A Financialization Model of Crude Oil Markets

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This paper theoretically and empirically investigates the financialization of crude oil markets. We propose a simple correlation model between stock and crude oil prices based on the supply and demand relationship taking into account the impact of stock markets on crude oil markets. Based on the correlation model, the optimal allocations of stock, crude oil and a risk free asset are obtained by solving the Merton’s problem under the assumption of a log utility function. By using the price correlation model it is empirically shown that the correlations between S&P 500 and WTI crude oil prices are positive and increasing. In contrast, the correlations between S&P 500 and Brent crude oil prices are close to zero, which are lower than the correlations between S&P 500 and WTI crude oil prices. It may suggest that the financialization of crude oil markets be limited to WTI crude oil markets. The optimal allocations of S&P 500, WTI or Brent crude oil and a risk free asset are empirically obtained based on the correlation model. It is shown that after the 2008 financial turmoil the optimal WTI crude oil positions decrease in line with the optimal S&P 500 positions while the optimal Brent crude oil positions are not relevant to the optimal S&P 500 positions. The results may suggest that after the 2008 financial turmoil WTI crude oil be financialized and do not show the diversification effect to S&P 500 while Brent crude oil be not the case. These results are fully supported by the other empirical studies using the dynamic conditional correlation (DCC) model of Engle (2002). Additional empirical studies using crude oil and natural gas prices based on the DCC model suggest that WTI crude oil prices have higher correlations with the US natural gas prices than Brent crude oil prices, implying that WTI crude oil markets still have strong impacts on the other energy markets while the financialization of WTI crude oil has recently proceeded.