analysing oil prices

8/9/2019 Analysing Oil Prices

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Analysing Oil Prices: TheAnalysing Oil Prices: TheUsefulness and Limitations of Usefulness and Limitations of

Existing ApproachesExisting ApproachesDr Bassam FattouhDr Bassam Fattouh

Centre for Financial and Management Studies,Centre for Financial and Management Studies,SOAS, University of LondonSOAS, University of London

&&

Oxford Institute for Energy StudiesOxford Institute for Energy StudiesPresentation Prepared for The EuropeanPresentation Prepared for The European

Investment BankInvestment Bank

25 January 200725 January 2007


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1. Introduction1. Introduction

Understanding oil price behaviour important inUnderstanding oil price behaviour important in

current environment of large rises in oil pricescurrent environment of large rises in oil pricesand marked increase in volatilityand marked increase in volatilityCan slow down economic growthCan slow down economic growth

Can cause inflationary pressuresCan cause inflationary pressuresCreate global imbalancesCreate global imbalancesVolatility increases uncertainty & discourages muchVolatility increases uncertainty & discourages muchneeded investment in oil sector needed investment in oil sector Tight market conditions raised fears about oil scarcityTight market conditions raised fears about oil scarcityand concerns about energy securityand concerns about energy security


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Different Views: Structural or Different Views: Structural or

Cyclical?Cyclical?Structural transformations placed oil prices in a new high pathStructural transformations placed oil prices in a new high path

Erosion of spare capacity in entire oil supply chain (upstream,Erosion of spare capacity in entire oil supply chain (upstream, refining)refining)

Emergence of new large consumersEmergence of new large consumersNew geopolitical uncertainties in the Middle East and elsewhereNew geopolitical uncertainties in the Middle East and elsewhereReRe --emergence of oil nationalism in many oilemergence of oil nationalism in many oil --producing countriesproducing countriesShift in oil pricing regime towards the futures market and growiShift in oil pricing regime towards the futures market and growi ngngimportance of financial investors and tradersimportance of financial investors and traders

Oil price behaviour explained in terms of cyclicality of commodiOil price behaviour explained in terms of cyclicality of commodi tytypricesprices

Increase in oil price stimulates oil production & slows demand gIncrease in oil price stimulates oil production & slows demand g rowthrowthcauses oil prices to go down stimulates demand oicauses oil prices to go down stimulates demand oi l price to risel price to rise

Different view about oil market reflect divergent expectations aDifferent view about oil market reflect divergent expectations a boutboutfuture evolution of oil pricesfuture evolution of oil prices


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Three Main Approaches For Three Main Approaches For

Analyzing Oil PricesAnalyzing Oil PricesModels of longModels of long --run oil pricesrun oil prices

NonNon --structural modelsstructural models Within context of oil resource exhaustibilityWithin context of oil resource exhaustibility

The competitive supplyThe competitive supply --demand frameworkdemand frameworkInformal approachInformal approach

Help identify economic, geopolitical and incidentalHelp identify economic, geopolitical and incidentalfactors that affect demand and supply and hencefactors that affect demand and supply and hence

oil price movements in certain contextsoil price movements in certain contexts Can help explain shortCan help explain short --term movements in oilterm movements in oil

pricesprices


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2. Upward Trends in Oil Prices and2. Upward Trends in Oil Prices and

exhaustibility of Oilexhaustibility of OilTwo features of nonTwo features of non --renewable resourcerenewable resource

Not replaceable or replaced at very slow rateNot replaceable or replaced at very slow rateSupply of nonSupply of non --renewable resource limited relative to demandrenewable resource limited relative to demand

Oil has both featuresOil has both featuresTreated as classic example of a nonTreated as classic example of a non --renewable resourcerenewable resource

Essential implications of exhaustibilityEssential implications of exhaustibilityProduction in one period affect production in future periods anProduction in one period affect production in future periods an ddoil behaviour should be analyzed within dynamic contextoil behaviour should be analyzed within dynamic contextOil commands a scarcity rent which reflect opportunity cost of Oil commands a scarcity rent which reflect opportunity cost of using the resource today rather than keeping it for futureusing the resource today rather than keeping it for future


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HotellingHotelling ModelModel

HotellingsHotellings main resultmain result

Optimum extraction path would be such thatOptimum extraction path would be such thatoil price in the ground over time will rise at theoil price in the ground over time will rise at theinterest rate even in the absence of interest rate even in the absence of information about demandinformation about demandAs the price of the resource keeps risingAs the price of the resource keeps rising

demand is slowly choked off and eventuallydemand is slowly choked off and eventuallywhen price reaches very high levels demandwhen price reaches very high levels demandfor the resource would be eliminatedfor the resource would be eliminated


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Upward trend in Oil PriceUpward trend in Oil Price

Most analysts using this theory as the basis for Most analysts using this theory as the basis for

understanding oil market conclude that the oilunderstanding oil market conclude that the oilprice must rise over timeprice must rise over timeHowever, various empirical studies show thatHowever, various empirical studies show that

market prices have been roughly trend less over market prices have been roughly trend less over timetimeBerckBerck and Roberts, 1996, p. 77 conclude that nonand Roberts, 1996, p. 77 conclude that non --renewable resource prices have a stochastic trendrenewable resource prices have a stochastic trendand that the property of increasing prices for mostand that the property of increasing prices for mostnonnon --renewablesrenewables is not clear reducing the predictionis not clear reducing the predictionof price increase from near certainty to maybeof price increase from near certainty to maybe


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Bearing on Oil Price ProjectionsBearing on Oil Price ProjectionsGradually rising price trend dominated forecastingGradually rising price trend dominated forecastingmodelsmodels

When forecasts proved erroneous trend retained but applied toWhen forecasts proved erroneous trend retained but applied tonew lower pointnew lower pointit has proven difficult to convince casual observers that althoit has proven difficult to convince casual observers that altho ughughprices might rise, it is neither inevitable no preordained by eiprices might rise, it is neither inevitable no preordained by ei ther ther economic law or geologyeconomic law or geology

PindyckPindyck (1999) competitive non structural model(1999) competitive non structural modelReal oil price follows a Brownian motion & oil price reverts toReal oil price follows a Brownian motion & oil price reverts to ananunobservable trending long rununobservable trending long run --marginal cost but with amarginal cost but with afluctuating level and slope over timefluctuating level and slope over timeLimited use and poor predictive performanceLimited use and poor predictive performanceputting aside the forecasting performance over the past twoputting aside the forecasting performance over the past twodecades, the model captures in a nondecades, the model captures in a non --structural framework whatstructural framework whatbasic theory tells us should be driving price movementsbasic theory tells us should be driving price movements


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RevisionsRevisions

By relaxing some of models initialBy relaxing some of models initial

assumptions studies have shown that oilassumptions studies have shown that oilprices can be revised downward or canprices can be revised downward or caneven follow a Ueven follow a U --shaped path butshaped path butdownward movement can occur only for adownward movement can occur only for ashort time scarcity rent will soon kick inshort time scarcity rent will soon kick in


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LimitationsLimitations

Literature on resource exhaustibility does not provideLiterature on resource exhaustibility does not provideinsights into the oil price issueinsights into the oil price issue

Application of Application of HotellingsHotellings model to the entire oilmodel to the entire oilindustry reduces its usefulnessindustry reduces its usefulness

Main criticism directed towards foundation of Main criticism directed towards foundation of HotellingHotelling

Model: fixed stock and exhaustibilityModel: fixed stock and exhaustibilityAdelmanAdelman (1990): Oil reserves should be treated similar to(1990): Oil reserves should be treated similar toinventories continuously depleted through extraction &inventories continuously depleted through extraction &augmented through exploration and developmentaugmented through exploration and development

Implication:Implication:No such thing as scarcity rentNo such thing as scarcity rentModels based on exhaustibility can not provide a description of Models based on exhaustibility can not provide a description of oil prices in the real worldoil prices in the real world


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3. The Supply Demand Framework3. The Supply Demand Framework

Interaction between demand and supply for oilInteraction between demand and supply for oilultimately determines the oil price in the long runultimately determines the oil price in the long runSpecial features of the oil market make theSpecial features of the oil market make themodelling exercise quite complexmodelling exercise quite complex

Various types of uncertaintiesVarious types of uncertaintiesDue to unknown future events such as geopoliticalDue to unknown future events such as geopoliticalfactors, supply disruptions, environmental disasters,factors, supply disruptions, environmental disasters,technological breakthroughstechnological breakthroughsDue to lack of knowledge about factors such as theDue to lack of knowledge about factors such as thelong run price and income elasticity of demand, thelong run price and income elasticity of demand, theresponse of nonresponse of non --OPEC and OPEC behaviour OPEC and OPEC behaviour


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Global Oil DemandGlobal Oil Demand

Oil demand as function of income and priceOil demand as function of income and priceOil demand and price usually examined within context of Oil demand and price usually examined within context of price elasticity of demandprice elasticity of demand

Measures relationship between the change in quantity of oilMeasures relationship between the change in quantity of oildemanded and change in oil pricedemanded and change in oil price

Wide variation in estimatesWide variation in estimatesSome general observationsSome general observations

Changes in oil prices have small effect on demand especially inChanges in oil prices have small effect on demand especially inshort runshort runLong run price elasticity of demand higher than short oneLong run price elasticity of demand higher than short one

Due to substitution and energy conservation but elasticity stillDue to substitution and energy conservation but elasticity still lowlowPrice elasticity of demand higher in developed countriesPrice elasticity of demand higher in developed countries


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Global Oil DemandGlobal Oil DemandRelationship between oil demand and GDP growthRelationship between oil demand and GDP growthstudied within context of income elasticity of demandstudied within context of income elasticity of demand

Change in quantity of oil demanded and change in incomeChange in quantity of oil demanded and change in incomeEstimates vary widely according to method used, periodEstimates vary widely according to method used, periodunder studyunder studyGeneral observationsGeneral observations

Oil demand more responsive to income than pricesOil demand more responsive to income than pricesLong run income elasticity for oil demand higher than shortLong run income elasticity for oil demand higher than short --runrunincome elasticityincome elasticityLarge heterogeneity in estimated income elasticity acrossLarge heterogeneity in estimated income elasticity acrosscountries and/or regionscountries and/or regionsDeveloping countries exhibit higher income elasticity than OECDDeveloping countries exhibit higher income elasticity than OECDResponsiveness of oil demand to income declining over timeResponsiveness of oil demand to income declining over timeespecially in OECD countriesespecially in OECD countries


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Projections of Oil DemandProjections of Oil Demand

Relationship between oil demand, prices &Relationship between oil demand, prices &

income used to project oil demand growthincome used to project oil demand growthProjections highly sensitive to assumptionsProjections highly sensitive to assumptionsmade about economic growth scenariosmade about economic growth scenarios

Highly sensitive to income and price elasticityHighly sensitive to income and price elasticityHighly sensitive to oil price path chosenHighly sensitive to oil price path chosenEndogeneityEndogeneity of prices and income biasof prices and income bias

resultsresultsIgnore potential relationship between oil priceIgnore potential relationship between oil price

increases and growthincreases and growth


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ProjectionsProjections

Table 3 : Projected Oil Demand (Millions of Barrels per day)2003(Actual)

2010 2015 2020 2025 2030

IMF79.8 92 102.42 113.5 125.5 138.5

EIA (2006) 80 92 98 104 111 118IEA (2006) 82.5 (2004) 91.3 99.3 116.3Source: IMF (2005), World Economic Outlook, April 2005, Table 4.5; Energy InformationAdministration (EIA), International Energy Outlook 2006, Figure 26. International Energy Agency,World Energy Outlook 2006, Table 3.1.


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Determinants of NonDeterminants of Non --OPEC OilOPEC Oil

SupplySupplyTwo General Approaches: geophysical and economicTwo General Approaches: geophysical and economicGeophysical factors determine oil supplyGeophysical factors determine oil supply

Production governed by historical cumulative production andProduction governed by historical cumulative production andsize of ultimately recoverable reserves (URR)size of ultimately recoverable reserves (URR)Based on specific logistic curve that specifies time path of Based on specific logistic curve that specifies time path of cumulative production possible to fit a symmetrical bell shapedcumulative production possible to fit a symmetrical bell shapedcurves for annual rate of productioncurves for annual rate of production

HubbertsHubberts approach been widely criticizedapproach been widely criticizedTreatment of URR as static variableTreatment of URR as static variable

Geophysical models overestimate depletion effectGeophysical models overestimate depletion effect


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Role of ReservesRole of Reserves

Reserves essential in geophysical modelsReserves essential in geophysical modelsIssue of reserves is highly contentiousIssue of reserves is highly contentiousWide disagreement on the size of global reservesWide disagreement on the size of global reservesEstimates vary considerably ranging fromEstimates vary considerably ranging from

Very low estimates of less than 2 trillion barrels of oil equivaVery low estimates of less than 2 trillion barrels of oil equiva lentlent(TBOE) (Campbell, 1989; Campbell and(TBOE) (Campbell, 1989; Campbell and LahererreLahererre ; 1998); 1998)Moderate estimates of reserves between 2 TBOE and 4 TBOEModerate estimates of reserves between 2 TBOE and 4 TBOE(USGC, 2000)(USGC, 2000)High estimates of reserves of excess of 4 TBOE (Odell, 1983;High estimates of reserves of excess of 4 TBOE (Odell, 1983;Shell 2001; and Exxon Mobil, 2005)Shell 2001; and Exxon Mobil, 2005)

Variation due to different methodologies used, vestedVariation due to different methodologies used, vestedinterests, whether studies take into account conventionalinterests, whether studies take into account conventional

and unconventional, adoption of different definitionsand unconventional, adoption of different definitions


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Oil Reserves IncreasingOil Reserves Increasing

Table 4: Oil Reserves and Production Data1973 1983 1993 2003

World Reserves(billion barrels)

635 723 1024 1148

World Output(million b/d)

59 57 66 77

World R/P ratio

(years)

30 35 42 41

Source: Watkins (2006), Table 1.

The bulk of this growth is not due to new discoveries but mainly due toreserve (or field) growth


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Economic Based ModelsEconomic Based ModelsEconomic factorsEconomic factors

real oil prices, costs, regulatory factors play an important rolreal oil prices, costs, regulatory factors play an important rol e ine in

determining oil productiondetermining oil productionVarious studies attempt to estimate price elasticity for Various studies attempt to estimate price elasticity for nonnon --OPEC oil supplyOPEC oil supplyResponse of nonResponse of non --OPEC production to oil pricesOPEC production to oil pricesespecially in short run is close to zero and even negativeespecially in short run is close to zero and even negative

Producers do not necessarily increase production in face of pricProducers do not necessarily increase production in face of pric eeriseriseA decrease in oil prices does not induce producers to reduceA decrease in oil prices does not induce producers to reduce

productionproductionAlthough long run price elasticity is found to be positiveAlthough long run price elasticity is found to be positiveestimates are quite low but not necessarily in all studiesestimates are quite low but not necessarily in all studies


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NonNon --OPEC Oil ProjectionsOPEC Oil Projections

Table 5: Non-OPECOil Production Projections2010 2015 2030

EIA(2006) 54.4 58.6 72.6EIA(2005) 56.6 61.7 66.2IEA(2006) 53.4 55.0 57.6

Given the different models and the wide range of elasticity estimates, itis no surprise that non-OPEC supply projections differ considerablyacross studies and over time.


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Supply of Oil: Role of OPECSupply of Oil: Role of OPEC

Modelling OPEC supply creates serious challenge for Modelling OPEC supply creates serious challenge for competitive supplycompetitive supply --demand frameworkdemand frameworkDescribe OPEC as cartel or oligopoly while at same timeDescribe OPEC as cartel or oligopoly while at same timeuse competitive supplyuse competitive supply --demand framework for analysingdemand framework for analysinglong run behaviour of oil marketlong run behaviour of oil market

Close the model by consideringClose the model by consideringOPEC acts as swing producer equilibrating demand and supplyOPEC acts as swing producer equilibrating demand and supplywith optimal prices/quantity levelswith optimal prices/quantity levelsTreat OPEC supply as a residual (Call on OPEC)Treat OPEC supply as a residual (Call on OPEC)

Hypothetical amount that OPEC needs to produce to close the gapHypothetical amount that OPEC needs to produce to close the gapbetween oil demand and nonbetween oil demand and non --OPEC supplyOPEC supply


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ProjectionsProjections

Table 5: Projections of OPEC Call2010 2020 2025 2030

EIA (2006)(Upper bound-Lower bound)32.9-37.9 29.3-43.3 29.8-46.9 30.9-51.0IMF (2005)(Upper bound-Lower bound)

30.6-32.7 43.5-49.2 51.6-61.0 61.3-74.4

IEA (2006) (base line

scenario)

35.9 56.3


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Incentive to Expand OutputIncentive to Expand Output

Implicitly assume that OPEC has incentive to increaseImplicitly assume that OPEC has incentive to increasemarket share without any regards to oil pricesmarket share without any regards to oil pricesNo analysis whether projected output path serves OPECNo analysis whether projected output path serves OPECinterestsinterestsGatelyGately (2004) calculates the OPECs net present value(2004) calculates the OPECs net present value

of profits for different choices of OPECs market shareof profits for different choices of OPECs market shareAggressive expansion plans to expand output can yield lower Aggressive expansion plans to expand output can yield lower payoff than if OPEC decides to maintain its market sharepayoff than if OPEC decides to maintain its market shareIncrease in discounted expected profit from higher output moreIncrease in discounted expected profit from higher output more

than offset by lower prices as result of rapid output expansionthan offset by lower prices as result of rapid output expansionrojectionsrojections made by EIA and IEA of rapid increases in marketmade by EIA and IEA of rapid increases in marketshare are likely to be contrary to OPECs own best interestsshare are likely to be contrary to OPECs own best interests


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The Underinvestment ProblemThe Underinvestment Problem

Unfavorable geopolitical factors/ sanctions can preventUnfavorable geopolitical factors/ sanctions can preventcapacity expansioncapacity expansion

Relationship between government and national oilRelationship between government and national oilcompany can result in unfavorable environment for company can result in unfavorable environment for investmentinvestment

Relationship between governments and/or national oilRelationship between governments and/or national oilcompanies andcompanies and IOCsIOCsAs markets have tightened terms and conditions demanded byAs markets have tightened terms and conditions demanded byowners have been hardening over timeowners have been hardening over time

For OPEC uncertainty about demand for OPEC oilFor OPEC uncertainty about demand for OPEC oilconstitutes a very important obstacle for investmentconstitutes a very important obstacle for investment

Calls for security of demandCalls for security of demand

f l d


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Limitations of SupplyLimitations of Supply --DemandDemand

FrameworkFrameworkUsing this framework to project oil prices is likely to result iUsing this framework to project oil prices is likely to result i nnmistakes for a number of reasonsmistakes for a number of reasons

highly sensitive to assumptions made about income and pricehighly sensitive to assumptions made about income and priceelasticity of demand, the price elasticity of supply, role of elasticity of demand, the price elasticity of supply, role of reserves, OPEC behaviour reserves, OPEC behaviour Can not capture impact of unexpected shocksCan not capture impact of unexpected shocks

CashinCashin el at al, 1999: it is incorrect to view shocks toel at al, 1999: it is incorrect to view shocks tocommodity prices as generally being a temporarycommodity prices as generally being a temporaryphenomenon that largely reflect shortphenomenon that largely reflect short --lived variability inlived variability insupply interacting with relatively unchanging demandsupply interacting with relatively unchanging demand

Does not take into account general geopolitical context andDoes not take into account general geopolitical context andmarket conditions in which oil prices are determinedmarket conditions in which oil prices are determined

SupplySupply --demand framework analyses oil prices and makesdemand framework analyses oil prices and makesprojections in a neutral contextprojections in a neutral context


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4. Informal Approach4. Informal Approach

Identify other factors affecting oil pricesIdentify other factors affecting oil prices

within a specific contextwithin a specific contextprovide only a cursory view about how oilprovide only a cursory view about how oilmarket and oil prices might develop in themarket and oil prices might develop in thefuturefuture

Of limited use to make projectionsOf limited use to make projections

U f h I f l A hU f h I f l A h


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Use of the Informal Approach toUse of the Informal Approach to

Explain Current DriversExplain Current DriversCurrent drivers of oil pricesCurrent drivers of oil prices

Spare Capacity: Can it be reSpare Capacity: Can it be re --established?established?Role of OPEC: Changing role?Role of OPEC: Changing role?Noise Traders: Do they matter?Noise Traders: Do they matter?Inventories: Is there a new relationship?Inventories: Is there a new relationship?

Are these drivers transitory or permanent?Are these drivers transitory or permanent?


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4.1 Rapid Decline in OPEC Spare4.1 Rapid Decline in OPEC Spare

CapacityCapacity

40

45

50

55

60

65

70

75

80

85

1 9 7 0

1 9 7 2

1 9 7 4

1 9 7 6

1 9 7 8

1 9 8 0

1 9 8 2

1 9 8 4

1 9 8 6

1 9 8 8

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

M i l l i o n s

b p

d

Global Production Capacity

World Total Production

1985: Spare Capapcity of around 10million bpd

Source: IMF; BP

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


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The Impact of Loss of SpareThe Impact of Loss of SpareCapacity Cushion on PricesCapacity Cushion on Prices

AcceleratingGlobalDemand

Acceleratedrise in oilprices

OPEC SpareCapacityReduced

Global oilsystemsability to

respond toshocksweakened

Low Non-OPECSupplyGrowth

Volatility in oilpricesBottlenecks inDownstream Frequent

spikes in oilpricesCycle of

UnderinvestmentGeopolitical shocks

Impact of shocksmagnified in

absence of spare capacity

Weather shocks

Refinery fires

Speculators


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Can the Spare Capacity CushionCan the Spare Capacity Cushionbe Rebe Re --established?established?

Spare capacity not outcomeof rational investmentdecision

Spare capacity outcome of anhistorical developments in 1970s &1980s

International Oil Companies willnot hold spare capacity

Few players today able or willing to invest in newspare capacity Who should bare the costs of

spare capacity?

Face several years of capacity constraints even if new investments are madetodayNo short-term relief for oilmarket

Any increase in spare

capacity in the coming twoyears arise mainly due tosharp slowdown in demandrather than increase in

production capacity


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4.2 OPEC Pricing Power 4.2 OPEC Pricing Power QuotaQuota decisions can be viewed as signals to market about OPECsdecisions can be viewed as signals to market about OPECspreferred range of pricespreferred range of pricesSignalling mechanism may or may not succeed depending on howSignalling mechanism may or may not succeed depending on howmarket interprets signalsmarket interprets signalsWeak market conditionsWeak market conditions

When required cuts significant small OPEC members find it difficWhen required cuts significant small OPEC members find it diffic ult toult toreduce their productionreduce their production

Market participants doubt the effectiveness and credibility of OMarket participants doubt the effectiveness and credibility of O PECPEC sspolicy and may ignore the signalpolicy and may ignore the signalTight market conditionsTight market conditions

Agreements to increase production easier to reach and implementAgreements to increase production easier to reach and implement whenwhenglobal demand rising but OPEC may not respond quickly to upwardglobal demand rising but OPEC may not respond quickly to upwardtrend in an environment of imperfect information and uncertaintytrend in an environment of imperfect information and uncertainty aboutaboutfuture demandfuture demand

Another channel: the erosion of spare capacityAnother channel: the erosion of spare capacity


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OPECs Current DilemmaOPECs Current DilemmaAn important consequence of the recent shift to the futures markAn important consequence of the recent shift to the futures mark etetfor oil price determination is the wide range of factors that OPfor oil price determination is the wide range of factors that OP ECECneeds to consider in making its output decisionsneeds to consider in making its output decisions

the level of inventoriesthe level of inventoriesforward curves shapeforward curves shape

size of speculative positions in the futures marketsize of speculative positions in the futures markettraders bearish or bullish sentimentstraders bearish or bullish sentiments

Flow of funds in and out of the marketFlow of funds in and out of the marketGreatly complicates decision making process for simple reason:Greatly complicates decision making process for simple reason:OPEC has only one policy tool at its disposal (implementingOPEC has only one policy tool at its disposal (implementingproduction cut) with which it would like to achieve a wide rangeproduction cut) with which it would like to achieve a wide range of of objectivesobjectives

May have undesired consequences on oil price fluctuations induciMay have undesired consequences on oil price fluctuations induci ngngvolatility and causing sharp rises or falls in oil prices in somvolatility and causing sharp rises or falls in oil prices in som e instancese instances


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4.3 Speculation and Oil Prices4.3 Speculation and Oil Prices

Claimed that large component of transactions inClaimed that large component of transactions inmarkets being driven by noise tradingmarkets being driven by noise tradingBlack (1986) defines noise traders as agentsBlack (1986) defines noise traders as agentswho sell and buy assets on the basis of who sell and buy assets on the basis of irrelevant informationirrelevant information

Transact on the basis of extrapolating past trendsTransact on the basis of extrapolating past trends(technical analysis) or irrational investors sentiments(technical analysis) or irrational investors sentiments(herding) rather than on market fundamentals or the(herding) rather than on market fundamentals or thearrival of new information (see for instancearrival of new information (see for instance Shiller Shiller

(1981) and(1981) and Shleifer Shleifer and Summers (1990) amongand Summers (1990) amongmany others)many others)


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Traditional ViewTraditional View

Noise traders exist in financial markets but can be ignored in mNoise traders exist in financial markets but can be ignored in m odelsodelsof price formationof price formation

If noise traders hold overvalued assets arbitrageurs should sellIf noise traders hold overvalued assets arbitrageurs should sellthese assets to noise traders and push down their pricesthese assets to noise traders and push down their pricesIf trader holds over If trader holds over --valued assets then arbitrageurs should purchasevalued assets then arbitrageurs should purchaseasset from the noise trader and raise the priceasset from the noise trader and raise the priceNet effect : noise traders lose money; sooner or later exit theNet effect : noise traders lose money; sooner or later exit the marketmarketFriedman (1953): people who argue that speculation is generallFriedman (1953): people who argue that speculation is generall yydestabilizing seldom realize that this is equivalent to saying tdestabilizing seldom realize that this is equivalent to saying t hathatspeculators lose money since speculation can be destabilizing inspeculators lose money since speculation can be destabilizing ingeneral only if speculators on average sell low and buy highgeneral only if speculators on average sell low and buy high


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Traditional View ChallengedTraditional View Challenged

Traditional view recently challengedTraditional view recently challengedThe survival of noise traders is possibleThe survival of noise traders is possible

Shleifer Shleifer and Summers (1990)and Summers (1990)KoganKogan , Ross, Wang and, Ross, Wang and WesterfieldWesterfield (2003)(2003)

Even if noise trading in financial markets can persist, theEven if noise trading in financial markets can persist, the

main issue is whether changes in demand due to noisemain issue is whether changes in demand due to noisetrading are big enough to affect prices and destabilizetrading are big enough to affect prices and destabilizethe marketthe marketPotential of herding: If shifts in demand correlated acrossPotential of herding: If shifts in demand correlated acrossnoise traders and do not cancel each other out thennoise traders and do not cancel each other out thennoise trading is capable of influencing market pricesnoise trading is capable of influencing market prices

Speculative Positions and OilSpeculative Positions and Oil


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Speculative Positions and OilSpeculative Positions and Oil

PricesPrices

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

0 9 / 0 1 / 1 9 9 5

0 2 / 0 2 / 1 9 9 6

0 7 / 0 5 / 1 9 9 6

1 2 / 0 6 / 1 9 9 6

0 5 / 0 9 / 1 9 9 7

1 0 / 1 0 / 1 9 9 7

3 / 1 3 / 1 9 9 8

8 / 1 4 / 1 9 9 8

1 / 1 5 / 1 9 9 9

6 / 1 8 / 1 9 9 9

1 1 / 1 9 / 1 9 9 9

4 / 2 1 / 2 0 0 0

9 / 2 2 / 2 0 0 0

2 / 2 3 / 2 0 0 1

7 / 2 7 / 2 0 0 1

1 2 / 2 8 / 2 0 0 1

5 / 3 1 / 2 0 0 2

1 1 / 0 1 / 2 0 0 2

0 4 / 0 4 / 2 0 0 3

0 9 / 0 5 / 2 0 0 3

0 2 / 0 6 / 2 0 0 4

0 7 / 0 9 / 2 0 0 4

1 2 / 1 0 / 2 0 0 4

5 / 1 3 / 2 0 0 5

1 0 / 1 4 / 2 0 0 5

3 / 1 7 / 2 0 0 6

-0.1

-0.08

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

0.08

0.1

0.12

Spot Price

Net Long Non-CommercialPositions

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

Source: IMF, World Economic Outlook, 2006


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Speculation and Oil PricesSpeculation and Oil Prices

Three broad generalizationsThree broad generalizationsPrices appear less volatile than speculative positionsPrices appear less volatile than speculative positionsNo common trend between prices and speculation: noNo common trend between prices and speculation: nopersistent pickup in net long nonpersistent pickup in net long non --commercialcommercialpositions when oil prices where trending upwardpositions when oil prices where trending upward

Changes in nonChanges in non --commercial traders net longcommercial traders net longpositions may coincide with changes in oil pricespositions may coincide with changes in oil prices

This evidence does not establish that speculators influenceThis evidence does not establish that speculators influenceoil pricesoil prices

Could be the result of changes in fundamentals that affectCould be the result of changes in fundamentals that affectboth oil prices and speculative positions of tradersboth oil prices and speculative positions of traders


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Role of Hedge FundsRole of Hedge FundsHaighHaigh ,, HranaiovaHranaiova , and, and OverdahlOverdahl (2005) use a unique(2005) use a uniquedataset from the Commodity Futures Tradingdataset from the Commodity Futures Trading ComissionComission

(CFTC) to examine the role of hedgers and speculators(CFTC) to examine the role of hedgers and speculatorsin the crude oil marketin the crude oil marketDisaggregated data allow authors to examine role of Disaggregated data allow authors to examine role of hedge fundshedge funds

Main findingsMain findingsSpeculators are proving liquidity to hedgers and not the other Speculators are proving liquidity to hedgers and not the other way aroundway aroundLarge speculators have little influence on oil pricesLarge speculators have little influence on oil prices

Evidence of herding is very weak and even if it exists, herdingEvidence of herding is very weak and even if it exists, herding isisnot destabilisingnot destabilising Traders do not buy when prices are low and sell when prices areTraders do not buy when prices are low and sell when prices are

high and do not cause an overshooting of oil priceshigh and do not cause an overshooting of oil prices


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4.4 Inventories4.4 Inventories

Inventories have risenInventories have risenMarket oversuppliedMarket oversuppliedPrecautionary DemandPrecautionary Demand

Current price structure signalling need for Current price structure signalling need for precautionary inventoriesprecautionary inventories

JustJust --inin--time inventories are no longer time inventories are no longer appropriate as OPEC has lost the spareappropriate as OPEC has lost the spare

capacity that enabled it to act as acapacity that enabled it to act as abuffer, shifting stock risk managementbuffer, shifting stock risk managementdown the crude supply chain to refinersdown the crude supply chain to refiners


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It is theIt is the ContnagoContnago

ContangoContango

ContangoContango creating incentive for marketcreating incentive for marketparticipants with storage facilities toparticipants with storage facilities toaccumulate inventories, stock up their tanks,accumulate inventories, stock up their tanks,

lock a profit by selling futures contractslock a profit by selling futures contractsInventories then shorted in the futures marketInventories then shorted in the futures marketcontangocontango


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WTI Forward Price CurveWTI Forward Price Curve

54

56

58

60

62

64

66

F e

b - 0

7

M a y - 0

7

A u g - 0

7

N o v - 0

7

F e

b - 0

8

M a y - 0

8

A u g - 0

8

N o v - 0

8

F e

b - 0

9

M a y - 0

9

A u g - 0

9

N o v - 0

9

F e

b - 1

0

M a y - 1

0

A u g - 1

0

N o v - 1

0

F e

b - 1

1

M a y - 1

1

A u g - 1

1

N o v - 1

1

F e

b - 1

2

M a y - 1

2

A u g - 1

2

N o v - 1

2

U S $

WTI Forward Price Curve (as of 3 January 2007)

d l


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Inventories and Oil PricesInventories and Oil Prices

Associated rise in inventories occurring (until recently)Associated rise in inventories occurring (until recently)with an upward trend in oil priceswith an upward trend in oil prices

Conventional wisdom that building up inventories wouldConventional wisdom that building up inventories woulddepress oil pricesdepress oil pricesSome argue conventional wisdom may no longer beSome argue conventional wisdom may no longer be

validvalidHigh 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

l blM Pl ibl I i


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More Plausible InterpretationMore Plausible Interpretation

Higher than expected levels of inventoriesHigher than expected levels of inventories

still cause oil prices for prompt delivery tostill cause oil prices for prompt delivery todeclinedeclineOther factors pushing prompt prices in theOther factors pushing prompt prices in the

opposite direction shadowing the impact of opposite direction shadowing the impact of inventories on oil pricesinventories on oil pricesUntil we able to isolate the impact of other Until we able to isolate the impact of other factors, it is difficult to tellfactors, it is difficult to tell

S l B k?S l B k?


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Structural Break?Structural Break?

Using the informal approach not possible to provide aUsing the informal approach not possible to provide aquantitative assessment of changes in oil marketquantitative assessment of changes in oil market

But allows us to provide a qualitative assessment of But allows us to provide a qualitative assessment of whether the market witnessed structural changes with awhether the market witnessed structural changes with alasting impact on oil price behaviour or whether thelasting impact on oil price behaviour or whether therecent strength in oil prices caused by temporary driversrecent strength in oil prices caused by temporary driversStructural changes in three areasStructural changes in three areas

Structural shift in the back end of the forward curveStructural shift in the back end of the forward curveInternational oil order where nonInternational oil order where non --OPEC supplies incrementalOPEC supplies incremental

global oil demand and OPEC provides capacity cushion hasglobal oil demand and OPEC provides capacity cushion hasbeen shaken in recent yearsbeen shaken in recent yearsThe shift to the futures market for oil price determinationThe shift to the futures market for oil price determination

Back End of the Curve Has MovedBack End of the Curve Has Moved


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UpwardUpward

20

30

40

50

60

70

80

1 2 3 4 5 6 7Ye ars to e xpiry

7 Se pte m ber 2006One ye a r a goTwo yea rs agoThre e yea rs agoFour yea rs a go

C l iC l i


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ConclusionsConclusions

Every attempt to predict oil prices wouldEvery attempt to predict oil prices wouldcertainly result in mistakescertainly result in mistakes

Various approaches allow us to analyse andVarious approaches allow us to analyse andgain better understanding of various elements of gain better understanding of various elements of oil marketoil market

Players should acknowledge limitations of Players should acknowledge limitations of various approaches & always keep them in mindvarious approaches & always keep them in mindwhen making decisions/policy recommendationswhen making decisions/policy recommendations

Pushing hard for policies based on thesePushing hard for policies based on thesemodels projections defeat the actual purpose of models projections defeat the actual purpose of these models and may result in misguidedthese models and may result in misguidedpolicies not to say dangerous onespolicies not to say dangerous ones

analysing oil prices

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