VoxEU Column Energy Financial Markets

What has contributed to oil price volatility?

The recent dramatic fall in oil prices has renewed the interest in the importance of shocks in the oil price volatility. This column presents results from new research on the role of shocks and speculation on oil prices. The authors find that when speculation is short in duration, it has the weakest impact on oil prices and demand shocks have the largest. However, when speculation is allowed to have short- and long-term effects, it is the main contributor to the volatility of oil prices.

The recent dramatic fall in oil prices has renewed interest in understanding the sources of shocks that lead to observed oil price volatility (Baumeister and Kilian 2014). In recent weeks, references have been made to a global supply glut and continued weak demand—factors that have been at play for some time now—while financial sector analysts have added to these a selloff of commodity futures. Assessing the contribution of each factor is the topic of this article and our recent paper (Beidas-Strom and Pescatori 2014).

  • We find that when speculation is confined to be short in duration, half the contribution during the first eleven months of this year has been due to weak demand, followed by supply, with a modest contribution from financial speculation.
  • However, when speculation is allowed to have short- and long-term effects, we find that news shocks manifest as speculation are the largest contributor.[1]

In the rest of this article we layout our research strategy and how we have arrived at these findings.

The role of supply and demand shocks

Let us start with the seminal contribution of Kilian (2009), who broke with the tradition of assuming most oil price changes reflect exogenous supply shocks. He emphasised that fluctuations in global crude oil spot prices also reflect global economic conditions. Using a structural vector auto regression (SVAR) model, he showed that global flow supply shocks have actually contributed very little to oil price movements when compared to global flow demand shocks, especially during the last decade.

However, since it is possible to store oil, changes in oil inventories are possibly a third driver behind oil price fluctuations. Of particular interest are changes in the demand for inventories arising from speculative motives, that is, changes driven by expectations of future price changes. Kilian and Murphy (2013) extended the Kilian (2009) model, identifying speculative demand shocks through the inclusion of data on oil inventories. Their identification strategy rests on the assumption that unobservable shifts in expectations about future oil prices must be reflected in shifts in the demand for above-ground crude oil inventories. Their main finding is that speculative demand (along with flow supply) has played only a modest role in driving the real oil price (including the buildup of 2003–08)—with flow demand being the main driver. This result was later confirmed by Kilian and Lee (2013), using propriety global data on inventories. Others, however, have found a substantial role for financial speculation.

The role of speculation

So how much does speculation, as opposed to flow supply and demand shocks, contribute to oil price volatility? First of all, let us try to open the black box of speculation a bit by distinguishing destabilising speculation (possibly exacerbated by the financialisation of commodity markets) from speculation driven by fundamentals.

Using a simple storage model (Brennan 1958, Scheinkman and Schechtman 1983), we show that revisions to expectations regarding oil market fundamentals and the effect of mispricing in oil derivative markets can be observationally equivalent in a SVAR model à la Kilian and Murphy (2013), since both imply a positive co-movement of oil prices and inventories. Using their framework, we find that we cannot distinguish between speculative demand shocks driven by news about fundamentals and those driven by noise trading (i.e., destabilising speculation).

Speculation related to fundamentals does not per se have adverse implications in terms of oil price volatility. Indeed, in a rational expectations world, speculation reflects the forward-looking nature of economic agents who manage inventories to smooth their oil consumption and production over time—paying attention to the expected future path of the oil price. In such a world, this sort of speculation helps stabilise spot prices in the presence of temporary demand and supply shocks. For example, if spot prices fall because flow production temporarily rises due to a positive supply shock or demand temporarily weakens due to softer economic activity, inventory holders can realise profits by buying stocks, which they can sell later at a higher price. This stocking up of inventories will decrease the effective supply in the market dampening the initial fall in the oil price. This is indeed what has been occurring in the global oil market.  

From this vantage point, speculative demand simply represents rational decisions of adjusting above-the-ground holdings of oil inventories in anticipation of price movements as new information arrives on future market conditions. Changes in speculative demand are, therefore, a response to anticipated changes in oil market fundamentals—also known as news shocks, such as oil discoveries (e.g. tight oil production in North America), expectations of production disruptions, backstop technologies, and changes in world real interest rates or in global demand growth. To distinguish noise trading from news about fundamentals we further narrow the set of admissible models by limiting the contribution of speculative demand shocks to the long-run oil price forecast error variance—we call this the minimum forecast error variance (MFEV for short).[2] By doing so, we are probably shifting the job of capturing speculation driven by news on fundamentals to the residual shock—especially the one with persistent effects on oil flow demand or supply—which now cannot be captured by our speculation shock. 

Given that this restriction may look too conservative, effectively ‘minimising’ the oil price volatility, we also use a less stringent condition, namely we select the model that maximises the difference between the short- and long-run oil price reaction to a speculative shock—in other words, the impulse response function with the largest slope (we call this the Max Ratio for short). In other words, what we are doing with these restrictions is estimating the range of oil price responses (i.e., oil price volatility) to speculative demand shocks.

Findings from the new research

Our results are shown in Figure 1. The first results shown are the MFEV (solid black lines). The total contribution of this type of speculative shock is very modest. Indeed, while a temporary speculative demand shock implies a large quest for physical inventories (as predicted by theory), the real spot oil price moves little, by at most 10% (Figure1, bottom row). Figure 1 and Table 1’s upper panel confirm that only 3% of the oil price forecast error variance (MFEV) is explained by speculative demand shocks at short horizons. Moreover, the residual demand shock now explains a larger amount of the real oil price variance, corroborating that what we have identified does not include fundamental oil market drivers (Table 1, upper panel, last column).

Figure 1. A narrow range of admissible estimated models

Now to give temporary speculative demand shocks the best chance of affecting the short-run oil price through a shift in demand for inventories (i.e., to obtain a plausible maximum), we choose the impulse response function with the steepest slope after impact (the Max Ratio). The response of the oil price under the Max Ratio restriction is almost three times greater than that under the MFEV restriction (Figure 1, bottom row, third column). The variance contribution of the speculative shock in the short term substantially increases to 22%, while the residual demand shock explains less of the variance (Figure 1 and Table 1, lower panel). The contribution at longer horizons, however, at 13%, becomes no longer negligible! So it no longer looks like the effect of short-run speculative demand; rather it seems now to be ‘contaminated’ by reactions of market participants to ‘news shocks’.

  • Our findings suggest that the impact response of the oil price to speculative demand shocks driven by temporary motives in explaining the short-run real oil price volatility lie between 10 to 35%—second to those of flow demand (between 40 to 45%) but conceivably larger than those of flow supply (at 20%).

This means that news on temporary supply expansions or movements in risk premiums or perhaps financial speculation have played a non-negligible role in moving oil prices in the short run.

Figure 2. Historical decomposition of the real oil price (log scale)

  MFEV: Financial Speculation                                                 Max Ratio: Speculation Contaminated by News

We also find that it matters what type of speculative demand is identified when looking at the evolution of the respective drivers of oil prices over time as well as during the last eleven months of this year. When speculative demand is confined to be short in duration (Figure 2, left, our MFEV), the main contributor to oil price variation over our sample is flow oil demand shocks, followed by flow supply shocks, and finally financial speculation shocks—the latter having played a minor role. However, when we allow speculative demand shocks to have larger effects in the short and long run (Figure 2, right, our Max Ratio), thus reflecting changes in expectations about future oil market conditions, then speculation shocks were the main contributor, with flow demand now in second place and supply playing a minor role.


[1] Data considered are at the quarterly frequency. The fourth quarter of 2014 is based on data as of end November 2014, spliced with some higher frequency observations for December 2014. 

[2] With this restriction, however, other shocks such as risk premium shocks and news shocks related to events that are expected to be temporary are also captured.


Baumeister, C and L Kilian (2014), “What does the market think? A general approach to inferring market expectations from future prices”, VoxEU.org, 19 November.

Beidas-Strom, S and A Pescatori (2014), “Oil price volatility and the role of speculation”, IMF working paper 14/218.

Brennan, M J (1958), “The Supply of Storage,” American Economic Review, 47, pp. 50–72.

Kilian, L (2009), “Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market,” American Economic Review, 99(3): 1053–69.

Kilian, L, and T Lee (2013), “Quantifying the Speculative Component in the Real Price of Oil: The Role of Global Oil Inventories,” Journal of International Money and Finance.

Kilian, L, and D Murphy (2013), “The Role of Inventories and Speculative Trading in the Global Market for Crude Oil,” Journal of Applied Econometrics.

Scheinkman, J A, and J Schechtman (1983), “A Simple Competitive Model with Production and Storage,” Review of Economic Studies, 50, 427–441.

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