The unprecedented surge in the spot price of crude oil during 2003–2008 has sparked a heated public debate about the determinants of the price of crude oil. A popular view is that this surge cannot be explained by changes in economic fundamentals, but was caused by the increased financialization of oil futures markets, which in turn allowed speculation to become a major determinant of the spot price of oil. (Fattouh et al. 2013, p. 7 and 8).
Abstract
From both theoretical and policy perspectives, it is important to understand if financial speculation contributes to the boom/bust in oil prices during 2003–2008. In this paper, we disentangle the effects of financial speculation from those of economic fundamentals by focusing on exogenous changes of financial speculation in oil markets identified by changes in financial investor sentiment. Furthermore, we focus on a quasi-experiment setting, and investigate both sentiment-driven overvaluation of oil prices and subsequent mispricing correction. Our findings suggest that financial speculation might have contributed to the 2003–2008 boom/bust in oil prices.
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Notes
See Fattouh et al. (2013) for an excellent review.
In 2004, index speculators invested $25 billion into commodity futures markets, which is 14 % of the total commodity market (Master 2008).
Investor sentiment in financial markets can have significant effects on speculative demand for assets, because (1) investors are subject to sentiment (DeLong et al. 1990), and (2) arbitrage against sentimental investors can be costly and risky (Shleifer and Vishny 1997; Wurgler and Zhuravskaya 2002; Lamont and Thaler 2003; Brunnermeier and Pedersen 2005).
“Sentiment may vary daily, but major episodes occur over years, and the most convincing tests of the effects of sentiment are those in which it is used to actually predict long-horizon returns—tests which suggest a contrarian trading strategy.” (Baker and Wurgler 2007, p. 138).
The U.S. Energy Information Administration also forecasts oil prices for horizons up to two years, which are widely used by practitioners.
We thank Professor Lutz Kilian for making the data available at http://www-personal.umich.edu/~lkilian/.
We thank Professor Jeffrey Wurgler for making these data available at http://people.stern.nyu.edu/jwurgler/.
We thank Fama and French for making these data available at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/.
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Acknowledgments
The authors thank the editor Cheng-Few Lee and one anonymous referee for their valuable and insightful comments. The responsibility of any remaining errors is ours.
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Part of this research was conducted while Ding Du was visiting the Robert H. Smith School of Business, University of Maryland at College Park.
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Du, D., Zhao, X. Financial investor sentiment and the boom/bust in oil prices during 2003–2008. Rev Quant Finan Acc 48, 331–361 (2017). https://doi.org/10.1007/s11156-016-0553-5
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DOI: https://doi.org/10.1007/s11156-016-0553-5