Fundamentals versus speculation in oil market: The role of asymmetries in price adjustment?

Abstract

The recent literature on financialisation of oil markets highlights the destabilizing impact of speculative activity on the oil price formation. Time-series studies using linear unit root tests might suggest absence of long-run mean reversion in oil prices, implying dominance of speculation over fundamental factors. However, the price adjustment could take a nonlinear form due to certain characteristics inherent to the oil markets. This study examines the presence of nonlinear adjustment behaviour in nominal and real crude oil prices towards a long-run equilibrium using two specific types of smooth transition models, capturing size and sign asymmetries. The results suggest asymmetric mean-reversion of oil prices towards the trend over the cycle and potential structural breaks leading to trend-shifts. In sum, taking cognizance of asymmetries suggests an adjustment behaviour largely based on fundamentals in long-run, pointing out relatively limited impact of speculation due to financialisation in oil market. Furthermore, the analysis suggest higher forecasting power of the proposed smooth transition models for nominal oil prices compared to alternative linear benchmarks.