Speculation, Fundamentals, and the Price of Crude Oil

Abstract

The causes and consequences of rising oil price over the past decade has been the subject of much debate. The role of speculation in financial markets has come increasingly under the microscope with many economists arguing that in commodity markets, such as oil, inventory adjustment should prevent speculative pressures from unduly influencing price. However, if demand and supply are relatively inelastic (not very price responsive) in the short run, then inventory adjustment can be slow to occur. In turn, the theory presented herein suggests that speculative activity can exacerbate price movements that are hinged on underlying market fundamentals. In other words, when constraints are present, inventory adjustment can be sluggish, which will reinforce the speculative notion that markets are becoming tighter. This will continue until something happens to unhinge that expectation, such as inventory build or economic collapse. Otherwise, speculation cannot exert an influence on price. This paper investigates whether speculative pressures can exert an influence on the price of storable commodities, such as crude oil and natural gas.