Transcript Wall Street and the price of oil

Presentation to:
New York Energy Forum
Wall Street and the price of oil
Adam Robinson
Energy Research Analyst
[email protected]
April 10, 2008
Agenda
I.
Wall Street and today’s oil price environment
II.
Wall Street and the term structure of oil prices
III. Wall Street and the volatility of oil prices
IV. Conclusions
Wall Street and the price of oil

Wall Street’s financial crisis temporarily breaking the links
between the physical and financial markets for crude oil

Wall Street facilitating huge financial demand for commodities

The investment vehicles created by Wall Street to express that
financial demand are artifacts of a less liquid market and create
distortions in the term structure of oil prices

Even when markets are functioning normally, if banks build up a
concentrated position in the options market at particular strikes,
they can affect crude oil price volatility
1
I. Wall Street and today’s oil price
environment
There are two markets pricing oil for delivery in five years
Long-dated NYMEX WTI (and natural gas) have shot up
WTI vs. HH NG 5-yr out in $/boe + 40/60 blended price
$/boe
110
$98.42
100
90
80
$72.38
70
60
$55.01
50
40
30
WTI
________________
Source: Bloomberg.
HH NG
40% oil, 60% gas blended price
2
Jan-08
Sep-07
May-07
Jan-07
Sep-06
May-06
Jan-06
Sep-05
May-05
Jan-05
Sep-04
May-04
Jan-04
Sep-03
May-03
Jan-03
Sep-02
May-02
Jan-02
20
There are two markets pricing oil for delivery in five years
While the price of US reserves has flat-lined
Price of US reserves valued through US M&A activity
$20.00
Weighted Average Implied Proved
Reserve Value US$/Boe
$18.00
$16.00
$14.00
$12.00
$10.00
$8.00
$6.00
$4.00
$2.00
3
2008Q1
2007Q3
2007Q1
2006Q3
2006Q1
2005Q3
2005Q1
2004Q3
2004Q1
2003Q3
________________
Source: John S. Herold Upstream M&A Review
2003Q1
2002Q3
2002Q1
2001Q3
2001Q1
2000Q3
2000Q1
$0.00
Higher costs in the US could explain the difference…
The market for US oil assets provides another data point for longdated crude oil prices, holding US costs and politics constant
US Oil
Production
Costs
US Tax Regime
and Political
Uncertainty
Value of a US Oil Field
Value of Long-Dated WTI
Financial
Demand for
Crude Oil
Global SupplyDemand
Balance
These should trend together
if fundamentals are behind
WTI price changes
Global SupplyDemand
Balance
4
But despite what some are saying, US costs are flattening
US PPI Oil Producer Cost Indices are flattening (3-month moving average)
150
140
130
120
110
100
Jan-08
Oct-07
Jul-07
Apr-07
Jan-07
Oct-06
Jul-06
Apr-06
Jan-06
Oct-05
Jul-05
Apr-05
Jan-05
Oct-04
Jul-04
Apr-04
Jan-04
Oct-03
Jul-03
Apr-03
Jan-03
Oct-02
Jul-02
Apr-02
Jan-02
90
Oil Field, Gas Field Machinery (MA)
Rotary oil & gas field drilling machinery & parts (MA)
Oil field and gas field production machinery (MA)
Support activities for oil & gas operation (MA)
________________
Source: US Bureau of Labor Statistics
5
US drilling cost rise and fall even more stark
US Drilling cost PPI (3-month moving average)
260
240
220
200
180
160
140
120
100
________________
Source: US Bureau of Labor Statistics
6
Jan-08
Oct-07
Jul-07
Apr-07
Jan-07
Oct-06
Jul-06
Apr-06
Jan-06
Oct-05
Jul-05
Apr-05
Jan-05
Oct-04
Jul-04
Apr-04
Jan-04
Oct-03
Jul-03
Apr-03
Jan-03
Oct-02
Jul-02
Apr-02
Jan-02
80
Even deepwater drilling costs are flattening
Deepwater Rig Day-Rates
Avg dayrates in '000 dollars
600
500
400
300
200
100
Semisubmersible Dayrates, U.S. GOM, 5,000- to 7,499-Foot
Semisubmersible Dayrates, North Sea, 3,000- to 4,999-Foot
Jan-08
Sep-07
May-07
Jan-07
Sep-06
May-06
Jan-06
Sep-05
May-05
Jan-05
Sep-04
May-04
Jan-04
Sep-03
May-03
Jan-03
Sep-02
May-02
Jan-02
Sep-01
May-01
Jan-01
0
Semisubmersible Dayrates, U.S. GOM, 7,500-Foot or More
Drillship Dayrates, GOM, Dynamically Positioned
________________
Source: ODS-Petrodata and Lehman Brothers Estimates
7
So with costs flat, what explains the markets’ divergence?
Relative to the fundamentals, either US reserves are undervalued
or WTI is overvalued
Index of WTI/HH prices vs US reserves valued through US M&A activity
Index = 100
350
300
250
200
150
100
2008Q1
2007Q4
2007Q3
2007Q2
2007Q1
2006Q4
2006Q3
2006Q2
2006Q1
2005Q4
2005Q3
2005Q2
2005Q1
2004Q4
2004Q3
2004Q2
2004Q1
2003Q4
2003Q3
2003Q2
2003Q1
2002Q4
2002Q3
2002Q2
2002Q1
50
Index of weighted average implied proved reserve value
Index of 5-yr out blended oil/gas prices weighted by average share of each fuel in the reserves purchased during the quarter
________________
Source: John S. Herold Upstream M&A Review
8
Wall Street turmoil may be allowing an arbitrage between
the two markets to open
Rule of thumb for the US: To find the arbitrage equilibrium,
multiply reserve valuation by 3-4x to get expected minimum
realized blended oil/gas price
Assumptions

Cost of proposed reserve acquisition: $15/bbl

Lifting cost: $8/bbl

R/P Ratio: 10 years

Required minimum ROCE: 10%

Government take = 40%
Math

Total capex = $15/bbl for 10 years = $150/bbl of daily capacity

That requires $15/bbl of daily profit to make a 10% return on capex

Assuming a 40% tax rate, profit before tax must equal $25/bbl

Then you must cover capex of $15/bbl and lifting costs of $8/bbl, meaning your overall realized price
must equal $25+$15+$8= $48, or 3.2x your capex cost

If reserve owner expects a 20% ROCE, then expected realized oil price is $73

A 30% ROCE could be achieved if $100/bbl is realized
9
How Wall Street may have broken the markets’ link

What may be preventing the arb?
– No access to credit to purchase assets
• Many producer hedges already underwater
– Counterparty risk and margin calls
• Grain elevator operators in 2008
– Inability especially of big players to hedge all production
• A big hedge could cause a major price drop (Mexico in Dec-06)

Arb may work again if:
– Confidence rebuilds in the US banking system
– Financial instruments to mitigate these risks become more widespread
10
So is NYMEX overvalued or reserves undervalued?

Cost of exploration and price of US oil assets are substitutes
– Could provide an anchor to price of oil reserves as the arb
closes, forcing NYMEX WTI down
 But
in the meantime, in the absence of producer selling
or links to the market for physical oil reserves, WTI
prices can trade purely on financial flows
11
So what might be fair value for long-dated NYMEX WTI?
Higher US costs appear to explain much of the rise in long-dated
WTI prices until the divergence in October 2007.
US monthly PPI data regressed against average monthly 5-yr out WTI prices
$/bbl
100
- R2 through Oct-07 is 96%
- Divergence worsens: Dec-13 WTI to average $98 in Mar-08
90
$91.19
80
70
$70.52
60
50
40
30
5-year out Dec avg monthy WTI price
Predicted 5-yr out WTI based on PPI cost indices
12
Feb-08
Dec-07
Oct-07
Aug-07
Jun-07
Apr-07
Feb-07
Dec-06
Oct-06
Aug-06
Jun-06
Apr-06
Feb-06
Dec-05
Oct-05
Aug-05
Jun-05
Apr-05
Feb-05
Dec-04
Oct-04
Aug-04
Jun-04
Apr-04
Feb-04
20
And if natural gas holds its gains, oil could drop even lower
Stronger natural gas prices take pressure off of oil to rise in
order to provide an incentive for upstream investment
US monthly PPI data regressed against average monthly 5-yr out WTI prices
$/boe
- R2 through Sept-07 is 94%
- Divergence worsens: Dec-13
averaged $72.51 in Mar-08
70
65
60
$65.62
55
$55.64
50
45
40
35
30
5-yr out Dec avg monthly blended price
Predicted 5-yr out blended price based on PPI cost indices
13
Feb-08
Dec-07
Oct-07
Aug-07
Jun-07
Apr-07
Feb-07
Dec-06
Oct-06
Aug-06
Jun-06
Apr-06
Feb-06
Dec-05
Oct-05
Aug-05
Jun-05
Apr-05
Feb-05
Dec-04
Oct-04
Aug-04
Jun-04
Apr-04
25
Meanwhile, thanks to Wall Street, financial prices have no
physical price ceiling and can trade on almost anything
While correlations have recently strengthened, there is no
longer-term relationship to justify the moves in the medium-term
WTI 1M vs. DXY Index
WTI 1M vs. Inflation*
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
Feb-08
Oct-07
Jun-07
Feb-07
Oct-06
Jun-06
Feb-06
Oct-05
Jun-05
Feb-05
Oct-04
Jun-04
Feb-04
Oct-03
Feb-08
Oct-07
Jun-07
Feb-07
Oct-06
Jun-06
Feb-06
Oct-05
Jun-05
Feb-05
Oct-04
Jun-04
Feb-04
Oct-03
Jun-03
Jun-03
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
WTI-10yr Treas/TIPS Breakeven 6-mth rolling correlation
WTI-DXY 6-mth rolling correlation
________________
*Inflation compensation as measured by the difference between 10-year treasuries and 10-year TIPS
Source: Bloomberg, Lehman Brothers Estimates
14
What happens when Wall Street turmoil removes the
physical ceiling on the financial market?
Investors buy commodities as an inflation hedge, pushing up
commodity prices, which then pushes up inflation
How does this play out?

Oil stocks build if the price is too high for the physical market, causing suppliers to overproduce and consumers to under-consume

But eventually inflation will be real or it won’t
– If commodity price inflation leads to core inflation, Fed will have to put a floor on
interest rates, the dollar rallies and commodities tank
– If the deflationary impact of the US recession offsets commodity price inflation, then
investors have an expensive + unnecessary hedge vs inflation and commodities tank
Meanwhile:

High commodity prices may add to other pressures on the economy and aggravate the US
recession and lower physical demand further

High commodity prices may aggravate any transmission of US economic weakness to the
rest of the OECD as well as emerging market economies
15
II. Wall Street and the
term structure of oil prices
Wall Street as creator and seller of commodity indices
After years of Wall Street going after pension funds, they finally
started to listen early this decade
Efficiency Frontier for a 60/40 Portfolio of Stocks (S&P500)
and Bonds (U.S. Agg.)
Return
16%
60% LBCI
15%
14%
13%
25% LBCI
12%
11%
10%
9%
0% LBCI
8%
7%
6%
7%
8%
9%
10%
Volatility
________________
Source: Lehman Brothers estimates
16
11%
12%
13%
14%
Wall Street benchmark commodity indices are channeling
investment into the wrong part of the curve
Ideally a passive investor would buy a commodity and never sell
it. So why invest at the very front of the futures curve?

In 1990s, liquidity only in
the front
GSCI spot and roll returns, 1999-2007
130%
100%


Producer hedging or
OPEC’s market power kept
curves backwardated
70%
40%
10%
-20%
-50%
Passive investors are now
herded into the front
-80%
– GSCI roll has been
negative since 2004
________________
Source: Bloomberg, NYMEX, S&P GSCI
17
1999-2003
2004-2007
Spot Return
34%
97%
Roll Return
10%
-72%
Overall Return
44%
25%
But liquidity should no longer be an excuse
Particularly in the energy sub-indices, liquidity in the back of the
curve has grown much more quickly than in the front
Nymex WTI futures avg open interest
mn bbls
800
2003-2007
Grow th: 132%
700
600
2003-2007
Grow th: 328%
500
400
300
2003-2007
Grow th: 96%
200
100
0
1M
1999
2M-12M
2003
________________
Source: Bloomberg, NYMEX, S&P GSCI
18
13M-60M
2007
Investing exclusively in the front contract exposes passive
investors to unnecessary risks

Risk 1: Other investors agree with index players

Risk 2: Index overcrowding

Risk 3: No way to exit the front contract after a spike
– Indices gave back all of their gains in natural gas after Hurricane Katrina and
in oil after the Iraq War of 2003 in the four months following the spike
– If oil spikes, it can hurt performance of non-energy commodities by weakening
the global economy
LBCI vs LBPB after 2003 Iraq War
LBCI vs LBPB after Hurricane Katrina
30%
15%
10.0%
28.2%
20%
10%
5.3%
6.8%
10%
5%
0%
0%
-2.6%
-10%
-5%
-20%
-5.8%
-6.7%
-30%
-10%
Crude
-23.9%
Nat gas
Total LBPB vs. LBCI
Feb-03 returns Cumulative returns for 4 months post Feb-03
________________
Source: Lehman Brothers estimates
Aug-05 returns
19
Total LBPB vs. LBCI
Cumulative returns for 4 months post Aug-05
Wall Street and new structured product innovation
To address these risks, Wall Street is designing new indices that
are likely to catch on, spreading index length along the oil curve
and taking pressure off the front during roll periods

New indices should focus
on roll methods
– Should balance
transaction costs vs
footprint


New indices should invest
in longer-dated futures but
also take open interest into
account
If the ideal is the spot return
ex-roll yield, why not buy
the contract whose spot +
roll return best correlates to
the spot return?
Lehman Pure Beta boosts index returns regardless
of commodity weights used
2007
2005-2007 2002-2007
LBPB outperformance by commodity index (%)
LBPB with LBCI weights
5.2
45.0
119.4
LBPB with DJAIG weights
12.9
70.1
178.8
LBPB with GSCI weights
5.2
36.5
105.8
Crude Oil
4.8
31.1
107.3
Natural Gas
6.0
39.6
107.2
Gasoline
7.7
98.2
188.0
Heating Oil
-4.6
38.7
125.3
Aluminum
10.4
33.4
53.9
Copper
5.0
49.6
74.0
Gold
0.0
1.1
2.0
Soybeans
2.5
19.3
48.5
Corn
9.8
33.6
35.2
Wheat
25.7
48.6
56.3
LBPB outperformance by commodity sub-index (%)
________________
Source: Bloomberg, Lehman Brothers estimates
20
III. Wall Street and the
volatility of oil prices
Oil market volatility likely to stay high for fundamental and
flow-related reasons

Tight markets become more volatile as demand runs up against supply
limits, then retreats with additions of new capacity

Stealth supply + black hole demand obscure signals about tightness

Wall Street option-positioning now means that banks will tend to buy in a
rising market and sell in a falling one, accentuating price swings
1M WTI Implied ATM Volatility (30-day rolling average to March 26, 2008)
________________
Source: Bloomberg
Mar-08
Feb-08
Jan-08
Dec-07
Nov-07
Oct-07
Sep-07
Aug-07
Jul-07
%
41
39
37
35
33
31
29
27
25
ATM Implied Volatility, WTI 1M, 30-day moving average
21
Telling the 2007 price story as a Wall Street options trader
It all started with producers using options to hedge the falling
market of late 2006

Banks sold $50 and $60 puts to producers

Producers sold $70 and $80 calls to banks

Banks also sold lottery tickets to hedge funds

As oil prices dropped in early 2007, banks sold oil to hedge

Once oil turned around, banks bought back their hedges

As oil pushed to $70, banks started selling to hedge calls bought
from producers

On the other side of $80, banks had to worry about the calls they
sold to hedge funds, buying and pushing prices quickly to $100

If hedge funds roll out their strikes to $120-$150, prices and
volatility could continue to run higher
22
Telling the 2007 price story as a Wall Street options trader
WTI Dec 07 vs WTI Dec 07 90 calls
As WTI approached $90 strike,
call options created feedback
loop to crude prices
$/contract
6
5
$/bbl
95
90
4
85
3
80
2
________________ WTI Dec 07
Source: Bloomberg, as of 29 Oct 07
90 calls (lhs)
26-Oct
23-Oct
18-Oct
15-Oct
10-Oct
5-Oct
2-Oct
27-Sep
24-Sep
19-Sep
14-Sep
70
11-Sep
0
6-Sep
75
3-Sep
1
WTI Dec 07 futures (rhs)
23
IV. Conclusions
To conclude, Wall Street matters on many levels
 Wall
Street’s current crisis has made it difficult and scary
for physical players to access the oil markets
 Meanwhile
it has made it easier for financial players to
enter
 And
through options it has created more volatility in the
market in certain times
24
How will Wall Street change the markets going forward?

As more banks make markets and longer-dated liquidity deepens,
it will be easier for producers to hedge oil price risk
– May take some risk premium out of oil prices

Wall Street also to convince pension funds to transfer length
from front to back
– Curve may shift to contango

Current Wall Street turmoil may exacerbate China overcapacities
vis-à-vis the stock market

Refining business about to undergo massive changes
– Requires new risk management solutions from Wall Street
25
Most critical, Wall Street needs to fund frontier investments
If cost inflation ending, non-OPEC supply may finally respond to
higher prices

Financing critical to development of the deepwater, arctic, biofuels, GTL and oil shale

Wall Street will be critical to financing the supply gap post-2010 if the politics in OPEC
do not improve
OPEC production capacity growth vs. global oil demand growth
k/bd
3,000
2,500
2,000
1,500
1,000
500
0
-500
2008
2009
2010
OPEC crude capacity grow th
OPEC NGL grow th
________________
Source: ODS-Petrodata and Lehman Brothers Estimates
26
2011
2012
Global demand grow th
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I, Adam Robinson, hereby certify (1) that the views expressed in this research report accurately reflect my/our personal views about any or all of the subject securities or issuers referred to
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