Oil prices respond to a wide range of fundamental and technical factors. These factors include, but are not limited to, energy supply and demand; inventory levels; geopolitics; economics; weather events and natural disasters; shutdowns and startups at refineries, pipelines and oil rigs; and speculative trading. To understand how and why these factors are responsible for influencing the direction of energy prices, it is useful to examine how changes in market sentiment are driven by human responses to these factors.
Energy markets are, at their cores, made up of peopleproducers, traders, suppliers, investors, consumers, etc. This means that markets are not only vulnerable to human emotional reactions such as anxiety, confidence and fear, but that they are also shaped by humans limited ability to predict what will happen in the future. This article explores how psychological reactions influence pricing in the oil market, and also how fluctuations in pricing are informed by market behavior and speculation. A review of the energy crises and price shocks of the 1970s and the 2000s provides a historical perspective on market and consumer reactions to planned and unplanned events.
Triple-digit oil and psychological price points
The impact of geopolitical factors has been seen recently in the price response to market worries about a potential disruption to oil supplies as a result of tensions between the West and Iran over Irans nuclear program. A European Union (EU) embargo on Iranian oilagreed upon in January 2012 and scheduled to go into effect on July 1, 2012pushed Iran to announce on February 19, 2012 that it would halt exports of oil to the UK and France. This retaliatory announcement, in turn, caused the price of US West Texas Intermediate (WTI) benchmark crude oil on the New York Mercantile Exchange (NYMEX) to spike to a 10-month high of over $125/bbl on February 24, 2012just two weeks after oil had reached $100/bbl for the first time in 2012. Oil prices have hovered around $90/bbl to $100/bbl since that time, and they are expected to remain near those levels for the rest of the year.
The first time oil prices breached the psychologically important level of $100/bbl was on January 2, 2008the first trading day of that yearas unrest in major oil producer Nigeria, weather-related closures at Mexican oil export ports, and worries over future OPEC supply briefly sent oil prices on the NYMEX above the triple-digit mark.1 Speculators were largely blamed for the run-up to $100/bbl, as trading volume on that day was only 50% of normal due to the New Years holiday.
Oil first closed above $100/bbl on the NYMEX in February 2008. The major influencing factors at that time were Venezuelan President Hugo Chávezs threat to cut off oil supplies to the US over a stakeholdings dispute with ExxonMobil; ongoing tensions in the Middle East; and oil price speculation. President Chávez eventually toned down his threats, but then a sudden explosion at Alon USAs refinery in Big Spring, Texas sent prices for both crude oil and refined fuels surging.
Although the Big Spring refinery is relatively small and US fuel inventories were considered sufficient at the time, oil traders and hedge fund managers interpreted the refinery outage as a buying signallikely because a record number of similar refinery shutdowns in the US during the summer of 2007 resulted in gasoline shortages, price hikes and panic buying. The 2007 refining capacity shortage pushed up oil prices by 23% between January and late July of that year, while gasoline prices surged upward by 35% in the same time period.2
In this instance, recent history influenced the oil markets thinking and sent traders into panic mode. Although the likelihood of previous events recurring was unknown, the possibility of such served to elevate traders anxieties. As energy trader Michael Rose explained in a February 20, 2008 interview with the New York Times, With this credit crisis going on, everyone is on edge and the slightest disruption in crude oil or its products takes prices right up.3
Consumer sentiment vs. market sentiment
According to IHS Global Insight, a 10% rise in the price of gasoline relative to the overall price level decreases US consumer confidence by 1.4%1.5%; likewise, a 10% drop in the price of gasoline increases consumer confidence by the same amount. When rising gasoline costs approach round-dollar valuese.g., $3/gal or $4/galconsumer confidence plummets by a sharp 3.79%, while consumer sentiment slips 1.4%, as the threshold price-point is neared. However, when decreasing gasoline prices fall below a round-dollar amount, no significant increases in either consumer confidence or sentiment are observed. This suggests that consumers tend to place more emphasis on (that is, be more emotionally responsive to) rising fuel prices than to falling fuel costs.
The same appears to be true of energy traders and analysts with regard to oil pricing. According to some market watchers, the excitement and apprehension of surpassing the psychologically important $100/bbl mark may have influenced oils 20072008 climb. Daniel Yergin, oil historian and Cambridge Energy Research Associates (CERA) chairman, remarked in November 2007, Todays markets feel like the crowds standing up in the final minutes of a football game shouting: Go! Go! Go! People seem almost more relaxed about [reaching] $100 [per bbl oil] than they were about $60 or $70 oil.4
Stock market analysis has shown that psychological resistance and support levels tend to be round and/or even numbers. Also, the prospect of oil hitting triple digits was, until 2007, an unthinkable scenario, as oil had traded around $15$25/bbl from the mid-1980s to September 2003. New York Times journalist Louise Story wrote in May 2008, In the 1990s, oil research was a sleepy area at banks. Many analysts assumed oil prices would hover near $15$20/bbl forever. If prices rose much above those levels, they figured consumers would start conserving, suppliers would raise production, or both, causing prices to decline.
Prices began moving upward in the fourth quarter of 2003, breaching $30/bbl. They moved into the $40/bbl range in 2004 as declining US petroleum reserves and worries about peak oil stirred market anxieties. By August 2005, prices had climbed to $60/bbl. During that month, Hurricane Katrinas landfall in the southern US destroyed 30 Gulf of Mexico oil platforms, closed nine refineries and sent prices soaring to over $70/bbl by late August.
Price shocks unsettle energy, consumer markets
The rapid run-up in oil prices in late 2007 and early 2008 is often viewed as the third energy price shock of this generation. The price shocks of the 1970s and 1980s stirred fears at the energy market, consumer market, and government levels of lasting supply shortages and sustained fuel price hikes, and also the economic damage that could result from these scenarios. As Fig. 1 shows, hikes in oil prices have preceded every global recession since the early 1970s.
Fig. 1. Oil price hikes have preceded every
global recession since the early 1970s.
The 1978 Iranian oil worker strike and the 1979 Iranian Revolutionwhich collectively resulted in a near-shutdown of Irans oil productionspurred panic fuel buying in the US, as the Organization of Arab Petroleum Exporting Countries (OAPEC) oil embargo of October 1973 to March 1974 was still fresh in consumers minds. This scenario is similar to that seen in February 2008, when US refinery outages echoing those of the previous summer pushed consumers to the pump en masse. However, supply fears during the energy crises of the 1970s were calmed within months, after political relationships stabilized, oil operations recommenced and supply flows resumed.
However, unlike the energy crises of the 1970s and 1980s, which resulted from cut-offs in Middle Eastern oil supplies to the West, the current price shock is due to surging economic expansionand, thus, rapid increases in fuel demandin developing countries. In that sense, it is the first demand-led energy price shock the world has witnessed, noted economist Lawrence Goldstein with the Energy Policy Research Foundation of Washington, D.C., in November 2007.4
Most analysts believe that todays energy price shock will have wider-ranging and longer-lasting implications. Chinas and Indias growing middle classes are demanding more and more fuel, and although the average Chinese consumer currently uses less than half the amount of energy than does the average US citizen, China is expected to consume 70% more energy than the US in the future. Aggressive expansions in other developing and non-Western economies, such as Brazil and Russia, are contributing to the demand-led energy shock. Another factor is continuously rising fuel consumption in the US and other Western nations.
Bold forecasts propel oil price frenzy
Nominal and inflation-adjusted annual average prices for WTI crude oil on the NYMEX over the 65 years through 2011 are shown in Fig. 2. Marked fluctuations from the 1970s onward demonstrate the effects of energy crises on oil pricing. These sharp fluctuations suggest that energy costs have become more closely tied to the markets reaction to fundamentals in the last 40 years than they were in the middle part of the 20th century.
Fig. 2. Nominal and inflation-adjusted average
WTI crude oil prices on the NYMEX, 1946
During the 20072008 price escalation, oil price forecasts varied widely due to market uncertainty and, perhaps, also because the number of political, economic and energy supply variables involved made it more difficult for analysts and market players to predict where prices would go. Some market watchers expected prices to fall back to around $70/bbl, while others projected that oil would rise to $120/bbl within months. The International Energy Agencys chief economist, Fatih Birol, warned in November 2007 as WTI prices approached $100/bbl, These prices are too high and will end up hurting everybodyproducers and consumers alike.4
Goldman Sachs economist Arjun N. Murti issued a bold prediction in May 2008, at the height of the price mania, that oil could hit a super spike of $150$200/bbl within the next 624 months, due to robust demand growth and slow supply growth. Nauman Barakat, senior vice president for global energy futures at Macquarie Futures USA, commented on the force of this forecast: Even if you disagree with their views, the problem is that Goldman [Sachs] does carry so much credibility. There are a lot of traders who are going to buy based on their reports.5
Famed oil tycoon T. Boone Pickens joined the frenzy with his forecast of $150/bbl oil by the end of 2008, while then-OPEC President Chakib Khelil predicted that prices would rise to $150$170/bbl over the summer of 2008. Meanwhile, Gazprom CEO Alexey Miller forecast that oil prices would hit $250/bbl in 2009. Bloomberg later reported that over 3,000 options contracts were purchased giving holders the right to purchase oil at $250/bbl in December 2008, demonstrating the strong effect of these forecasts on the market.
The bullish predictions sent ripples of uncertainty and fear through the oil market, which further drove up prices as speculators attempted to forecast how high prices would rise, while OPEC members raised production quotas in an effort to calm prices. Oil prices eventually spiked at an all-time high of $147.30/bbl in July 2008. On average, the cost of oil rose 23% per year between 2003 and 2008 (as measured in real dollars),6 which resulted in erroneous finger-pointing at market speculators.
Global recession reverses price hike
The onset of the global recession of 20082009 calmed energy demand and, consequently, dampened the market frenzy over $100-plus/bbl oil. Prices plummeted to $32/bbl by December 2008. This was an unprecedented movement, given the July clamor over near-$150/bbl oil, which was more highly publicized than the December drop. This speaks to the theory that consumers and market players alike are more emotionally responsive to rising costs than to falling prices.
Saudi Arabian Oil Minister Ali al-Naimi cautioned in March 2009, I have often described unsustainably low oil prices as carrying the seeds of future spikes and volatility. In a low-price environment, the trend is often to focus on survival instead of expansion. If we place a low priority on preparing for the future, that lack of action can come back to haunt us through supply shortages and another round of high prices.7
The present state of the market appears to confirm Mr. Al-Naimis warning. Oil prices stabilized briefly between late 2009 and the middle of 2010, to around $60$80/bbl; however, in early 2011, costs climbed back above $90/bbl on political upheaval in Libya and other African and Middle Eastern oil-producing nations. By early 2012, anxiety over the continuing conflict between Iran and the West sent WTI oil prices back above $100/bbl and pushed up European Brent oil futures to nearly $130/bbl in Marchlevels that Mr. Al-Naimi deemed too high.
Speculations role in the oil market
The most publicized and visible impacts on oil prices since late 2007 have been stormy geopolitics and political unrest, supply/demand uncertainty, and a handful of uncontrollable weather events. However, a fourth factor that has influenced price direction (albeit to a debatable degree) is speculation by noncommercial traders.
Unlike the utilities, industrial consumers, governments and energy companies that physically buy and sell crude oil and fuel supplies, noncommercial market speculators do not participate in energy markets for end-use purposes. These entitieswhich include investment banks, hedge funds and other large financial institutionsbuy and sell futures contracts as bets on forward price direction, based on calculated risk and on forecasts issued by their analysts and economists. These forecasts are normally derived from a combination of fundamental and technical factors, in addition to analysts gauge of market sentiment. Speculation by commercial traderssuch as oil producers, refiners, airlines and other energy buyersserves as a way for commercial players to hedge against sharp fluctuations in prices, and is not focused on here.
Much of the daily fluctuation in oil prices can be attributed to noncommercial speculation. The practice is a legal (and many claim essential) factor in market functioning, as it provides the market with needed liquidity. However, many analysts and market watchers insist that the movement of excessive amounts of speculative money into and out of the oil market has helped accelerate price spikes and drops over the past five years. These price hikes have hit consumers the hardest, as energy firms have been forced to pass down increased feedstock costs during times of high prices. Excessive speculation is undesirable from a consumer point of view, as it frequently results in higher retail fuel prices and is not required for oil futures and spot markets to function.8
The US Commodity Futures Trading Commission (CFTC) and the UK Financial Services Authority (FSA) jointly investigated market speculation on the NYMEX and IntercontinentalExchange (ICE) trading platforms in 2008, at the height of the oil price frenzy, to determine if illegal price manipulation was taking place. The CFTCs and FSAs Interagency Task Force concluded in July 2008 that rapidly expanding fuel demand as a result of the economic boom in developing countries was largely to blame for the rapid run-up in prices, and not market speculation alone.
In an effort to protect consumers, however, the CFTC drafted the Dodd-Frank Wall Street Reform and Consumer Protection Act, which went into effect in July 2010. The act calls for financial regulatory reform for capital investments by banks and insurance firms, and imposes regulatory restraints on hedge funds and private equity funds.
Research downplays speculations impact on market
A March 2012 study by the Oxford Institute for Energy Studies (OIES) and the University of Michigans Department of Economics reached similar conclusions to the Interagency Task Force on oil market speculation. We find that the existing evidence is not supportive of an important role of speculation in driving the spot price of oil after 2003, the authors wrote. Instead, there is strong evidence that the co-movement between spot and futures prices reflects common economic fundamentals rather than the financialization of oil futures markets.8 This is because, as the authors explain, changes in open interest on the futures market are primarily driven by forecasts of higher economic activity, which stimulate hedging demand and, therefore, help predict fluctuations in futures and spot prices for oil. Fig. 3 illustrates the co-movement of WTI crude oil futures and spot prices on the NYMEX from May 2003 to May 2012.
Fig. 3. Co-movement of WTI crude oil futures
and spot prices on the NYMEX, May 2003
Blake Clayton, a fellow for energy and national security at the US Council on Foreign Relations, also links speculations role in the oil market to the difficulty inherent in predicting market direction. In an April 9, 2012 article, he wrote, In light of such a complex environment, it should come as no surprise that oil prices have been wildly volatile as market participants struggle to anticipate what is around the bend. Discerning the future path of supply and demand is hardly straightforward when the market is calm, let alone when economic and geopolitical uncertainty are magnifying the risk of otherwise unlikely events. The opaqueness of the world oil market, which is plagued by partial and contradictory data, only compounds the perils of prophecy. But there is no reason to believe that prices would better reflect fair value, or that the economy and consumers would be better served, if speculation in the oil market were severely curtailed.9
Mr. Clayton went on to explain how todays trading market is far superior to other pricing methods that have been used since the 1940s. The 1950s and 1960s saw benchmark prices set by executives at large, integrated oil firms amid aggressive open-market trading. OPEC then commandeered oil pricing from the early 1970s through the late 1980s, after which market trading took over as the primary method for pricing oil. Wall Street speculators had nowhere near the presence in the oil market during those two earlier eras that they do today, and yet few would choose to return to those defunct arrangements, Mr. Clayton asserted.9
Yet another study, released in January 2012 by Bates White Economic Consulting, examined a range of political, economic, financial and environmental factors affecting the oil market between 2006 and 2009. The authors reached a similar conclusion to the OIES study and Mr. Claytons analysis. They stated, During the part of the 20072008 period in which prices increased the most quickly and about which the most concern was expressed ... we are unable to find statistical support for causation ... of oil prices by financial traders or speculators. Instead, the authors claim that fundamental factors (including OPEC production decisions and surprise changes in inventory levels of major consuming nations) as well as political events (particularly violent ones) were the driving factors in the run-up in oil prices from late 2007 through July 2008. The onset of the recession in the second half of 2008 dominated fluctuations in prices during that time period.6
The majority of the analyses and studies that have been conducted on speculation over the last five years by government, financial, consulting and other institutions have reached the same conclusion: speculation plays a role in price fluctuations, but it does not dictate price direction. It is one of a myriad of factors that impact the market, and speculation generally has a shorter-term effect on market movement than do fundamentals with wider-reaching and longer-lasting implications, such as demand booms, supply shortages and political and economic turmoil. However, the temporary run-ups in prices that are partially caused by speculative activity can be burdensome to consumers, as these price increases are filtered down to the retail level.
Fundamentals, price trends key to market analysis
An examination of the energy price shocks of the 1970s and 2000s demonstrates the range and extent to which fundamental and technical factors influence oil market sentiment and, therefore, price direction. It also shows how these factors may change over time as new patterns emerge in the fundamentals kaleidoscopee.g., the supply-driven price shocks of the 1970s giving way to the demand-focused price hikes of the last decade.
At the heart of these price fluctuations are reactions by traders, producers, suppliers, consumers and other energy market participants. Both consumers and traders tend to be more emotionally responsive during times of increasing and high prices than they are during times of decreasing and low prices. This is supported by the bigger market and media reactions to the 20072008 run-up in oil prices compared with the subsequent plunge in prices in the latter half of 2008. Studies of consumer sentiment during gasoline price increases and decreases also support this theory.
Furthermore, noncommercial speculation in the oil market (specifically during the price run-ups of recent years) has been found to play a role in short-term oil price fluctuations, but it does not determine the direction of the market over the longer term. Fundamental factors including geopolitics, supply and demand, economics, weather and others have a significantly greater influence on oil price direction, according to recent studies.
Price forecasts and estimates of future supply and demand do inform general market sentiment as well as speculative trading, although such forecasts are still shaped by humans limited ability to predict what will happen in the future. For this reason, traders and analysts often look to market trends and lessons learned from past energy crises when evaluating present and future market direction and sentiment. HP
1 Oil Prices Jump to $100 a Barrel, NPR, January 2, 2008, online.
2 Mouawad, J., Record Failures at Oil Refineries Raise Gas Prices, New York Times, July 22, 2007, online.
3 Krauss, C., Supply Fears Push Oil to Triple Digits, New York Times, February 20, 2008, online.
4 Mouawad, J., Rising Demand for Oil Provokes New Energy Crisis, New York Times, November 9, 2007, online.
5 Story, L., An Oracle of Oil Predicts $200-a-Barrel Crude, New York Times, May 21, 2008, online.
6 King, K., A. Deng and D. Metz, An Econometric Analysis of Oil Price Movements: The Role of Political Events and Economic News, Financial Trading, and Market Fundamentals, Bates White Economic Consulting, January 2012.
7 Mouawad, J., Rising Fear of a Future Oil Shock, New York Times, March 26, 2009, online.
8 Fattouh, B., L. Kilian and L. Mahadeva, The Role of Speculation in Oil Markets: What Have We Learned So Far? Oxford Institute for Energy Studies and the University of Michigan, March 18, 2012.
9 Clayton, B., In Defense of Oil Speculators: Dont Blame Wall Street for High Gas Prices, Foreign Affairs, Council on Foreign Relations, April 9, 2012, online.