Oil Prices & Markets:Oil Prices & Markets:Ten ObservationsTen Observations

Dr Bassam FattouhDr Bassam FattouhDepartment for Financial and Management Studies, SOASDepartment for Financial and Management Studies, SOAS

&&Oxford Institute for Energy StudiesOxford Institute for Energy Studies

28 September, 200628 September, 2006

1. Spare Capacity and Prices1. Spare Capacity and Prices

Lack of spare capacity affects the Lack of spare capacity affects the dynamics of oil pricesdynamics of oil pricesOne major change in recent years has One major change in recent years has been the gradual erosion of spare capacity been the gradual erosion of spare capacity

Rapid Decline in OPEC Spare CapacityRapid Decline in OPEC Spare Capacity

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197019721974197619781980198219841986198819901992199419961998200020022004

Millio

ns bp

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Global Production Capacity

World Total Production

1985: Spare Capapcity of around 10 million bpd

Source: IMF; BP

• Spare capacity around 2% of global oil demand in 2004 despite increase in OPEC production capacity

Spare CapacitySpare Capacity

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12

Algeria Indonesia Iran Kuw ait Libya Nigeria Qatar SaudiArabia

UAE Venezuela

April 2006 Production

Sustainable Production Capacity

• Saudi Arabia holds 55% of OPEC spare capacity in 2006

The Impact of Loss of Spare The Impact of Loss of Spare Capacity Cushion on PricesCapacity Cushion on Prices

Accelerating Global Demand

Accelerated rise in oil prices

OPEC Spare Capacity Reduced

Global oil system’s ability to respond to shocks weakened

Low Non-OPEC Supply Growth

Volatility in oil prices

Bottlenecks in Downstream Occasional

spikes in oil pricesCycle of

UnderinvestmentGeopolitical shocks

Impact of shocks magnified in absence of spare capacity

Weather shocks

Refinery fires

Speculators

2. Rise in Long Run Oil Prices2. Rise in Long Run Oil Prices

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1 2 3 4 5 6 7Years to expiry

7 Septem ber 2006One year agoTwo years agoThree years agoFour years ago

Source: Paul Horsnell, Long-term oil prices and the capital market

3. 3. ContangoContango Situation Situation

Figure 2- WTI Forward Price Curve (as of 21 September 2006)

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Peak Oil?Peak Oil?

Transition to Transition to contangocontango due to a greater acceptance of due to a greater acceptance of peak oilpeak oil

Hypothesis predicts oil production will reach a peak soon after Hypothesis predicts oil production will reach a peak soon after which production would start to declinewhich production would start to declineIn face of an expected growth in global demand implies oil In face of an expected growth in global demand implies oil prices for future delivery should rise faster than prompt pricesprices for future delivery should rise faster than prompt pricesImplies a Implies a contangocontango structure widening at later segments of structure widening at later segments of forward curve as impending shortages become more acute forward curve as impending shortages become more acute further aheadfurther ahead

Implication not supported by dataImplication not supported by dataTerm structure of futures contracts for long term maturities is Term structure of futures contracts for long term maturities is in in backwardation backwardation

Precautionary DemandPrecautionary Demand

Current price structure signalling need for precautionary inventCurrent price structure signalling need for precautionary inventoriesoriesGreater demand for precautionary inventories cause price of oil Greater demand for precautionary inventories cause price of oil for for prompt delivery to rise causing backwardationprompt delivery to rise causing backwardation

Holds as long as there is available storage capacity enough crudHolds as long as there is available storage capacity enough crude oil e oil available in the marketavailable in the market

Participants meet precautionary inventories by buying futures Participants meet precautionary inventories by buying futures contracts creating a contracts creating a contangocontangoImplies a fundamental shift in behaviour of market participants Implies a fundamental shift in behaviour of market participants away from justaway from just--inin--time inventory policy time inventory policy Shift has important implications on return on capital employed Shift has important implications on return on capital employed

Given pressure to maximize shareholder value unlikely private Given pressure to maximize shareholder value unlikely private companies keep inventories when makes commercial sense to scale companies keep inventories when makes commercial sense to scale downdown

Should be shown how precautionary inventories would maximize Should be shown how precautionary inventories would maximize shareholder valueshareholder value

Security PremiumSecurity Premium

ContangoContango explained in terms of investorsexplained in terms of investors’’ expectations of tighter expectations of tighter crude oil market conditions in the futurecrude oil market conditions in the futureNot driven by irrational factors but by the future fundamentals Not driven by irrational factors but by the future fundamentals of of supply and demand for crude oilsupply and demand for crude oil

Expectations of growth in global demand, supply response from OPExpectations of growth in global demand, supply response from OPEC EC and nonand non--OPEC, the probability of hurricanes, geopolitical uncertainties OPEC, the probability of hurricanes, geopolitical uncertainties (Iran, Iraq, Nigeria)(Iran, Iraq, Nigeria)Thin spare capacity made bets on potential supply shocks extremeThin spare capacity made bets on potential supply shocks extremely ly attractiveattractiveProbability of supply shock might not have changed compared to Probability of supply shock might not have changed compared to previous years or might have increased slightly upside potentialprevious years or might have increased slightly upside potential in the in the event of such a shock can be extremely highevent of such a shock can be extremely highAlthough inventories risen, investors believe that in case of suAlthough inventories risen, investors believe that in case of such a ch a supply shock current level of inventories would not be enough tosupply shock current level of inventories would not be enough to absorb absorb the price rise the price rise

ContangoContango Helping the MarketHelping the Market

ContangoContango creating incentive for market creating incentive for market participants with storage facilities to accumulate participants with storage facilities to accumulate inventories, stock up their tanks, lock a profit by inventories, stock up their tanks, lock a profit by selling futures contractsselling futures contractsInventories then shorted in the futures market Inventories then shorted in the futures market contango contango Effect of keeping the prices oil for future delivery Effect of keeping the prices oil for future delivery lower than would have been in the absence of a lower than would have been in the absence of a contangocontango

4. 4. ContangoContango this time associated this time associated with upward trend in oil priceswith upward trend in oil prices

First Month Forward-Second Month Forward for Brent

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First Month Forward-Second Month Forward

1998 Reinforcing 1998 Reinforcing ContangoContango

1998 market entered in prolonged 1998 market entered in prolonged contangocontango (which lasted more than 12 months) (which lasted more than 12 months) Contrary to current Contrary to current situaionsituaion, 1998 , 1998 contangocontango associated with decline trend in oil associated with decline trend in oil prices. prices. Market fell in reinforcing Market fell in reinforcing contango contango ContangoContango encourage those with physical facilities to accumulate inventorencourage those with physical facilities to accumulate inventoriesiesInterpreted by market participants a sign of an oversupply Interpreted by market participants a sign of an oversupply price of oil for immediate delivery would go down price of oil for immediate delivery would go down widen differential between the oil price for future delivery andwiden differential between the oil price for future delivery and prompt price prompt price increasing the size of the increasing the size of the contangocontangoIn turn induce traders with physical capacity to augment their sIn turn induce traders with physical capacity to augment their stock furthertock furtherGoes on and on Goes on and on Contango Contango associated with falling oil prices and large accumulation of invassociated with falling oil prices and large accumulation of inventoriesentories

5. Inventories and Oil Prices5. Inventories and Oil Prices

Associated rise in inventories occurring together with an Associated rise in inventories occurring together with an upward trend in oil pricesupward trend in oil pricesConventional wisdom that building up inventories would Conventional wisdom that building up inventories would depress oil pricesdepress oil pricesSome argue that conventional wisdom may no longer be Some argue that conventional wisdom may no longer be valid valid

High levels of inventories no longer seen as necessary sign of High levels of inventories no longer seen as necessary sign of oversupply and hence do not exert downward pressure on pricesoversupply and hence do not exert downward pressure on pricesCurrent levels of stocks (although high by historical standards)Current levels of stocks (although high by historical standards)do not imply that markets are oversupplieddo not imply that markets are oversupplied

More Plausible Interpretation More Plausible Interpretation

Higher than expected levels of inventories Higher than expected levels of inventories still cause oil prices for prompt delivery to still cause oil prices for prompt delivery to declinedeclineOther factors pushing prompt prices in the Other factors pushing prompt prices in the opposite direction shadowing the impact opposite direction shadowing the impact of inventories on oil pricesof inventories on oil prices

Decline in oil price caused by rising Decline in oil price caused by rising inventories continuously being dominated by inventories continuously being dominated by other factors causing oil prices to riseother factors causing oil prices to rise

6. Speculation and Oil Prices6. Speculation and Oil Prices

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Spot Price

Net Long Non-Commercial Positions

Notes: Spot Price in Log Scale (left scale); Net long term positions in millions of contracts (right scale)

Source: IMF, World Economic Outlook, 2006

Speculation and Oil PricesSpeculation and Oil Prices

Three broad generalizations Three broad generalizations Prices appear less volatile than speculative positionsPrices appear less volatile than speculative positionsNo common trend between prices and speculation: no No common trend between prices and speculation: no persistent pickup in net long nonpersistent pickup in net long non--commercial commercial positions when oil prices where trending upward positions when oil prices where trending upward (IMF, 2006)(IMF, 2006)Changes in nonChanges in non--commercial traderscommercial traders’’ net long positions net long positions may coincide with changes in oil pricesmay coincide with changes in oil prices

This evidence does not establish that speculators influence This evidence does not establish that speculators influence oil pricesoil pricesCould be the result of changes in fundamentals that affect Could be the result of changes in fundamentals that affect both oil prices and speculative positions of traders both oil prices and speculative positions of traders

7. Crude Oil Price Differentials7. Crude Oil Price DifferentialsArab Heavy Discounts to Spot WTI

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Features of Crude Oil Price Features of Crude Oil Price DifferentialDifferential

WTI which is a sweet/light crude variety trades at a premium WTI which is a sweet/light crude variety trades at a premium compared to Arab Heavy which is considered as a sour/heavy crudecompared to Arab Heavy which is considered as a sour/heavy crudevarietyvarietyPrice differential can reach very high levelsPrice differential can reach very high levels

For exporters of low quality crude oils, this has important implFor exporters of low quality crude oils, this has important implications ications on their revenueson their revenues

Rise in the price differential in last few yearsRise in the price differential in last few yearsAverage discount almost doubled from $6.22 to $11.77 between theAverage discount almost doubled from $6.22 to $11.77 between theperiods 2000periods 2000--2003 and 20042003 and 2004--2006 (until July).2006 (until July).

Large variation in price differential between two crude oils oveLarge variation in price differential between two crude oils over time, r time, especially in the last three years of the sampleespecially in the last three years of the sample

Between December 2003 and January 2005, discount of Arab Heavy tBetween December 2003 and January 2005, discount of Arab Heavy to o WTI increased from $6 to over $14 and then fell back to $9.45 inWTI increased from $6 to over $14 and then fell back to $9.45 in July July 2005; by November 2005, the discount rebounded to $14.50, but th2005; by November 2005, the discount rebounded to $14.50, but then en declined to 11$ in February 2006declined to 11$ in February 2006

Refining ConstraintRefining Constraint

Discounts have responded to changes in the Discounts have responded to changes in the relative prices of petroleum productsrelative prices of petroleum productsExplanation based on the following three Explanation based on the following three elementselements

an increase in demand for light productsan increase in demand for light productschanging mix of crude production towards higher changing mix of crude production towards higher incremental volumes of sour and heavierincremental volumes of sour and heavier crudescrudesConstraints on refining conversion capacityConstraints on refining conversion capacity

Refining Constraints Affect Refining Constraints Affect Differentials but Not LevelsDifferentials but Not Levels

Least complex refineries forced to run heavier slates Least complex refineries forced to run heavier slates producing lower proportion of light petroleum products producing lower proportion of light petroleum products and higher proportions of heavy petroleum productsand higher proportions of heavy petroleum productsPrice elasticity of heavy products high since can be more Price elasticity of heavy products high since can be more easily substituted; demand for gasoline more inelastic easily substituted; demand for gasoline more inelastic because of lack of substitutesbecause of lack of substitutesIncrease in demand for gasoline widened differential in Increase in demand for gasoline widened differential in products market between light and heavy petroleum products market between light and heavy petroleum products products

fed back into the crude oil market resulting in a higher spread fed back into the crude oil market resulting in a higher spread between heavy/sour and light/sweet crude oilsbetween heavy/sour and light/sweet crude oils

8. OPEC and Prices8. OPEC and Prices

Two questions:Two questions:Will OPEC respond to recent slide in oil prices?Will OPEC respond to recent slide in oil prices?Will OPEC be effective in inducing production cuts?Will OPEC be effective in inducing production cuts?

Conflicting signalsConflicting signalsOPECOPEC’’s president s president ““The price is very low and itThe price is very low and it’’s not s not good for investorsgood for investors…… Something needs to de done to Something needs to de done to steady the pricesteady the price””Saudi Arabian Monetary Agency official: oil prices at Saudi Arabian Monetary Agency official: oil prices at $60 a barrel provide a "healthy situation" for $60 a barrel provide a "healthy situation" for exportersexporters

OPEC Pricing PowerOPEC Pricing Power

OPEC pricing power is not constantOPEC pricing power is not constantOPEC can lose its influence oil pricesOPEC can lose its influence oil pricesSuch instances can emerge both in weak and tight oil market Such instances can emerge both in weak and tight oil market conditions but for entirely different reasonsconditions but for entirely different reasons

OPEC alone can not determine the oil priceOPEC alone can not determine the oil priceDepends on other playersDepends on other players’’ behaviour behaviour

OPEC influence on prices complicated by participants OPEC influence on prices complicated by participants behaviour in the futures marketbehaviour in the futures market

Quota Quota decisions can be viewed as signals to market about decisions can be viewed as signals to market about OPECOPEC’’s preferred range of pricess preferred range of pricesSignalling mechanism may or may not succeed, depending on Signalling mechanism may or may not succeed, depending on how the market interprets these signals and whether it attach how the market interprets these signals and whether it attach credibility to these movescredibility to these moves

This Time Round?This Time Round?

Which oil price to defend?Which oil price to defend?Who would share the burden of cuts?Who would share the burden of cuts?Direction of market would depend Direction of market would depend primarily on Saudi Arabiaprimarily on Saudi Arabia

9. Oil Prices and Growth9. Oil Prices and Growth

Oil price hikes often preceded global recessions Oil price hikes often preceded global recessions IMF: a 10$ rise in crude prices reduces global growth by 0.1 to IMF: a 10$ rise in crude prices reduces global growth by 0.1 to 0.5 0.5 percentage points percentage pointspercentage points percentage pointsAsian Development Bank: Escalating oil prices could cut economicAsian Development Bank: Escalating oil prices could cut economicAsian Development Bank growth across Asia by at least 0.6%growthAsian Development Bank growth across Asia by at least 0.6%growthacross Asiaacross AsiaG8:"Overall global growth remains solid and this is expected to G8:"Overall global growth remains solid and this is expected to continue in 2006. Risks remain, including high and volatile enercontinue in 2006. Risks remain, including high and volatile energy gy prices" high and volatile energy prices"prices" high and volatile energy prices"Samuel Samuel BodmanBodman, the U.S. energy secretary , the U.S. energy , the U.S. energy secretary , the U.S. energy secretary: "Am I concerned about the impact of high oil prices osecretary: "Am I concerned about the impact of high oil prices on n the Sure. Having said that, it hasn't happened yet in the Sure. Having said that, it hasn't happened yet in ameaningfulameaningfulway."way."

Global Expansion Continues Above Global Expansion Continues Above TrendTrend

World Real GDP Growth

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Source: IMF, World Economic Outlook, 2006

Oil Price and InflationOil Price and Inflation

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1 9 7 3 1 9 7 5 1 9 7 8 1 9 8 0 2 0 0 2 2 0 0 4 2 0 0 61 0 0

1 1 0

1 2 0

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1 4 0

1 5 0O i l p r i c e ( L H S )

C o n s u m e r p r i c e s ( R H S )

O i l p r i c e a n d O E C D C P I

1 9 7 3 - 7 6

1 9 7 8 - 8 1

2 0 0 2 - 0 6

10. Demand For Oil Responds to 10. Demand For Oil Responds to Price, butPrice, but……

Oil Global Demand Growth

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

2004 2005 2006

Global Oil Demand by RegionGlobal Oil Demand by Region

1.541.541.081.081.111.11WorldWorld0.110.110.10.10.130.13Latin AmericaLatin America

0.070.070.070.070.080.08AfricaAfrica

0.340.340.330.330.320.32Middle EastMiddle East

0.030.030.050.050.050.05FSUFSU

0.220.220.090.090.160.16Other AsiaOther Asia

0.390.390.430.430.170.17ChinaChina

--0.020.02--0.030.030.10.1OECD PacificOECD Pacific

0.010.01--0.010.010.010.01EuropeEurope

0.390.390.050.050.090.09North AmericaNorth America

200720072006200620052005

Source: IEA, September 2006