Smooth transition regime shifts and oil price dynamics

- A LSTAR model of oil futures pricing is derived.
- Optimally hedged positions are readjusted in order to reduce their variability.
- In 2008 destabilizing hedging positions result in feedback trading behavior.
- A new interpretation of the 2008 oil price bubble is provided.

The interaction between rational hedgers and informed oil traders is parameterized and tested empirically with the help of a complex non linear smooth transition regime shift CCC-GARCH procedure. In spite of their gyrations, futures price changes are usually self-correcting. Well informed producers and consumers will ensure that crude oil prices - and thus the prices of the corresponding futures contracts - fluctuate within a long run equilibrium range determined by market fundamentals. During a steep price upswing, however, shifts in positions in the futures markets by well informed optimizing agents that usually dampen price changes, result in destabilizing positive feedback trading. Futures price changes that can be classified as speculative are due to destabilizing hedgers' reactions to movements in the variability of the return of their covered cash position. The paper provides in this way an innovative interpretation of the 2008 oil price bubble.