Transcript What is the Price of Oil?

What is the Price of Oil?
By
Dr. Eric Girard
Professor of Finance
Hickey Chair in Business
Director of the Center for Global Financial Studies
“Crude Processing”
• Extraction-- Crude oil occur in the earth's crust as a result of
a “million of years” decay of plants and animals. Once
extracted, crude oil is transported to refineries, by ship and/or
by pipeline.
• The refining process-- Crude is separated into lighter groups
of hydrocarbons--fuel oil , heating oil, and naphtha.
• The chemistry process: naphtha is processed into olefins and
aromatics; then transformed into more specialized products
leading to plastic, rubber, detergents, aspirin, nylon and other
synthetic fibers, paints, insulating materials...
Oil Consumers
Oil Consumers
50%
45%
40%
35%
30%
25%
20%
1985
1988
1991
1994
1997
2000
15%
10%
5%
2003
UK
Italy
2006
Mexico
France
Brazil
Canada
India
Japan
China
US
0%
Oil Exporters
Oil Producers
25%
20%
15%
10%
1985
1988
1991
1994
1997
2000
2003
2006
5%
Quatar
Libya
Iraq
Algeria
Venezuela
UAE
norway
Nigeria
Kuwait
Mexico
iran
russia
saudi
0%
What Price?
• The crude oil price cycle may extend over
several years responding to changes in
demand as well as OPEC and non-OPEC
supply (OPEC: Iran, Iraq, Kuwait, Saudi Arabia, Venezuela,
Qatar, Indonesia, Libya, United Arab Emirates, Algeria and
Nigeria).
• Wide price swings in times of shortage or
oversupply.
What Makes Oil Prices Swing?
Economic and Financial Forces
(Consumption/ Demand)
–
–
–
–
–
Growth in Real GDP
Inflation
Strength of the Dollar
Reserves/Inventories
Crises and price controls
Political Forces
(Production/Supply)
–
–
–
–
–
Wars
Conflicts
Regulations
Quotas, Embargos
Price controls
Market forces Vs. Price Controls: OPEC
OPEC has failed to time
its increase/cuts in
production quotas with
world economic events.
Various members of
OPEC produce beyond their
quotas.
Non-OPEC members are
producing at least as much
as OPEC members.
What about Oil Reserves? Oil wells, Natural
gas wells or dry holes.
• Oil Reserves: Don’t know! A
well guarded secret…
• Lead-lag Test: oil prices
weakly lead production
efficiency…
•In fact, technological and
financial forces also affect
production efficiency .
 On the finance side: price risk
is accounted for in the
“decision to drill.”
 Technological improvements
have been tremendous– 3-D
seismic data, directional and
horizontal drilling; CO2
floods
Are Oil Prices too High?
•On an inflation-adjusted basis—not really.
•What happened since 2003?
 Increasing demand in the US, China and
India, coupled with lower US and OECD
countries oil inventories. The world
consumes over 100 million barrels a day
 Storage and refining capabilities in the US
affected by hurricane season.
 Iraq war and Middle East tensions
 loss of production capacity in OPEC
(Venezuela and Iraq): In 2003 the excess
production capacity was below 2 M, as
compared to 6 M in 2002; in 2004 and
2005 under 1M barrels per day.
Note that if oil is too expensive, economic
growth stiffens and demand for oil decreases.
In addition, R&D efforts support energy
saving and replacement programs.
80
70
Futures Oil Prices
Inflation Adjusted Futures Prices
60
50
40
30
20
10
0
Nov-84
Aug-87
May-90
Jan-93
Oct-95
Jul-98
Apr-01
Jan-04
Oct-06
2 Markets and 2 Quotes for Oil?
• Spot Prices
– Current price Per Barrels
– Reflects the current settlement in cash for oil barrels
• Futures Prices
– Commitment to Buy/sell at a price in the future (1
month, 2 months…from today)
– NYMEX (“light sweet crude oil”)
– 1 contract is for 1,000 barrels
– Margin deposit only and margin maintenance requires
– Huge leverage (>90%)
Who Leads Who: Spot or Futures
Prices?
VAR/Generalized Impulse response
Standard Response to One Standard Shock
34
Response of Futures Prices to 1 std shock in Spot prices
Response of Spot prices to one std shock in Futures prices
32
Response of Spot prices to oone std shock in Spot prices
Cummulated Standard Response
Response of Futures price to one std shock in Futures price
30
28
26
24
22
20
0
10
20
30
40
50
Forecast period (Days)
60
70
80
90
100
Pricing Oil -- Spot and Futures
•The price or “intrinsic
value” of an asset is the
present value of its cash flow
•For a commodity—not that
easy to figure out.
•Traditional factor models do
not work--CAPM
•Well, at least the market
value reflects all forces on
the demand and supply sides.
•Why is there a spread?
80
70
60
50
40
30
20
10
0
-10
86 88 90 92 94 96 98 00 02 04 06
FOIL
SPOT
FOIL-SPOT
Spot-Futures parity
E [S T  T  t ]  S t e
R (T  t )
if the futures price FT - t is an unbiased
of the expected
FT  t  S t e
spot price ( E [ S T  T  t ]), then
R (T  t )
Thus , the following
estimate
relationsh ip must exist :
 Ft  B t  S t ,
Where B t is a time factor depending on R...
What Does R mean?
• R depends on Inflation, disruption of supply,
disruption of consumption, cost of transportation,
extraction, storage, storage insurance, etc…
• It compensates for the forces/costs associated with
owning/selling the commodity.
• It is an opportunity cost adapted to changes in
supply and demand for the commodity
• Thus, it is time varying depending on changes in
financial, economic and political risk of oil
exporters and consumers
Building a Fundamental
Models to Price Oil
 Ft      S t  Z t 1  S t   t
Where  =0,  is the roll-over yield,
Zt-1 are lagged conditioning financial, economic
and political variables affecting exporter and
consumers of oil.
t is random noise
Applying the model




Monthly data (1985-2006)
Detrended (to get rid of the seasonal demand for the commodity)
Spot price
Conditioning variables: 44 oil exporters/importers weighted-average
economic, financial and political risk ratings reduced with a factor
analysis.
In-the-sample characteristics:
• R-squared
• Roll-over yield
• Exporter impact on oil prices
• Importers impact on oil prices
• Unconditioned effects
• Unforeseeable events
0.61
0.81
18 %
11 %
32 %
39 %
Out-of-the sample forecast—2007: $71 +/- $3
Distribution of Unpredictable
Movements
Normality is rejected at the 99% level
Theoretical Quantile-Quantile
Kernel Density (Normal, h = 0.3850)
4
.30
3
.25
Normal Quantile
2
.20
.15
.10
1
0
-1
-2
.05
-3
.00
-4
-4
-2
0
2
4
Orthogonalized d(futures prices)
6
-6
-4
-2
0
2
4
6
Orthogonalized d(futures prices)
8
“Predictable” Unpredictable Price
Movements?
3 clues, 1 conclusion…
• Strong (significant) autocorrelation (two lags) in
residuals and squared residuals unexpected event
occurrences are somewhat predictable.
• A regime-switching model also shows that oil futures
are prone to periodically bursting bubbles.
• A GARCH analysis shows that the size of an
unexpected event is more important than its direction;
this can only happen when bubbles form and burst.
In sum, prices are determined by periodic herding
behaviors unwarranted by fundamentals…
Distribution of Unpredictable Movements
Hedge funds behavior
Traders behavior (closing positions)
“Technicals” self-fulfilling behaviors
Herding behavior
End-of-the quarter behavior
End of the month behavior
End-of-the week behavior
Time of the day behavior
Contract maturity behavior
Option maturity behavior
Theoretical Quantile-Quantile
4
3
2
Normal Quantile
On the left side (price decrease): fat
tails, narrower mid-sections.
On the right side (price increase):
larger mid-section, thin tail.
More month of price increase than
price decrease (autocorrelation, RS, and
GARCH tests)
1
0
-1
-2
-3
-4
-6
-4
-2
0
2
4
6
Orthogonalized d(futures prices)
8
Oil Prices and Trading Behaviors
$80
7,000,000
$8
Futures Prices and Trading Volume
$70
6,000,000
7,000,000
Futures-Spot Spread Futures-Spot Spread and Trading Volume
TRADING_VOLUME
$6
6,000,000
5,000,000
$4
5,000,000
4,000,000
$2
4,000,000
3,000,000
$0
3,000,000
2,000,000
-$2
2,000,000
1,000,000
-$4
1,000,000
0
-$6
0
FOIL
TRADING_VOLUME
$60
$50
$40
$30
02
06
20
05
M
10
20
03
M
02
20
01
M
06
20
00
M
10
19
98
M
02
19
96
M
06
19
95
M
10
19
93
M
02
19
91
M
06
19
90
M
10
19
88
M
19
86
M
M0
6
M1
0
M0
2
M0
6
M1
0
M0
2
M0
6
M1
0
M0
2
M0
6
M1
0
M0
2
200
5
200
3
200
1
200
0
199
8
199
6
199
5
199
3
199
1
199
0
198
8
198
6
198
5
M0
2
$0
19
85
M
$10
02
$20
Of Utmost Importance: Volume!
Volume: a proxy for information flow and a predictor of
unforeseeable market events?
Tests (EGARCH): we use detrended Volume, then we brake it
down into expected and unexpected volume…
 Lagged Volume predicts volatility, not the opposite
 Unexpected volume moves prices
 Expected volume also moves prices, but reduces
volatility asymmetric access to information there is a
cluster of better informed traders!!!
Concluding remarks
• Oil prices are moved by political, economic and financial
factors affecting demanders and suppliers of oil…not so
much changes in oil reserves and production efficiency.
• A “conditioned” pricing model explains 61% of futures
price movements—My Prediction $71 a barrel.
• A sizable portion of price movements is attributable to
traders’ behaviors
• Volume traded is a strong determinant of oil price volatility
• Oil trading strategy should focus on volatility changes
rather than price changes…
• Futures options strategy are more adapted to provide
investors with a “winning” solution.