“Oil Shocks and OPEC”by

Dr. James L. SmithMaguire Chair in Oil & Gas Management

Southern Methodist University

A Presentation to the Forum on“Energy Security: Global & US Fundamentals”

Dallas Committee on Foreign RelationsJune 29, 2011

Agenda

• Energy shocks and price volatility: The 10x multiplier.

• Interaction of supply & demand:Is the market “well supplied”?

• OPEC: Is it still relevant?

• Financial trading and speculators:The real culprits?

Predicted Impact of Libyan Outage

Global crude oil production = 85.0 million bbl per day Loss of production capacity = 1.80 million bbl per day % reduction in supply = 2.1% (= 1.8085.0) Predicted price change = 10 x 2.1% = 21% Initial price (Feb. 10, 2011) = $85.44 per bbl Predicted price = $103.38 (= $85.00 1.21) Actual price (March 10, 2011) = $102.73

Demand Shocks also Disrupt the Market

• Chinese demand does not grow by 10% each year.

• It grows by 2% or 17% per year (s = 5%)

• Just like supply shocks, demand shocks also produce the 10-x multiplier:

– 2% demand shortfall = 20% oil price reduction

– 4% demand surge = 40% oil price escalation

According to OPEC: Market is “Well Supplied” and Speculators are to Blame.

Source: J. L. Smith, J. of Econ. Perspectives, 2009 (updated)

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Demand Supply (Non-OPEC) OPEC Production

Oil Prices are High Because OPEC Capacity is Low

• Since 2000 …– Demand increased by 52%– Non-OPEC Supply decreased by 13%– OPEC production capacity increased only by 8%

• OPEC capacity is low because investment is low:– During 2007, the 5 “super-majors” (who own 3% of global

reserves) invested $75 billion upstream.– During 2007, OPEC (who owns 60% of global reserves)

invested only $40 billion upstream.

• OPEC reckons the risk of expanding low-cost capacity within the cartel exceeds the potential harm from expanding high-cost capacity outside the cartel.

Where do the Speculators Fit In?

“It is still rather generally believed that futures

markets are primarily speculative markets. They

appear so on superficial observation, as the earth

appears, from such observation, to be flat.”

-- Holbrook Working, Stanford

University,1960

Two Versions of the “Hedge Fund Hypothesis”

1. The Quantity Theory of Futures: The new money

forced the oil price to rise of its own volition—

independent of fundamental forces in the physical

market.

2. Contagion: Trading by financial speculators

altered the expectations of commercial traders, who

were complicit in driving the oil price up.

Neither Version Seems True !!

Physical Market Drives Futures, Not Vice Versa

Summary and Conclusions

• Price volatility is inherent, not contrived, and will not subside going forward.

• Physical disruptions to supply and demand are predictably magnified (10x) by inelastic behavior.

• OPEC is still relevant and effective at what it does:– OPEC not effective in deploying spare capacity to stabilize

prices…– …but highly effective in suppressing investment and

limiting development of new production capacity.

• No credible evidence that financial trading impacts physical oil prices. Fundamentals drive the market.