.g. [4] or [2]. This latter paper, however, provides strong evidence that the 1990/91 oil price hike is partly driven by speculative demand. In a nutshell, there is at least some evidence of speculative influences in the oil market, but additional research is required.

The remainder of the paper is organized as follows: Section 2 outlines the empirical method employed in this paper and Section 3 presents the empirical results. Section 4 discusses the consequences of the empirical behavior of oil prices; Section 5 provides some comments on the recent debate on oil price bubbles. Section 6 finally concludes. 2 Testing for explosiveness The statistical properties of monthly as well as daily oil prices are investigated here using a forward recursive application of a augmented Dicker Fuller unit root test. The null of a unit root is tested against the alternative of an explosive root.

Thus, the following equation is estimated: xt = µx + δxt−1 + J ∑ j=1 ϕj∆xt−j + ϵx,t, ϵx,t ∼ NID(0, σ2 x). (1) The hypothesis H0: δ = 1 is tested against the alternative H1: δ > 1. Initially, a subset of the sample with τ0 = nr0 observations is used. In each 5

subsequent regression this subset is supplemented by successive observations giving a sample of size τ = nr for r0 ≤ r ≤ 1. This procedure yields a sequence of t-statistics with corresponding p-values. These sequences are used in order to identify origination r̂e and collapse dates r̂f of explosive behavior in the data: r̂e = infs≥r0 {s : ADFs > cvadf βn (s)} r̂f = infs≥r̂e {s : ADFs < cvadf βn (s)} This procedure has been derived from the test for periodically collapsing bubbles recently proposed by [6].

This paper uses nominal monthly oil prices spanning from 1982-2010 as well as nominal daily oil prices from 1986-2010 (WTI) in order to test for explosiveness in oil prices.

The following section presents the empirical results. 3 Results This section presents the results obtained from applying the test procedure outlined above on monthly as well as daily oil prices. Initially, the results for monthly data are considered. Figure 2 displays oil prices as well as the sequence of p-values. p-values below 5 % indicate rejection of the null hypothesis. As explained above, for periods in which the null of a unit root is rejected, oil prices are said to exhibit explosive behavior. This is the case in particular 2005-2006 as well as 2007-2008, but also the price hike associated with Gulf war at the end of 1990 is classified as explosive.

While the earlier phase is of relative short duration, the two later ones are about year-long. The analysis of daily oil prices generally confirms these results, see Figure 3.

Having presented this paper’s empirical results, now the consequences of explosive oil prices are discussed. 6

0.0 0.2 0.4 0.6 0.8 1.0 40 80 120 160 1990 1995 2000 2005 2010 Monthly oil prices p-values 5% Figure 2: Explosiveness of monthly oil prices 4 Explosive oil prices and oil field development When it comes to studying the economic consequences of oil price shocks, predominantly consequences for macroeconomic activity are considered. This paper, however, considers the decision when to optimally extract the fossil resource oil. The vehicle for studying this issue is [8]’s analysis of the relationship between transitory oil price hikes and oil field development.

The point of departure of their analysis is a situation in which a firm discovers an offshore oil field of a certain size.1 Developing this oil field involves investing a lump sum irreversible charge. Once the field is developed it is assumed that the extraction rate is geologically determined. The firm decides when to develop the field. A real option model is used in order to analyze the influence of uncertain oil prices on this irreversible investment decision. Initially, oil 1 For a detailed exposition of the model, the reader is referred to the original publication. For a general introduction to the investment decision under uncertainty, see [12].

0.0 0.2 0.4 0.6 0.8 1.0 40 80 120 160 1990 1995 2000 2005 2010 Daily oil prices p-values 5% Figure 3: Explosiveness of daily oil prices prices are assumed to follow a continuous Brownian motion with drift: dPt = αPtdt + σPtdBt Based on this assumption, [8] show that the oil field is developed once oil prices exceeds a certain trigger price. This trigger price is higher than the one in absence of uncertainty. Motivated by the oil price hike associated with the Gulf War 1990/1991 they investigate whether or not also transitory oil price hikes lead to oil field development. Therefore, they augment the price process by a jump component so that oil prices are now assumed to follow a Brownian motion mixed with a jump component.

In peace time, prices are assumed to jump up by a certain portion: dPt Pt = αdt + σdBt + ϕdqN t .

Once the war started, it is assumed that oil prices will go down again once 8

war is over: dPt Pt = αdt + σdBt dqN t Their main finding is that not only permanent, but also transitory oil price hikes lead to development of oil fields. These transitory hikes, however, need to be 4 times as large as a permanent one in order to have the same effect. In the following it is assumed that the periods of explosive oil price behavior and transitory oil price hikes are different ways to capture the same phenomenon. Thus, this paper’s empirical results can be used as basis for a reconsideration of [8].

As asserted above [8]’s model is motivated by the 1990/1991 Gulf War and it is assumed that a war occurs once in 20 years and lasts on average 6 months. This paper’s empirical results, however, clearly indicate that, first, transitory oil price hikes can have other causes than just wars. Second, due to this finding, it would be implausible to assume that they occur only once in 20 years. Finally, they can last considerably longer than just 6 months. Carrying forward the comparative statics in [8], it can be shown that these different features lead to a higher responsiveness of investments in oil field developments to jumps.

5 Oil market speculation? It is important to note that the effect of transitory oil price hike on the oil field development decision holds regardless of whether the oil price hike is explained by fundamental factors or driven by “speculation”. However, various recent papers attempt to shed light on the influence of “speculation” as well as the “financialization” of oil futures markets. This section briefly summarizes this debate. The concerted research efforts on “oil price bubbles” is epitomized by the following papers: [1] argue that there is a fundamentally driven longterm increase in oil prices, which, however, is “exacerbated by speculators.” In the same vein, [10] show that there is a “change in the relationship between real oil prices and real stock prices which may suggest the presence of several stock market and/or oil price bubbles.” [11] also conclude that 9

financial activity appears to have exacerbated gyrations in the oil market, particularly in 2007-2009.” These findings, however, are far from being undisputed: The survey paper by [7] reviews a number of recent studies and comes to the conclusion that “the co-movements between spot and futures prices reflect common economic fundamentals rather than the financialisztion of oil futures markets.” Moreover, [4] argues that “a low price elasticity of demand, and the failure of physical production to increase, rather than speculation per se, should be construed as the primary cause of the oil shock of 2007-08.” [2], finally, shows that the 2003-08 oil price surge “was caused by unexpected increases in world oil consumption driven by the global business cycle.” This same paper, however, provides strong evidence that the 1990/91 oil price hike is partly driven by speculative demand.

[2] use a structural VAR model with the variables global crude oil production, a measure of global real activity, the real price of crude oil and the change in oil inventories above the ground. Four different types of shocks are identified: an oil flow supply shock, an oil flow demand shock, a residual oil demand shock and, most importantly, a speculative demand shock. This last shock is defined as a shock to the demand for “above-ground oil inventories arising from forward-looking behavior not otherwise captured by the model”. [7] trenchantly assert that “one of the problems in this literature and, more importantly, in the public debate about speculation is that it is rarely clear how speculation is defined and why it is considered harmful to the economy.” This paper’s empirical findings in combination with the identified influence of transitory oil price hikes on the oil field development decision indicate that there is a ground for concluding that there are indeed undesirable effects of speculation.

6 Conclusions Academic studies on crude oil are anything but scarce. To some extent this literature evolves wavelike: The oil crises witnessed in the 1970s sparked enormous efforts to investigate macroeconomic consequences of oil price shocks. Moreover, the emergence of various resource economic studies which 10

focus on the scarcity of resources can also be explained by these incidents. A recent offshoot of this literature is motivated by the increasing awareness of the challenge of climate change. Interest in studying the behavior of oil prices, however, seems to have been present continuously.

Motivated by the oil price hikes witnessed at the end of the past decade, this paper contributes to the literature in three ways. First, the behavior of oil prices is investigated by testing whether or not oil prices are explosive. Based on this empirical exercise, second, this paper deals with the consequences of the observed behavior on the resource extraction decision. Third, the role of speculation in this context is discussed.

The key findings that emerge from this study are that oil prices are marked by transitory explosive behavior. Phases in which oil prices exhibit this kind of behavior are 1990/1991, 2005/2006 and 2007/2008. These findings point to the fact that transitory oil price hikes can occur relatively often. A reconsideration of existing studies on the relationship between this type of oil price hikes and oil field development shows that the response of investments in oil field developments is stronger than originally assumed. These results hold irrespective of whether the observed oil price hike is fundamentally driven or caused by speculative influences.

However, as there is at least some evidence that oil market speculation can play a role during oil price hikes, it seems to be the case that oil market speculation can have harmful consequences which previously appear to have been overlooked. References [1] R.K.Kaufmann B.Ullman. Oil prices, speculation, and fundamentals: Interpreting causal relations among spot and futures prices. Energy Economics, 31:550–558, 2009. [2] L.Kilian D.P.Murphy. The role of inventories and speculative trading in the global market for crude oil. Working Paper, 2011.

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[5] Y.-H.Lee H.-N.Hu J.-C.Chiou. Jump dynamics with structural breaks for crude oil prices. Energy Economics, 32:343–350, 2010. [6] P.C.B.Phillips Y.Wu J.Yu. Explosive behavior in the 1990s nasdaq: When did exuberance escalate asset values. International Economic Review, 52(1):201–226, 2011. [7] B.Fattouh L.Kilian L.Mahadeva.

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