Essays on the Role of Speculation in the Volatility of Oil Prices and Oil Futures Risk Premia



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The greater volatility and higher prices in the oil market after 2003 suggest the possibility of increased speculation. Many researchers have investigated the origin of this change in oil price dynamics. The literature, however, lacks a comprehensive empirical model of oil price dynamics that incorporates both fundamentals and the influence of all economic agents who behave speculatively, and is also able to distinguish between speculation which is necessary for the oil market and “excess speculation”.

The first chapter introduces a comprehensive empirical model which incorporates all of these elements, and uses it to examine the contribution of fundamentals and excess speculation to oil price fluctuations. I do this by introducing three novel features to the literature. First, I introduce an operational definition for excess speculation. Second, using a dynamic common factor model, I extract orthogonal factors from monthly time-series data that are specific to economic fundamentals and purely speculative activities, respectively, and decompose the variance of oil prices using these orthogonal factors. Third, I employ a larger set of underlying variables to represent speculative activities. My results show that the contribution of excess speculation in this market increased to 28% after 2003 compared to 1% before 2003, which shows a structural break in speculators’ contribution after 2003.

Moreover, one of the six strands of the literature considers variation in oil risk premia to address the existence of speculative activities in oil futures market, and a structural change in oil futures markets in recent years. The literature, however, lacks a general model of time-varying risk premia that incorporates all of the possible explanatory variables of oil price fluctuations.

The second chapter employs this approach, time-varying oil risk premia, to investigate the role of speculative activity in this market, by introducing two novel features to the literature. First, I consider the notion of time-varying risk premia along with other explanations of oil price fluctuations. Second, I provide evidence of excess speculation based on these models. My results verify the variation of oil futures risk premia in recent years.



Oil price, Oil Futures Risk Premia, Fundamentals, Speculation, Factor models, Principal component, Financialization, Spot market, Futures market