Recently, the world has witnessed extremely high and volatile crude oil prices. After hovering between $10 and $30 per barrel from 1998 to 2003, crude oil prices have risen rapidly since 2004. This year’s price movement has been tremendously volatile, moving from $61 per barrel and jumping to an all-time record high of $147 on July 11, and then sharply declining to $67 by the end of October. Looking at the day-to-day price movement in the market, it is not uncommon to see prices changing by $5 in a single trading day. For instance, the price rose by as much as $25 in just one day (September 22, 2008), which was entirely unprecedented.
2. Problem Definition
High and volatile crude oil prices have threatened the growth of the world economy. The surge in oil prices has brought on cost-push inflation, which could diminish individual purchasing power, as wage levels fail to keep pace with oil prices. These prices have also cut into the profits of a wide range of corporations whose products are made from crude oil, since they can not easily pass the higher cost along to consumers.
All of the above factors have already had adverse effects on economic growth, especially in countries whose economies depend on imported oil. Even for oil producers, the excessive price volatility is not desirable, since it makes it harder for them to establish a reliable plan for investment. It is, therefore, necessary to analyze the root causes of the problem and to present feasible solutions so that the world economy can achieve stable growth, which is the prerequisite for people’s daily lives and businesses.
3. Cause Analysis
There seem to be two possible causes for the oil price boom and market fluctuations: one is unbalanced supply and demand and the second is an influx of speculative money.
(a) Unbalanced supply and demand
The first hypothesis is that constrained supply relative to sustained demand growth may be contributing to the current surge and volatility in oil prices. The economic growth of emerging countries, particularly in Asia, has caused a rapid increase in demand for crude oil, while oil supply has responded sluggishly to the increasing demand. This is partly because oil producers are reluctant to invest in new oil field exploitation, so they continue to focus on existing oil fields with declining yearly output. The imbalance between growing demand and limited supply, as well as expectations that this trend will persist for the time being, may have brought upward pressure on oil prices. Since the trend and expectations are so prevalent, market participants react more exuberantly than they should to any information implying a potential decrease in oil supply, such as political instability in oil-producing countries or upcoming hurricanes in regions where petroleum refineries are concentrated. This may accelerate the surge in oil prices. The fact that the stock of oil has been decreasing may bolster the validity of the above hypothesis. From this perspective, there should be feasible measures to ease the supply constraints that would improve the situation of both producers and consumers. On the other hand, this hypothesis does not explain the volatility of oil prices, since the macroeconomic situations in both oil-producing and importing countries have not changed so rapidly in the short term. Therefore, there must be another factor behind price volatility, as discussed below.
(b) Influx of speculative money
This section focuses on the hypothesis that the influx of speculative money into oil futures markets could be driving the volatility of oil prices. Producers and consumers typically seek to hedge their exposure to oil price fluctuations through financial trading, such as futures and option transactions. In the oil futures markets, net financial demand from hedgers with actual needs for oil in their businesses should be met by the net supply of speculators who have no direct interest in oil for their businesses, but seek to profit from futures-price movements. Thus, informed speculators should add liquidity to the market and facilitate the price discovery process, thereby lowering price volatility. Speculators could, however, drive up prices and exacerbate price volatility if they do not have sufficient information about the markets. As discussed in the previous section, market trends should be consistent if demand and supply are the only determinants of the price level. The premise of this argument is, however, that the market is functioning under perfect conditions. In real oil markets, where producers form cartels, and both producers and consumers lack sufficient and timely information, the theory fails to hold up. From this aspect, the necessary measure to address excessive volatility in the oil market could be enhancing market transparency by providing more timely and sufficient information to help market participants act reasonably.
To address high and volatile oil prices, it is necessary to take effective and feasible measures to relax oil supply constraints and to enhance transparency in oil markets.
(a) Relaxing oil supply constraints
As discussed above, oil producers are reluctant to invest in new oil field exploitation that would help them to keep up with rapidly increasing oil demand. The governments of oil-importing countries point to this attitude and have been requesting greater investment. To effectively solve the problem, however, it is necessary to put ourselves into the position of the oil producers. They have hesitated to invest because of uncertainty about the persistence of the current trend. They are concerned that the demand for oil might dramatically decrease in the near future, especially given innovations in bio-fuel technology as well as electric vehicles. As long as uncertainty remains, oil producers will not invest to meet demand.
To decrease the asymmetry of information about oil demand, both oil-producing and consuming countries should share the perspective about world oil demand in the future by providing each of their investment plans for alterative energy policy as well as new oil field exploitation. Such producer-consumer dialogues are feasible if they can create a real understanding of the appropriate price level that best balances producers’ capacity and consumers’ needs to improve conditions on both sides. Thus, a shared perspective on oil demands would alleviate the uncertainty that has obsessed oil producers, thereby easing the constraints on oil supply through sufficient investment for new oil fields.
(b) Increasing transparency of the oil market
Speculators could exacerbate oil price volatility if they are ill-informed about market conditions. This requires regular access to reliable statistics in a timely manner so that speculators can contribute to the appropriate price discovery process.
At present, the Joint Oil Data Initiative (JODI) provides market participants with information about oil markets. The JODI gathers and publishes data on oil consumption, production, and amount of trade and stocks. The statistics come from the top 30 oil-producing and consuming countries, which accounts for approximately 90 percent of overall world production and consumption. Although the JODI is somewhat helpful, the current data does not sufficiently meet market participants’ needs, for a number of reasons.
The first reason for this relates to the timeliness of information distribution. The JODI publishes monthly oil stock data at the end of the following month. Since daily transaction volume is so vast and market participants must make investment decisions every day, receiving month-old information once a month is not helpful to make reasonable judgments. The JODI tends to value the accuracy of market data too highly and sacrifices timeliness. To make the JODI statistics more effective and helpful for market participants, it should gather information more promptly and publish provisional statistics as quickly as possible. More timely oil stock data would improve transparency to the market and lower price volatility.
The second factor is related to the coverage of the JODI statistics. Certainly the JODI statistics cover around 90 percent of world production and consumption, but it will soon lose its validity as non-participating countries are emerging market economies and developing countries whose demands are rapidly increasing. Insufficient coverage of market data impairs the validity of the statistics. Hence, the world’s leading economies, such as the G7 countries, should encourage non-member countries to join the JODI by sharing reliable information that would be beneficial for them in the cause of reducing market volatility.
High and volatile oil prices have been caused by oil supply constraints and opaque market conditions. This paper discusses two major recommendations; one is reducing uncertainty about future oil demands through substantial producer-consumer dialogues to attain balanced supply and demand, and the second is to publish JODI statistics with sufficient coverage in a more timely manner. By implementing these measures, oil markets will function more smoothly so that the world economy, both oil-producing and consuming countries, would enjoy balanced and stable economic growth.