The Determinants of Crude Oil Prices Osama M. Badr

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1 Abstract The Determiats of Crude Oil Prices Osama M. Badr 1 ad Ahmed F. El-khadrawi 2 Uderstadig the factors drivig crude oil price fluctuatios is essetial for assessig their effects. For this purpose, the study based o the price equatio preseted by Kaufma et al (24) ad expad the model to iclude aother set of potetial determiats that may reflect the fluctuatios i crude oil prices. These determiats classified i to three types of factors: Supply ad demad factors ad factor associated with the behavior of fiacial market participats. The study employed quarterly data from 28Q1 to 215Q4. Egel ad Grager ecoometric techiques allow us to estimate the short ad log-ru effects of the previous determiats o the crude oil prices. The results of our aalysis idicate a robust effects of GDP growth for both Chia a OECD coutries to crude oil prices fluctuatios. Chages i the refiig capacity also appear robustly related to oil prices chages. O the other had, idicate little-to-o evidece that icreased role of speculators drives prices. 1. Itroductio: After four years of stability at aroud $15 per barrel, oil prices have declied sharply sice Jue 214. It is expected that Middle East ad oil exportig coutries will face slowdow ad weakess i ecoomic eviromet due to sharp drop i oil prices. After four years of stability at aroud $15 per barrel, oil prices have declied sharply sice Jue 214. It is expected that Middle East ad oil exportig coutries will face slowdow ad weakess i ecoomic eviromet due to this sharp drop i oil prices. Especially, the last oil price declie is due to factors related to global ecoomic coditios like chages i oil supply caused by techology Aasim et al (215). Whereas last chages ca reflect a symptom of uexpected shocks i global ecoomic activity. There is a belief that the curret declie i oil prices drive by supply factors will have positive effects o global ecoomic growth over the medium term. I spite of that, the severe ecoomic pressures o oil exports coutries as well as the ucertaity associated with the occurrece of crisis, may limit the optimistic expectatios of the global ecoomy i the short term. There is o doubt that oil price drop lowerig cosumers cost of livig which leads to icreased cosumer's real icome if oly price declie have bee passed to them. At the same time price drop meas declie i firm's margial costs usig oil i their productio which implies more beefits. But the flipside to these gais is icome losses of oil producers. The effects of these factors ot deped o demad ad supply factors oly but also o the declie type, whether a temporary or permaet. If the oil prices drop o a temporary basis, the 1 Osama M. Badr, Faculty of Commerce, Tata Uiversity, Egypt, College of Busiess, Umm Al-Qura Uiversity, KSA, ombadr@uqu.edu.sa 2 Ahmed F. El-khadrawi, Faculty of Commerce, Damietta Uiversity, Egypt,Faculty of Islamic Ecoomic ad Fiace, Umm Al-Qura Uiversity, KSA, afkhadrawi@uqu.edu.sa 1

2 gais will be i oil importig coutries which they will be mostly wier. While the oil exportig coutries will lose their expected icome which put a pressure o the atioal budget ad lead to icrease borrowig ad public debt. But if the oil prices drop o a permaet basis especially i case of ecoomy reliace o reveues from oil exports to fud other activities i the ecoomy. Such coutries experiece a terms-of-trade loss, govermets will eed to adjust ad recostruct the public spedig. From all the above, Idetifyig the determiats for the oil price declie is critically importat for assessig its likely global ecoomic impact. Accordig to that, our aim is to examie which factors are sigificat i determiig crude oil prices betwee Our study orgaized as follows; Sectio II. Review the causes behid oil prices fluctuatios. Sectio III presets the ecoomic ad fiacial cosequeces associated with oil prices fluctuatio. Sectio IV presets the empirical model used, the estimatio techique ad discusses the empirical results. Sectio V. brief summary ad the importat coclusio derived from the study. 2. The causes behid fluctuatios i oil prices pluge As per ay storable commodity, oil demad ad supply coditios determie log-ru treds i oil price, however, there are other factors ad expectatios ca play a critical role i drivig price fluctuatios (e.g. geopolitical coflicts i some oil producig regios ad producers decisios specially OPEC s decisios ad fially with appreciatio of U.S dollar). Theoretically, there are four groups of explaatory factors ca be idetified as possible cotributors to the developmet of crude oil prices. First, chage i demad due to chage i global ecoomic growth. Secod, chagig i supply or aticipatig supply. Third, chage i objectives ad decisios of crude oil producers. Fourth, the factors associated with the behavior of fiacial market participats ad speculatio. Accordig to Hamilto (28) ad Dees et al. (28), the above determiats are ot ecessarily mutually exclusive, but ca complemet each other. Kilia (29) Argue that durig the period , oil price shocks have bee drive maily by demad shocks rather tha supply shocks. This essetially stems from precautioary demad drive by ucertaity about future supplies. Peersma (211) discrimiate betwee oil demad shocks ad oil supply shocks to study the macroecoomic effects across 11 idustrialized coutries. The results idicate that for oil demad shocks drive by global ecoomic activity, almost all coutries experiece iflatioary pressure ad a temporary icrease of ecoomic activity. But whe arise i oil prices is caused by oil-specific demad shocks there will be a trasitory declie of output. Similarly, Cashi et al (214) compare betwee supply-drive ad demad-drive oil-price shocks to study the macroecoomic cosequeces for 38 coutries ad regios usig quarterly data coverig the period The results were similar pretty much to Peersma (211), i the fact that oil importig coutries became more susceptible to oil supply shocks compared to oil exportig coutries, while oil demad shocks ca't explai cross-coutry differeces. 2

3 From literature review, we ca ote that the most importat variables that affect the oil price are supply ad demad quatity. World ecoomic activity represeted by world GDP ad advaced ecoomies GDP. Temperature ad its ifluece o oil price. Which we ca describe it over the time i the followig figures. Fig (1b ) show that Advaced ecoomies represet more tha 6% from World GDP ad Fig (1b ) show that World GDP ad Advaced ecoomies GDP declied from year 28 to 29 ad start to rose from 29 to 214 but re-declied from 214 to 215 due to slowdow i advaced ecoomies especially Chiese Ecoomy. 1 Fig (1a) World ad Advaced Ecoomies GDP 1 Fig (1b) World ad Advaced Ecoomies GDP World Advaced ecoomies World Advaced ecoomies Fig (2) show the world ecoomy growth rate fluctuatio from year 28 to 215 especially the declied i world ecoomy growth year 29 ad Fig (2) World Ecoomy Growth Rate Fig (3) show the reflect of global climate chagig with icreasig the global temperature which will lead to icrease the oil demad 3

4 1Q8 3Q8 1Q9 3Q9 1Q1 3Q1 1Q11 3Q11 1Q12 3Q12 1Q13 3Q13 1Q14 3Q14 1Q15 3Q15 1Q8 3Q8 1Q9 3Q9 1Q1 3Q1 1Q11 3Q11 1Q12 3Q12 1Q13 3Q13 1Q14 3Q14 1Q15 3Q Fig (3) Global Temperature Fig (4a) show the fluctuatio of oil demad & supply but sice the first quarter213 where the world supply icrease over the world demad ad Fig (4b) show that OPEC supply quatity is bigger tha OPEC supply quatity which idicate ad explai the OPEC weakess to cotrol Oil market over the time 1 Fig (4a) World Oil Demad & Supply Fig (4b) OPEC & - OPEC Supply world Demad world supply 2 1 o-opec supply opec supply 75 Fig (5) shows the crude oil price which reflects the chage i above variables. ad represet wide price swigs i times of shortage or oversupply durig the period Fig (5) OPEC Oil Basket Price U$/Bbl 4

5 4. Methodology 4.1The Model To determie the most importat factors which ifluecig crude oil prices, the study based o the price equatio preseted by Kaufma et al (24) ad expad the model to iclude aother set of variables that may reflect the declie i crude oil prices based o the quarterly data coverig the period So our model ca be expressed as followig: Log(P) t = a + a 1 Log(GDPch) t + a 2 Log(GDPoe) t + a 3 Log(Days) t + a 4 Log(Refie) t + a 5 Log(Caputil) t + a 6 Log(Temp) t + a 7 Log(Oil. st) t + a 8 Log(Oil. re) t + a 9 Log(Neer) t + ε t (1) Where (P) is the crude oil prices. (GDPch), (GDPeo) is the gross domestic product growth of Chia ad OECD respectively. (Days) is days of forward cosumptio of the OECD ad Chia crude oil stocks, which is calculated by dividig the sum of OECD ad Chia Stocks of crude oil by Chia ad OECD demads for crude oil. (Refie) is the total refiig capacity worldwide. (Caputil)is the capacity utilizatio by OPEC, which deote the rate at which the processig capacities of the available refieries are utilized, ad ca calculated by divided OPEC productio by OPEC capacity. (Temp) is the average world temperature. (Oil. st) is worldwide oil stocks. (Oil. re) is the worldwide oil reserves. (Neer ) is the mial effective exchage rate of the U.S. dollar. (ε t ) is the error term. All the variables are expressed i atural logarithms i order to estimate their elasticities. 4.2 Data Descriptio ad Sources From equatio (1), we expect the regressio coefficiet associated with (GDPch) ad (GDPeo) to be positive a icrease i gross domestic product of chia ad OECD raises oil prices. The coefficiet of (Days) is expected to be egative, as a icrease i oil stocks reduce oil price by reducig reliace o curret productio ad thereby lowerig the lowerig the risk premium that associated with a supply disruptio. We also expect a egative relatioship betwee Refiig capacity (Refie) ad oil prices. If there is a geeral expasio of refiig capacities, bottleecks caused by growig demad ca be coutered more quickly. Followig this logic, a egative impact o crude oil prices would be the result. O the other had, if the rate of actual utilizatio (Caputil) gets closer the total refiig capacity limit (which meas a shortage i the market), the crude oil prices will raise. We expect a positive relatioship betwee (Temp) ad crude oil prices. We expect a egative effect of (Oil. st) ad (Oil. re) o prices. Fially, the coefficiet of (Neer) is expected to be egative. The data used i this study obtaied from U.S Eergy Iformatio Admiistratio (EIA) ad IMF website. 4.3 The Estimatios Procedure 5

6 I order to estimate equatio (1), we use Egle ad Grager s (1987) procedure to estimate our model. This method seems appropriate for our study i the sese that it allows us to estimate the log-ru ad short-ru relatioship betwee the crude oil prices ad the cosidered explaatory variables. Accordig to Egel ad Grager if the variables i the model is ot statioary i level I(), we will get spurious regressio. I spite of that, Egle - Grager believes that there is a possibility to geerate a liear combiatio from o-statioary time series data, ad if this liear combiatio is statioary, the time series is itegrated of the same order. Thus, the variables ca be used i their level. The focus of the coitegratio test is to fid out whether this combiatio geerated from the model is Statioary or itegrated I() by applyig the Augmeted Dickey Fuller (ADF) test (Dickey ad Fuller, 1979) o the residuals. if we reject the ull, it meas that there is a coitegratio betwee variables, which idicates a existece of log-term equilibrium relatioship betwee the variables of the model. Sice the error correctio model (ECMs) depeds o its first step to carry out the verificatio process of a log-ru equilibrium relatioship betwee the variables (through regressio of the coitegratio represeted by equatio (1)) usig the applicatio of ordiary squares (OLS), the secod step of this test is to estimate the ECMs which reflect the short-term relatioship by eterig the residual lagged for oe period. Accordigly the equatio will be as follow: ΔLog(P) t = k + λ 1i ΔLog(GDPch) t i + λ 2i ΔLog(GDPoe) t i + + λ 3i ΔLog(Days) t i + λ 4i ΔLog(Refie) t i + λ 5i ΔLog(Caputil) t i + λ 6i ΔLog(Temp) t i + λ 7i ΔLog(Oil. st) t i + λ 8i ΔLog(Oil. re) t i + λ 8i ΔLog(Neer) t i + ρη t 1 + υ t (2) I which Δ is the first differece, ad η t 1 is the oe period lagged discrepacy (or disequilibrium) term, which estimated from the coitegratio equatio (1). The umber of lags () for the right-had side variables is chose usig the Akaike iformatio criteria. The coefficiet ρ i the ECM model measures the adjustmet force which should be sigificat ad egative. The egative value for ρ idicates that disequilibrium betwee crude oil prices ad its determiats moves prices toward its log-ru equilibrium value. 5. Empirical Results ad Discussio Before turig to the estimatio results, it is importat to make prelimiary test which assess whether the variables used i equatio (1) are statioary or itegrated of the same order I(1) by applyig the ADF test. The results i table (1) i the appedix show that all the variables i model 6

7 (1) are ot statioary i levels but statioary i their first differece, which mea that all the variables are itegrated i same order I(1), ad therefore ca be used i their levels. Table (2) i the appedix, shows the results of coitegratio equatio (1). All the variables have sigs cosistet with what was expected ad, except for Temperature, are sigificat. The coefficiets of GDPch, GDPoe are positive ad highly sigificat. The estimates imply that a oe percet additioal icrease i gross domestic product for Chia or OECD coutries is associated with aroud.11 ad.382 per cet icrease i crude oil prices. The effect of Days is egative. A icrease i stocks reduces reliace o curret productio, which teds to lower the risk premium that is associated with a supply disruptio. Oe percet poit additioal icrease i days of forward cosumptio results a reductio i crude oil prices by about.225. Refiig capacity has a egative effect o the log-ru level of oil prices. As we expected, Capacity utilizatio has a positive impact o oil prices. The sigs of the regressio coefficiets are cosistet with a priori expectatios that prices drop rapidly at low levels of capacity utilizatio ad rise rapidly at high levels of capacity utilizatio. As expected, the coefficiets associated with the worldwide oil stocks ad worldwide oil reserves are egative. Oe per cet additioal icrease i oil stocks ad oil reserves is associated with of about.42 ad.72 percet i oil prices. Fially, the coefficiet associated with exchage rate is egative. The estimates imply that a oe percet appreciatio i U.S. dollar is associated with a declie of about.9. Let us ow move to the ECM (equatio (2)), Table (3) i the appedix shows the short-ru dyamics of oil prices. The regressio results idicate that the coitegratig relatioship give by equatio (1) ca be iterpreted as a equatio for the log-term determiats of oil price. The coefficiet of the error correctio term, which Kow as the adjustmet force (ρ) is egative, ad aroud.53, implyig that 53 percet of the disequilibrium of the period t 1 is revised i period t. 6. Coclusio Uderstadig the factors drivig crude oil price fluctuatios is essetial for assessig their effects. For this purpose, the study based o the price equatio preseted by Kaufma et al (24) ad expad the model to iclude aother set of potetial determiats that may reflect the fluctuatios i crude oil prices. These determiats classified i to three types of factors: Supply ad demad factors ad factor associated with the behavior of fiacial market participats. The study employed quarterly data from 28Q1 to 215Q4. Egel ad Grager ecoometric techiques allow us to estimate the short ad log-ru effects of the previous determiats o the crude oil prices. The results of our aalysis idicate a robust effects of GDP growth for both Chia a OECD coutries to crude oil prices fluctuatios. Chages i the refiig capacity also appear robustly related to oil prices chages. O the other had, the speculatio factors idicate little-too evidece that icreased role of speculators drives prices. Refereces: 7

8 1. Kaufma, R.K, S. Dees, P. Karadeloglou, ad M. Sachez. (24), Does OPEC matter? A ecoometric aalysis of oil prices, The Eergy Joural, 25(4), Aasim, M. H., Rabah, A., Peter, B., Vikram, H., Thomas, H., Paulo, M., Marti, S., (215), Global Implicatios of Lower Oil Prices, IMF staff discussio ote, SDN/15/ Hamilto, J. (29), Causes ad Cosequeces of the Oil Shock of 27 8, Brookigs Papers o Ecoomic Activity (Sprig), Dées, S. Gasteuil, A. Kaufma, R. ad Ma, M. (28), Assessig the factors behid oil price chages, Europea Cetral Bak, Workig paper NO Hamilto, J. (28), Uderstadig Crude Oil Prices, NBER, Workig Paper Kilia, L. (29), t all Oil Price Shocks are Alike: Disetaglig Demad ad Supply Shocks i the Crude Oil Market, America Ecoomic Review 99(3), Pp Cashi, P., K. Mohaddes, ad M. Raissi. (214), The differetial effects of oil demad ad supply shocks o the global ecoomy, Eergy Ecoomics 44, Peersma, G. ad I. Va Robays. (212). Cross-coutry differeces i the effects of oil shocks. Eergy Ecoomics, 34(5), Bees, J., M. Chauvet, O. Kameik, M. Kumhof, D. Laxto, S. Mursula ad J. Selody. (212), The Future of Oil: Geology versus Techology, IMF Workig Paper. 12/ U.S. Eergy Iformatio Admiistratio (EIA), 8

9 Appedix Variables Log(P) Log(GDP ch ) Log(GDP e ) Log(Days) Log(Refie) Log(Caputil) Log(Temp) Log(Oil. st) Log(Oil. re) Neer Table 1: Uit root test for the variables used i the study Augmeted Dickey-Fuller test Level Tred First differece * * * * * * * * * * 9 Tred Table (2): Estimates for log-ru Price Equatio (1) Coitegratig equatio: Depedet variable : Log(P) t Coefficiet t-statistic C (-5.92)* Log(GDPch) t.11 (6.61)* Log(GDPoe) t.382 )5.27)* Log(Day) t (-3.28)* Log(Refie) t (-2.97)** Log(Caputil) t.21 (2.93)** Log(Temp) t.34 (-1.37) Log(Oil. st) t -.42 (-2.96)** Log(Oil. re) t -.72 (-2.72)** Log(Neer) t -.9 (-6.22)* R 2.73 D.W 2.19 ADF (>-2.63 (1%)) Breusch-p.614 The umbers i paretheses are t-ratio. *, **, *** deote statistical sigificace at 1%, 5%, ad 1% respectively. D.W refers to Durbi-Watso test for serial correlatio.

10 ADF refers to Augmeted Dickey Fuller test for statioarity of the residuals. Breusch P idicates the Breusch Paga test for heteroscedasticity. Table (3): Estimates for short-ru Price Equatio (2) ECM : Depedet variable : Log(P) t Δlog(P) t 1 ΔLog(GDPch) t ΔLog(GDPoe) t ΔLog(Day) t ΔLog(Refie) t ΔLog(Caputil) t ΔLog(Temp) t ΔLog(Oil. st) t ΔLog(Oil. re) t ΔLog(Neer) t (ρ) R 2 D.W ADF AIC (1) Breusch-p rmality Coefficiet t-statistic.7 (1.88)***.97 (2.63)**.237 )3.14)* -.12 (-2.46)** (-2.61)**.9 (2.22)**.1 (-1.12) -.12 (-2.34)** -.44 (-2.51)** -.2 (-2.38)** -.53 (-4.1)* (>-2.63 (1%)) ( ) The umber i paretheses are t-ratio. *, **, *** deote statistical sigificace at 1%, 5%, ad 1% respectively. D.W refers to Durbi-Watso test for serial correlatio. Breusch P idicates the Breusch Paga test for heteroscedasticity. rmality refers to the ormality test for the residuals 1