Speculating on oil

The recent fall in the price of Brent crude to its lowest level since July raises the possibility that it is speculative demand, rather than real economic activity, that drives the oil price.

It would be easy to attribute the fall to signs of weakness in the world economy. But if the oil price responded neatly to global growth, it would have fallen months ago.

The Markit/HSBC purchasing managers' survey has indicated a fall in Chinese manufacturing activity since November 2011. But since then, the oil price has been choppy, rising at the start of this year, falling in the spring, rising in the summer and falling recently. There was a good correlation (0.42) between China's purchasing managers' index and monthly changes in the oil price between January 2007 and December 2011, but the link hasn't been so clear this year.

This raises the possibility that the oil price is driven not just by 'fundamental' supply and demand but by speculation. New research by Filippo Lechthaler and Lisa Leinert at the Swiss Federal Institute of Technology corroborates this possibility. They compared the response of oil prices with global industrial production and with a computer-generated index of good news about oil prices based on news from Thomson Reuters. They found that the latter was better able to predict changes in oil prices since 2003 than the former. "Non-fundamental demand," they conclude, has been the main driver of oil prices recently.

Now, this is a controversial result; it flatly contradicts the finding of Lutz Kilian and Dan Murphy, two University of Michigan economists, that speculation isn't a major cause of changes in oil prices. Such disagreement reflects the fact that there's no agreed way of accurately measuring fundamental and speculative demand.

Nevertheless, the fact that oil's recent moves can't be obviously tied to global economic activity strengthens the possibility that speculation does affect oil prices. And if speculators can push prices up, they can also push them down.

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