Recent Dynamics of Crude Oil Prices

A new working paper on oil price dynamics from the Fund- conclusion excerpted below;

Oil prices have been on a rising spree during the recent past, reaching unexpected territories, and seemed to become unbounded. Despite the importance of these prices, little was known about their underlying stochastic process. This paper studied the dynamics of oil prices during January 2, 2002–July 7, 2006. Main findings were that these dynamics were dominated by frequent jumps, causing oil markets to be constantly out-of-equilibrium. While oil prices attempted to retreat following major upward jumps, there was a strong positive drift which kept pushing these prices upward. Volatility was high, making oil prices very sensitive to small shocks and to news. The findings for both the J-D and VG specification were fully consistent with the underlying fundamentals of oil markets and world economy. More specifically, faster world economy growth during the sample period and highly expansionary monetary policies caused demand for crude oil to expand at similar pace. In view of the price inelasticities of oil demand and supply, any small excess demand (supply) would require a large price increase (decrease) to clear oil markets; hence, the observed high intensity of jumps and the strong drive for oil prices to rise.

Attention was not only limited to historical dynamics of oil prices, but it was also extended to gauging market expectations regarding future developments in these prices. Based on call and put option prices on July 21, 2006 and for maturity end-September 2006, the implied risk-neutral distribution was right-skewed, indicating that market participants maintained higher probabilities for prices to rise above the expected mean, given by the futures price, rather than fall below this mean. The risk-neutral distribution was also characterized by high volatility and high kurtosis, indicating that market participants were expecting prices to remain highly volatile and dominated by frequent jumps.

The findings of this paper could be relevant for policy-makers and industry analysts. They established the nature of the stochastic process underlying oil prices and the importance of components driving this process. An explanation of the process parameter estimates in terms of the underlying fundamentals for the oil markets was offered in order to comprehend the economics underpinning the observed oil prices dynamics. Namely, a change in the process parameters would require a change in the underlying fundamentals. Alternative modeling approaches in the paper were highly relevant for forecasting, risk management, derivatives pricing, and gauging market’s sentiment; they allowed to ascertain robustness of estimated parameters. The findings of the paper could also be relevant for the Fund in monitoring oil markets and seeking policies for stabilizing these markets."

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