drivers of oil prices

8/3/2019 Drivers of Oil Prices

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Drivers of Oil PricesDrivers of Oil PricesDr 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 Studies

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 volatility

Can slow down economic growthCan slow down economic growth

Can cause inflationary pressuresCan cause inflationary pressures Create global imbalancesCreate global imbalances

Volatility increases uncertainty & discourages muchVolatility increases uncertainty & discourages much

needed investment in oil sectorneeded investment in oil sector

Tight market conditions raised fears about oil scarcityTight market conditions raised fears about oil scarcity

and concerns about energy securityand concerns about energy security


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Different Views: Structural orDifferent 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 consumers New geopolitical uncertainties in the Middle East and elsewhereNew geopolitical uncertainties in the Middle East and elsewhere

ReRe--emergence of oil nationalism in many oilemergence of oil nationalism in many oil--producing countriesproducing countries

Shift in oil pricing regime towards the futures market and growiShift in oil pricing regime towards the futures market and growingngimportance 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 commoditytypricespricesIncrease in oil price stimulates oil production & slows demand gIncrease in oil price stimulates oil production & slows demand growthrowth

causes oil prices to go down stimulates demand oicauses oil prices to go down stimulates demand oil price to risel price to rise

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


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Three Main Approaches ForThree Main Approaches For

Analyzing Oil PricesAnalyzing Oil Prices Models of longModels of long--run oil pricesrun oil prices

NonNon--structural modelsstructural models Oil resource exhaustibility basis for understanding oil pricesOil resource exhaustibility basis for understanding oil prices Oil prices must rise: dominated forecasting modelsOil prices must rise: dominated forecasting models

The competitive supplyThe competitive supply--demanddemand Demand income and price elasticityDemand income and price elasticity

NonNon--OPEC supply: Economics factorOPEC supply: Economics factor vsvs geology?geology?

OPEC behaviourOPEC behaviour

Informal approachInformal approach Help identify economic, geopolitical and incidental factorsHelp identify economic, geopolitical and incidental factors

that affect demand and supplythat affect demand and supply

Can help explain shortCan help explain short--term movements in oil pricesterm movements in oil prices


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LimitationsLimitations

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 ofgain better understanding of various elements ofoil marketoil market

Players should acknowledge limitations ofPlayers should acknowledge limitations ofvarious 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 ofmodels projections defeat the actual purpose ofthese models and may result in misguidedthese models and may result in misguided

policies not to say dangerous onespolicies not to say dangerous ones


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2. Informal Approach2. Informal Approach

Identify certain drivers within a specificIdentify certain drivers within a specific

contextcontext Current 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 and speculators: Do theyNoise Traders and speculators: Do they

matter?matter? Inventories and oil prices: Is there a newInventories and oil prices: Is there a new

relationship?relationship?

Transitory or Permanent?Transitory or Permanent?


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2.1 Rapid Decline in OPEC Spare2.1 Rapid Decline in OPEC Spare

CapacityCapacity

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

40

45

50

55

60

65

70

75

80

85

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Millionsbp

Global Production Capacity

World Total Production

1985: Spare Capapcity of around 10

million bpd

Source: IMF; BP


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Spare CapacitySpare Capacity

0

2

4

6

8

10

12

Algeria Indonesia Iran Kuw ait Libya Nigeria Qatar Saudi

Arabia

UAE Venezuela

November 2006Production

SustainableProduction

Capacity


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Can the Spare Capacity CushionCan the Spare Capacity Cushion

be Rebe Re--established?established?Spare capacity not outcomeof rational investmentdecision

Few players today able orwilling to invest in newspare capacity

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

International Oil Companies willnot hold spare capacity

Face several years of

capacity constraints even ifnew 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

Who should bare the costs ofspare capacity?


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2.2 OPEC Pricing Power2.2 OPEC Pricing Power

Switches in perceptionSwitches in perception

QuotaQuota decisions should be viewed as signals todecisions should be viewed as signals tomarket about OPECs preferred range of pricesmarket about OPECs preferred range of prices

Signalling mechanism may or may not succeedSignalling mechanism may or may not succeed

depending on how market interprets signalsdepending on how market interprets signals

Weak market conditionsWeak market conditions

When required cuts significant small OPEC membersWhen required cuts significant small OPEC membersfind it difficult to reduce their productionfind it difficult to reduce their production

Market participants doubt the effectiveness andMarket participants doubt the effectiveness and

credibility of OPECcredibility of OPECs policy and may ignore the signals policy and may ignore the signal


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OPEC Pricing PowerOPEC Pricing Power

Tight market conditionsTight market conditions

Agreements to increase production easier toAgreements to increase production easier toreach and implement when global demandreach and implement when global demand

rising but OPEC may not respond quickly torising but OPEC may not respond quickly to

upward trend in an environment of imperfectupward trend in an environment of imperfectinformation and uncertainty about futureinformation and uncertainty about future

demanddemand

Another channel: the erosion of spareAnother channel: the erosion of spare

capacitycapacity


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OPEC Pricing PowerOPEC Pricing Power

OPEC alone can not determine the oil priceOPEC alone can not determine the oil price

Depends on other players behaviourDepends on other players behaviour OPEC pricing power varies over timeOPEC pricing power varies over time

OPEC can lose influence on oil pricesOPEC can lose influence on oil prices

OPEC can lose pricing powerOPEC can lose pricing power

Both in weak and tight oil market conditions but forBoth in weak and tight oil market conditions but for

entirely different reasonsentirely different reasons

OPEC influence on prices complicated byOPEC influence on prices complicated by

participants behaviour in the futures marketparticipants behaviour in the futures market


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OPECs Current DilemmaOPECs Current Dilemma

An important consequence of the recent shift to the futures markAn important consequence of the recent shift to the futures marketetfor oil price determination is the wide range of factors that OPfor oil price determination is the wide range of factors that OPECECneeds to consider in making its output decisionsneeds to consider in making its output decisions the level of inventoriesthe level of inventories

forward curves shapeforward curves shape

size of speculative positions in the futures marketsize of speculative positions in the futures market

traders bearish or bullish sentimentstraders bearish or bullish sentiments

Flow of funds in and out of the marketFlow of funds in and out of the market Greatly 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 ofofobjectivesobjectives May have undesired consequences on oil price fluctuations induciMay have undesired consequences on oil price fluctuations inducingng

volatility and causing sharp rises or falls in oil prices in somvolatility and causing sharp rises or falls in oil prices in some instancese instances


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2.3 Speculation and Oil Prices2.3 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 trading

Black (1986) defines noise traders as agentsBlack (1986) defines noise traders as agentswho sell and buy assets on the basis ofwho sell and buy assets on the basis ofirrelevant 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 ShillerShiller

(1981) and(1981) and ShleiferShleifer 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 modelsodelsof 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 prices

If trader holds overIf 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 price

Net effect : noise traders lose money; sooner or later exit theNet effect : noise traders lose money; sooner or later exit the

marketmarket

Friedman (1953): people who argue that speculation is generallFriedman (1953): people who argue that speculation is generallyydestabilizing seldom realize that this is equivalent to saying tdestabilizing seldom realize that this is equivalent to saying thathatspeculators 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 challenged

The survival of noise traders is possibleThe survival of noise traders is possible ShleiferShleifer 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 market

Potential 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


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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

09/01/1995

02/02/1996

07/05/1996

12/06/1996

05/09/1997

10/10/1997

3/13/1998

8/14/1998

1/15/1999

6/18/1999

11/19/1999

4/21/2000

9/22/2000

2/23/2001

7/27/2001

12/28/2001

5/31/2002

11/01/2002

04/04/2003

09/05/2003

02/06/2004

07/09/2004

12/10/2004

5/13/2005

10/14/2005

3/17/2006

-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 generalizations Prices appear less volatile than speculative positionsPrices appear less volatile than speculative positions

No 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 Funds

HaighHaigh,, 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 market

Disaggregated data allow authors to examine role ofDisaggregated data allow authors to examine role ofhedge fundshedge funds

Main findingsMain findings Speculators are proving liquidity to hedgers and not the otherSpeculators are proving liquidity to hedgers and not the other

way aroundway around

Large 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 arehigh and do not cause an overshooting of oil priceshigh and do not cause an overshooting of oil prices


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2.4 Inventories2.4 Inventories

Inventories have risenInventories have risen

Market oversupplied?Market oversupplied? Precautionary Demand?Precautionary Demand?

Current price structure signalling need forCurrent price structure signalling need for

precautionary inventoriesprecautionary inventories JustJust--inin--time inventories are no longertime 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 contracts Inventories then shorted in the futures marketInventories then shorted in the futures market

contangocontango

Effect of keeping prices oil for future deliveryEffect of keeping prices oil for future deliverylower than would have been in absence oflower than would have been in absence ofcontangocontango


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WTI Forward Price CurveWTI Forward Price Curve

54

56

58

60

62

64

66

Feb-07

May-07

Aug-07

Nov-07

Feb-08

May-08

Aug-08

Nov-08

Feb-09

May-09

Aug-09

Nov-09

Feb-10

May-10

Aug-10

Nov-10

Feb-11

May-11

Aug-11

Nov-11

Feb-12

May-12

Aug-12

Nov-12

US

WTI Forward Price Curve (as of 3 January 2007)


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ContangoContango

First Month Forward-Second Month Forward for Brent

-1.5

-1

-0.5

0

0.5

1

1.5

2

25/10/1993

25/04/1994

25/10/1994

25/04/1995

25/10/1995

25/04/1996

25/10/1996

25/04/1997

25/10/1997

25/04/1998

25/10/1998

25/04/1999

25/10/1999

25/04/2000

25/10/2000

25/04/2001

25/10/2001

25/04/2002

25/10/2002

25/04/2003

25/10/2003

25/04/2004

25/10/2004

25/04/2005

25/10/2005

25/04/2006

$/Barrel

First Month Forward-Second Month Forward


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1998 Reinforcing1998 Reinforcing ContangoContango

1998 market entered in prolonged1998 market entered in prolonged contangocontango (which lasted more than(which lasted more than12 months)12 months)

Contrary to currentContrary to current situaionsituaion, 1998, 1998 contangocontango associated with declineassociated with declinetrend in oil prices.trend in oil prices.

Market fell in reinforcingMarket fell in reinforcing contangocontango

ContangoContango encourage those with physical facilities to accumulateencourage those with physical facilities to accumulateinventoriesinventories

Interpreted by market participants a sign of an oversupplyInterpreted by market participants a sign of an oversupply price of oil for immediate delivery would go downprice 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 promptpromptprice increasing the size of theprice increasing the size of the contangocontango

In turn induce traders with physical capacity to augment their sIn turn induce traders with physical capacity to augment their stocktockfurtherfurther

Goes on and onGoes on and on

ContangoContango associated with falling oil prices and large accumulation ofassociated with falling oil prices and large accumulation of

inventoriesinventories


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Inventories and Oil PricesInventories and Oil Prices

Associated rise in inventories occurring this time (untilAssociated rise in inventories occurring this time (untilrecently) with an upward trend in oil pricesrecently) with an upward trend in oil prices

Conventional wisdom that building up inventories wouldConventional wisdom that building up inventories woulddepress oil pricesdepress oil prices

Some argue conventional wisdom may no longer beSome argue conventional wisdom may no longer be

validvalid High levels of inventories no longer seen as necessary sign ofHigh 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 prices

Current 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


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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 todeclinedecline

Other factors pushing prompt prices in theOther factors pushing prompt prices in the

opposite direction shadowing the impact ofopposite direction shadowing the impact ofinventories on oil pricesinventories on oil prices

Until we able to isolate the impact of otherUntil we able to isolate the impact of otherfactors, it is difficult to tellfactors, it is difficult to tell


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Structural Break?Structural Break?

The back end of the curve has been risingThe back end of the curve has been rising

Spare capacitySpare capacity The shift to the futures marketThe shift to the futures market

B k E d f th C H M dBack End of the Curve Has Moved


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

UpwardUpward

20

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60

70

80

1 2 3 4 5 6 7Years to e xpiry

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

drivers of oil prices

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