Lessons for policy

In a recent paper (Fattouh and Mahadeva 2012), we built a small model of the oil market where financial speculators’ risk aversion and wealth are exogenous. We calibrate it to match the pre-2003 data and ask if, as a result of a fall in the risk aversion of financial speculators or a rise in the financial resources they can muster, we can expect a greater participation by purely financial investors and a higher oil price level.

The sizes of these shifts are considerable. We lower the risk appetite of financial players halfway towards making them completely indifferent to risk and raise their wealth by a considerable 25%. A control is provided by shifts in the physical layer of the oil market, such as a sudden expectation of a 5% more expansive net supply as could have occurred in 2006-8.

Figure 2 describes one of our results. Even large changes in financial players’ incentives— shown in the first two sets of columns — are not predicted, by themselves, to have led to more than a small rise in financial player’s futures positions. And they are predicted to imply only small rises in the current spot level.

On the other hand, as the right-hand side of Figure 2 shows, an expected 5% loosening of net supply leads to a large fall in financial participation. This suggests that the fall in participation in 2008 may have been the result of an anticipation

... contd.