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Oil Futures Trading in the Gulf Crisis

Report from the Front - By Robert Weiner

Funding: GWCSG
Status: Second Revision, JIBS (top journal in IB)

The last two decades have seen much economic and policy research devoted to better understanding the effect of derivatives trading on market volatility. Studies of actual episodes of market turmoil, however, have been largely limited to equity derivatives’ role in the stock market crash of 1987. The international petroleum market is a natural candidate for scrutinizing the role of derivatives during periods of market disruption. The petroleum market has been subject to periodic supply shocks, which have had sufficiently dramatic effects on prices and the international economy as to be labeled "Crises."

This project examines the behavior of the crude oil market during the Gulf Crisis of 1990-1991. The controversial issues raised by crude oil price behavior during the Crisis are several. First, why did oil prices rise so rapidly, and to such a high level, when the physical supply disruption itself was relatively modest? Why did prices decline so sharply in the middle of the Crisis? How can the unprecedented volatility in the oil market be explained? Was the presence of futures trading responsible for this volatility? Or was there underlying volatility present in the market, which was exacerbated by futures trading? Or did futures markets mitigate, or have no effect on underlying price volatility?

The question of the role of the trading process in market stability is an old one, but it is only in the last decade that methods have been developed to address the question empirically. The empirical research in the project takes advantage of recent methodology developed for untangling trading from variations in underlying supply and demand fundamentals as sources of market volatility. The methodology compares price volatility during periods when the exchanges are open, and thus both news and trading effects are present, with periods when they are closed, so that only the news effect is present. If the news effect is the same during trading and non-trading periods, then any observed differences in volatility can be ascribed to the trading process itself.

The project applies this methodology to crude oil futures prices on the New York Mercantile Exchange (NYMEX), for the period 1989 through 1991, which includes the Gulf Crisis, as well as the periods immediately before and after it. The methodology yields results that indicate that trading activity on the NYMEX contributed less to price volatility during the Gulf Crisis than during normal periods. The primary source of market fluctuations was news about fundamentals coming out of the Gulf area while the exchange was closed. For those concerned about the role of futures markets in oil supply disruptions, the evidence is that, at least for the "case-study Crisis" examined here, and for the NYMEX WTI crude oil contract, the futures markets worked relatively better during the Crisis than immediately before or afterward.