What is the Price of Oil?

1
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

2
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...

3
Oil Consumers
4
Oil Exporters
5
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.

6
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

7
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.

8
What about Oil Reserves? Oil wells, Natural gas
wells or dry holes.

• Oil Reserves Dont 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

9
Are Oil Prices too High?

• On an inflation-adjusted basisnot 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, RD efforts support energy saving and
  replacement programs.

10
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 monthsfrom today)
• NYMEX (light sweet crude oil)
• 1 contract is for 1,000 barrels
• Margin deposit only and margin maintenance
  requires
• Huge leverage (gt90)

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Who Leads Who Spot or Futures Prices?

• VAR/Generalized Impulse response 

12
Pricing Oil -- Spot and Futures

• The price or intrinsic value of an asset is the
  present value of its cash flow
• For a commoditynot 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?

13
Spot-Futures parity
14
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

15
Building a Fundamental Models to Price Oil
Where a 0, b is the roll-over yield, Zt-1 are
lagged conditioning financial, economic and
political variables affecting exporter and
consumers of oil. et is random noise
16
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 0.61
• Roll-over yield 0.81
• Exporter impact on oil prices 18
• Importers impact on oil prices 11
• Unconditioned effects 32
• Unforeseeable events 39
• Out-of-the sample forecast2007 71 /- 3

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Distribution of Unpredictable MovementsNormality
is rejected at the 99 level
18
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

19
Distribution of Unpredictable Movements

• 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)
• 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

20
Oil Prices and Trading Behaviors
21
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!!!

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Concluding remarks

• Oil prices are moved by political, economic and
  financial factors affecting demanders and
  suppliers of oilnot so much changes in oil
  reserves and production efficiency.
• A conditioned pricing model explains 61 of
  futures price movementsMy 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.