The Oil Market Through the Lense of the Latest Oil Price Cycle:Issues and Proposals

Bassam Fattouh

Senior Research Fellow&

Academic Director of the Oil and Middle East Programme

Oxford Institute for Energy Studies

9 October 2009

Introduction• Behaviour of oil prices

– A sustained annual increase for seven years– Spectacular collapse of oil price – Increase in volatility– Dislocation of the long term oil prices– Dislocation of benchmarks– Volatile time spreads

• Polarised views about key drivers of oil prices– Fundamentals – Speculation

• A dichotomy dominates debate, but is it useful? – Simplistic and harmful in terms of formulating policy

• An Alternative view– Dual nature of crude oil as a physical commodity and as a financial asset

• Potential policy response

Crude Oil Prices: A Quick Look Back

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04/01/2000 04/01/2001 04/01/2002 04/01/2003 04/01/2004 04/01/2005 04/01/2006 04/01/2007 04/01/2008

2000: $28.49

2001: $24.44

2002: $25

2003: $28.83

2004: $38.26

2005: $54.52

2006: $65.14

2007: $72.38

2008: $97.25

Dated Brent: US$/Barrel

Source: BPNotes: Annual Average

Sharp Cycles in Oil Prices

88.96

Jul 07, 2008, 141.37

Dec 18, 2008, 36.22

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160

Jan 02, 2008

Feb 02, 2008

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2008

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2008

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2008

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2008

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2009

Apr 02, 2009

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2009

Jun 02, 2009

Jul 02, 2009

Aug 02,

2009

Front Month WTI Price, US$/Barrel

Source: EIA

Marked Increase in Volatility

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120%

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160%

Annualised Daily Volatility (1 month rolling Average)

Dislocation of Long Term Oil Prices

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60th contract Front month

Nymex Light Sweet Crude Oil contract Front-Month Contract and 60th Contract ($/barrel)

Source: Bloomberg

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85

105

125

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US$/bbl nominal

Dislocation of Benchmarks

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03/01/2000 03/01/2001 03/01/2002 03/01/2003 03/01/2004 03/01/2005 03/01/2006 03/01/2007 03/01/2008 03/01/2009

WTI-Brent Differential ($/barrel)

Volatile Time Spreads

-30

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03/01/2000 03/01/2001 03/01/2002 03/01/2003 03/01/2004 03/01/2005 03/01/2006 03/01/2007 03/01/2008 03/01/2009

First Month-12th Month

Time Spreads for WTI ($/barrel)

Fundamentals

4.125.00

01234567

1998 2000 2002 2004 2006 2008 2010

OPEC Surplus Crude Oil Production Capacity

Elasticity Matters: • Price elasticity of oil supply low• Price elasticity of oil demand low• Oil demand more responsive to income than prices• Perfect recipe for oil price volatility

Source: EIA

Speculation

Risks to the Dichotomy• Assumes a clear dividing line between speculators and hedgers

– “ the line between minimizing risks – which is what the term “hedge” connotes – and maximizing profits – which is what the term “speculation” connotes –can be exceedingly difficult to draw”

– In need to define speculation • Idea that the oil price can be sliced into various components

reflecting fundamental and non-fundamental factors is theoretically weak– Interrelated determinants– By no means suggests that market always generate the ‘correct’ or

efficient price• Financial players don’t operate in isolation of the physical

parameters of the oil market – Choice to enter and leave market is partly endogenous to oil market

dynamics• Two layers of price discovery: paper and physical

– What are the links between the two?

Dual Nature of Crude Oil• Changing nature of crude oil result of structural

transformations over last two decades but accelerated recently– Change in oil pricing regime, rapid growth of paper market entry of

diverse players with different investment strategies

• Brings to forefront role of expectations in formation of price– Expectations of future fundamentals and news and information about

future fundamentals play an important role in its pricing• Not only current fundamentals

– Current market fundamentals should affect market’s view about future fundamentals and the two set of expectations should be linked

– Dislocation between short-term and long-term expectations• Expectations the key missing link, but raises key issues

– What affects market expectations? – Do financial players amplify expectations? For how long? What

about governments and international organisations?

Forward Curve Out of Balance

Source: Barclay’s Capital

Policy Responses• A key question: How to stabilise market expectations? Is there a role for

government policy and international coordination? – Distinguish between price cycles and short term (inter-day and intra-day) volatility– Causes are different

• Various proposals under discussion – Change the international pricing regime (Mabro, Luciani)– Spare capacity

• It is now there, but issues of when, who, and how it would be used?– Regulation of derivatives (US)

• Is it the magic bullet? • Very unlikely

– Price band (UK government)• Heavy handed approach

– A global oil agency (ENI)– Focal point (OIES)

• Stronger when exporters and importers send a common signal as to preferable range of oil price