Transcript Petroleum Marketers in a Vise

Oil Prices: The Short Run, the Long
Run, and the Role of Policy
NABE Annual Meeting
Denver, Colorado
October 11, 2010
Philip K. Verleger, Jr.
Haskayne School of Business, University of Calgary,
and PKVerleger LLC
Outline
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Short-run Oil Prices: Set in Europe
Long-run Oil Prices: Shale gas may be a game
changer
Energy Policy: Nothing but a potpourri of
gimmicks
Short-run Oil Prices


Europe has emerged as the marginal market and, to
quote Marshall, we go to the margin of the market to
discover prices.
The marginal product in Europe is diesel fuel (or gasoil).

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Demand is surging due to dieselization.
European refiners are not capable of making product.
Europe has become heavily dependent on diesel exports
from the U.S.
In 2008, Europe’s thirst for low-sulfur diesel caused oil
prices to rise to $145 per barrel.
In 2010/2011, “benign neglect” of dollar could send oil
over $100.
Short-run Oil Prices:
Oil Prices Have Been In A “Rut”

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Oil prices have been in a rut for several years.
The price spike in 2008 as an anomaly.
Much of the stability is due to higher inventories
and lower volatility in consumption.

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
Passive investors have promoted inventory
accumulation.
Substitution of natural gas and coal has captured
seasonal markets.
A weak dollar could change the situation.
Dated Brent Spot Price and
Normal Range, 2005-2010
160
Dollars per Barrel
140
120
100
80
Normal Range
60
40
20
Note: Normal range excludes 2007/2008 and the financial collapse that followed.
Source: Platts; PKVerleger LLC.
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
0
U.S. Distillate Product Supplied,
Monthly Data, 1960-2010
Million Barrels per Day
6
5
4
3
2
1
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: U.S. Department of Energy.
Range in U.S. Distillate Consumption, 1960-2009 – High,
Low, and Average of Product Supplied by Year
Million Barrels per Day
6
5
4
3
2
High/Low
1
Avg.
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Source: PKVerleger LLC.
Percent of Long Open Interest Attributable to Passive
Investors in Certain Commodities, End-July 2010
60
Percent
50
40
30
20
10
Source: CFTC index investment data.
WTI
Natural
Heating
Gasoline
Wheat
Wheat
Sugar
Soybeans
Soybean
Silver
Live
Lean
Gold
Feeder
Cotton
Corn
Copper
Coffee
Cocoa
0
Usable Commercial Stocks in OECD
Countries – History and Normal Range
Days of Supply
30
25
Normal Range
20
15
10
5
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
0
Source: EIG; PKVerleger LLC.
Short-run Oil Prices:
High Stocks Moderated Price Volatility
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Record cold occurred in January 2010 in both
the US, Europe and Asia.
There was no price spike, unlike prior episodes.
The absence of price “spikes” is explained by
very high inventories.
The very high level of inventories was linked to
passive investors.
PADD I Heating Oil Stocks, Weekly Data –
1989, 1999, 2009, and Normal Range
Normal Range
Note: Normal range computed from DOE data for years 1990 to 2009.
Source: PKVerleger LLC.
Open Interest in Distillate Futures vs.
Distillate Inventories, 2000-2010
Source: DOE; NYMEX.
Open Interest in Distillate Futures vs.
Distillate Inventories, 2000-2010
2008-2010
Observations
Source: PKVerleger LLC.
Distillate Forward Price Curve – End-December 1989,
Second Week of January 2000, and End-December 2009
Source: PKVerleger LLC.
Short-run Oil Prices:
Currency, Not “Fundamentals” The Risk

Today, oil price fluctuations are not caused by
fundamentals.
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Inventories are high.
Refinery capacity is in excess.
Consumption is stable.
The marginal market has moved from the US to
Europe. This will leave the price of oil in dollars
subject to fluctuations in the euro.
Short-run Oil Prices:
Europe Needs Diesel Imports
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European energy policy has emphasized dieselization.
European environmental policy emphasized ultra-lowsulfur diesel fuel.
European refineries are built to make gasoline, not
diesel.
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Diesel production can be boosted by using very light sweet
crude.
However, European refiners cannot meet local demand.
Trade has solved the problem. The U.S. exports diesel
to Europe. This makes the euro price of diesel the key
determinant of crude prices.
U.S. Exports of Distillate Fuel Oil
to the Netherlands, 2005-2010
Thousand Barrels per Day
250
200
150
100
50
0
2005
2006
Source: U.S. Department of Energy.
2007
2008
2009
2010
Short-run Oil Prices: Europe’s
Diesel Thirst Caused ’08 Oil Spike
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The 2008 crude price increase was caused by Europe’s
shift to ultra-low-sulfur diesel.
EU environmental authorities ordered conversion by
January 2009. However, the global refining industry was
short of capacity.
Refiners bid up prices of sweet crudes with high distillate
yields. Troubles in Nigeria added to the market squeeze.
Empirical proof of causality rests on the fact that cargos
of heavy sour crudes could not be sold in the spring of
2008 at any price and the rise of retail prices relative to
crude prices in Europe.
Short-run Oil Prices:
Exhaustion of Desulfurization

Exhaustion of desulfurization capacity in 2008 at
refineries left the world with four, not three,
hydrocarbons.
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
Natural gas
Coal
Sour crude
Sweet crude
Sour crude could not be used to produce diesel
fuel meeting European requirements.
Sweet crude oil makes up less than
25 percent of world supply.
Million Barrels
per Day
Cumulative World Oil Production
Sorted by Sulfur Content
70
60
50
40
30
20
10
0
0
1
2
3
Sulfur Content (%)
Source: PKVerleger LLC.
4
5
6
Nigeria accounts for a large share of
the world’s sweet crude supply.

In good times, when production is not disrupted,
Nigeria dominates the sweet crude market,
producing
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
20% of crude with 0.1% sulfur or less
25% of crude with 0.2% sulfur or less
19% of crude with 0.5% sulfur or less
Sweet crude is valuable because it has a
very high yield of low-sulfur diesel fuel.
Product Distillation Yields from a Standard Complex Refinery
Crude Sulfur Content (%)
Volume of Gasoline (%)
Volume of Diesel (%)
Source: EIG.
Arab Heavy
(Saudi Arabia)
Bonny Light
(Nigeria)
2.94
17.4
18.5
0.14
27.2
44.8
Much less sulfur must be removed
to produce diesel from Nigerian crude.
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
3.5 kilograms of sulfur must be removed to make
one metric ton of low-sulfur diesel from Nigerian
crude.
180 kilograms of sulfur must be removed to
make one metric ton of low-sulfur diesel from
Arab Heavy crude.
Refiner capacity to remove sulfur from crude
was limited.
Short-run Crude Outlook:
Retail Prices in 2008 Provide Key Evidence

Some economists (Hamilton, for example) claim the
price increase was caused by a global crude shortage.
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Their assertion implies that all product prices should have
increased in parallel.
The evidence refutes this.
In Europe, retail diesel prices rose from 75 percent of
gasoline to 110 percent of gasoline, suggesting it was
diesel, not crude, that was in short supply.
Prices of light sweet crude followed gasoil (diesel)
prices.
Evidence for the squeeze is found in the
rise of diesel price relative to gasoline.
Euros per Liter
1.60
Monthly Diesel and Unleaded Gasoline
Retail Prices in Germany, 2006-2009
1.40
Gasoline
1.20
1.00
Diesel
0.80
Jan-06
Jul-06
Source: PKVerleger LLC.
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
In Germany, diesel prices rose to parity
with gasoline at retail during the squeeze.
1.10
1.05
1.00
Ratio
0.95
0.90
0.85
0.80
Ratio of German Retail Diesel Price to
German Retail Gasoline Price, 2006-2009
0.75
0.70
Jan-06
Jul-06
Source: PKVerleger LLC.
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Short-run Crude Outlook: Civil War in
Nigeria Contributed to Squeeze
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Nigeria dominates world sweet crude market.
Nigerian production collapsed in 2008 due to
civil war.
The United States made matters worse by taking
sweet crude from the market and putting it in the
Strategic Petroleum Reserve.
Nigerian crude production has
been disrupted by civil war.
Million Barrels per Day
2.8
2.6
2.4
2.2
2.0
1.8
1.6
Nigerian Monthly Crude Output, 1999-2009
1.4
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: PKVerleger LLC.
Short-run Crude Outlook: European
Gasoil Demand Again Driving Crude

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European gasoil consumption has increased
with economic recovery.
Once again, buyers must turn to other markets.
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Product spot prices in Europe trade at a premium to
U.S. prices.
So far, European prices are stable when measured in
euros.
European prices are at a premium to U.S.
Oil prices measured in dollars have moved up
as dollar has weakened.
Premium/Discount
(Gasoil less Distillate; Cents/Gal)
Premium or Discount between European
Gasoil and U.S. Gulf Coast Distillate, 2009-2010
25
20
15
10
5
0
-5
-10
-15
Jan-09
Apr-09
Source: PKVerleger LLC.
Jul-09
Oct-09
Jan-10
Apr-10
Jul-10
250
1.50
240
1.45
230
1.40
220
1.35
210
1.30
200
1.25
190
1.20
180
1/4/10
2/26/10
4/21/10
ULSD Price
Source: PKVerleger LLC.
6/14/10
8/5/10
Exchange Rate
1.15
9/28/10
Exchange Rate
(Dollars per Euro)
ULSD Price (Cents/Gal)
Dollar/Euro Exchange Rate vs.
U.S. Gulf Coast Ultra Low Sulfur Diesel Price, 2010
Short-run Crude Outlook: Expect Crude
Prices to Move Inversely with Euro
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Crude prices will likely continue to move in the
opposite direction from the euro.
The failure of IMF meetings this weekend
suggests the dollar will decline further.
U.S. policy to let the dollar fall seems aimed at
isolating China just as Iran has been isolated.
Oil prices can be expected to rise as dollar
declines in value. A dollar/euro exchange rate of
1.75 would yield $100-per-barrel crude.
Short-run Crude Outlook: Saudi Arabia
Will Try to Stabilize Markets
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Saudi Arabia has become skillful in managing
the market by applying a De Beers-type
procedure.
Saudi Arabia sets differentials for its crude
relative to traded crudes in each market. Buyers
nominate purchases based on premiums or
discounts.
Other OPEC producers follow Saudi Arabia’s
lead to avoid a price war.
The discounts influence OPEC volumes.
Discount to “B-Wave” for Cargos of Arab Heavy
Delivered to Western Europe, January 2003 to October 2010
0
Dollars per Barrel
-2
-4
-6
-8
-10
-12
-14
-16
2003
2004
Source: PKVerleger LLC.
2005
2006
2007
2008
2009
2010
OPEC Production excluding
Gabon and Ecuador
(Million Barrels per Day)
Price Spread Set by Saudi Arabia for Arab Heavy
Delivered to Europe vs. Adjusted OPEC Output, 2002-2009
32
31
30
29
28
27
26
25
24
23
-16
-14
-12
-10
-8
-6
-4
-2
Price Spread Set by Saudis for Arab Heavy ($/bbl)
Source: PKVerleger LLC.
0
Short-run Crude Outlook: OPEC
Probably Cannot Prevent Price Rise

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Saudi Arabia is taking steps to limit price
increases by raising discounts.
However, the principal market for Middle Eastern
crude is in Asia. Prices now are being set in
Europe.
Long-run Crude Outlook
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Key factors influencing long-run crude prices:
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Global agreement on climate change
World economic growth rates
Expansion of natural gas production from shale
Expansion in global supply
Long-run Crude Outlook:
Shale Gas is a Real Game Changer

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Natural gas production in the U.S. was supposed to end.
New technical discoveries have vastly expanded
reserves.
Increased availability of gas could threaten the position
of oil in many uses.

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On Friday, gas could be purchased for $23.50 per barrel while oil
sold for more than $80 per barrel.
Forward natural gas prices have declined even as forward oil
prices have increased.
The development of “fracking” could match the
development of the PC or the cell phone as a game
changer.
18
16
14
12
10
8
6
4
2
0
Note: Normal range excludes 2007/2008 and period before March 2006.
Source: Platts; PKVerleger LLC.
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Normal Range
Jan-05
Dollars per Million Btu
Natural Gas Daily Spot Price and
Normal Range, 2005-2010
Dollars per Barrel
WTI Forward Price Curve vs. Natural Gas Forward
Price Curve, End-August 2007 vs. End-August 2010
100
90
80
70
60
50
40
30
20
10
0
10
20
30
40
50
Months Forward
WTI 2007
Source: PKVerleger LLC.
WTI 2010
NG 2007
NG 2010
60
U.S. Monthly Natural Gas Production
2.0
Trillion Cubic Feet
1.9
1.8
1.7
1.6
1.5
1.4
1.3
Source: U.S. Department of Energy.
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1.2
Long-run Crude Outlook:
Shale Gas Could Change Economy
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Availability of very low priced natural gas could
improve U.S. competitiveness.
Other countries, particularly China, can be
expected to apply the same technology
aggressively.
History suggests that price differences of 5 to 1
will accelerate change.
Long-run Crude Outlook:
Slow Global Growth Will Affect Prices
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The global slowdown following 2008 will limit
growth in oil use through 2015.
Lower demand combined with increased natural
gas supplies could leave the oil market stuck at
current demand levels.
Stagnation does not, however, necessarily imply
that prices will fall. OPEC is much more
sophisticated.
Long-run Crude Outlook:
Outlaw Production Will Affect Prices
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The current OPEC members, except Iraq, have been
very disciplined since 1999.
Russia and Iraq, however, threaten OPEC’s ability to
maintain price stability, just as De Beers’ control of
diamonds was undermined by outsiders.
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Iraq intends to boost production to 12 million barrels per day from
2.3 million barrels per day, an increase that cannot be
accommodated.
Russia, too, wants to boost production and build sales in Asia. It
has opened a new pipeline and port.
Slow growth, increased supply, and competition from
natural gas could break crude prices.
Long-run Crude Outlook: Global
Warming Limits Could Have an Effect

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
Agreements to limit global energy use in 2050 to
a fraction of 2000 use would depress oil demand
and prices.
Prospects of agreements could, in theory, lead
to lower levels of investment and lower supply.
The absence of agreements, on the other hand,
could lead to supply squeezes of the type
imagined to have occurred in 2008.
Any answers are unlikely before 2020.
Long-run Crude Outlook
Dodd/Frank Could Change Market

Dodd Frank could reduce the size of energy
commodity markets.

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Congress wrongly blamed speculators for the price
spike.
Position limits are required for energy commodities.
Regulators could force passive investors from
markets.
The loss of passive investors would lead to
lower inventory levels resulting in more price
volatility.
Energy Policies:
Almost All Gimmicks

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
For almost 40 years, the politicians and policymakers
have refused to address the energy problem. Gimmicks
have again and again substituted for serious action.
Free trade has been the rule. Energy has been the
exception.
The consequences have been environmental disasters,
bankruptcies of major auto companies, and the loss of
manufacturing jobs.
The future promises to be full of more gimmicks and
more economic losses.