Source: EIA AEO2012
Source: EIA AEO2012
In the AEO2012 Reference case, the increased cost of non-OPEC supplies, a constant OPEC market share, and easing of Cushing WTI infrastructure constraints combine to support average increases in real oil prices of about 5% per year from 2010 to 2020 and about 1% per year from 2020 to 2035. In 2035, the average real price of crude oil in the Reference case is $145 per barrel in 2010 dollars.
The Low Oil Price case assumes that oil prices fall steadily after 2011 to about $58 per barrel (2010 dollars) in 2017, then rise slowly to $62 per barrel in 2035.
In the High Oil Price case, oil prices ramp up quickly to $186 per barrel (2010 dollars) in 2017 and continue rising slowly thereafter, to about $200 per barrel in 2035.
The economic conditions behind these price scenarios are described in the AEO2012 report.
Source: EIA AEO2012
We here at the EFO have always been sympathetic (dare we say: enthusiastic) about a release of the SPR in the face of rising oil prices. Today, the Obama Administration did just that.
What has been the result? As of 10 a.m. this morning, WTI and Dated Brent spot prices are down about 5%.
Not a bad result at all. So why is this a good thing? There are more than 700 million barrels in various salt domes along the Gulf Coast. This oil was mostly purchased at very low prices; so selling it into the market now makes some clear economic sense (buy low, sell high!)
The real question is national security. What should we use the SPR for? There is a widespread belief that the SPR should be kept for big-time supply interruptions. Libya certainly counts, but what about the larger question of using the SPR to regulate oil price spikes?
The machinery of the world oil market is famously opaque. No one can even agree on the role of speculators, much less model the behavior of oil-exporting nations. Given the low elasticities of supply and demand for oil, plus the lack of transparency on both oil consumption (see China) and oil production, the oil market is a mess.
But a price for oil well above $100 is not sustainable and does not seem to be driven by a supply and demand dynamic. That’s why we’re sympathetic to the SPR release done today, and also why we look forward to seeing the market response.
Not everyone is happy about this, and the decision is likely to be somewhat controversial.
Stay tuned for more writing on the subject of the SPR.
The third modeling question, after demand and supply, that we wondered about is the oil price projection. How do the EIA (Energy Information Administration), the IEA (International Energy Agency) and OPEC (the Organization of the Petroleum Exporting Countries) figure out a particular price? Do they take expected supply and expected demand and then figure out a price which would put them in equilibrium? Seems like it is more projecting demand (although some of that depends on price) and figuring out how much it would cost to produce that much supply. Here is how they describe it.
EIA: the International Energy Module (IEM) uses assumptions of economic growth and expectations of future U.S. and world petroleum liquids production and consumption, by year, to compute world oil prices. World oil prices are determined by four broad factors: non-OPEC conventional liquids supply, OPEC investment and production decisions, unconventional liquids supply, and world liquids demand. Satisfying the growing world demand for liquids in the next decade will require accessing higher cost supplies, particularly from non-OPEC producers. In the Reference case, the higher cost of non-OPEC supply supports average annual increases in real world oil prices of approximately 0.7 percent from 2008 to 2020 and 1.4 percent from 2020 to 2035. Oil prices, in real terms, rebound following the global recession, to $95 per barrel in 2015 and $133 per barrel in 2035 (real 2008 dollars). Although increases in OPEC production will meet a portion of the growing world demand, the Reference case assumes that OPEC’s limits on production growth will maintain its share of total world liquids supply at approximately 40 percent, where it has roughly been over the past 15 years. Growth in non-OPEC production will come primarily from high-cost conventional projects in regions with unstable fiscal or political regimes and from relatively expensive unconventional liquids projects. The return to higher price levels in the Reference case results from limited access to prospective areas for foreign investors, less attractive fiscal terms, and higher exploration and production costs than have been seen in the past.
IEA: International fossil fuel prices are an input to the model. The IEA’s description of its world energy model does not describe how the price projections are made. The WEO2010 Factsheet includes the following observations about price: The oil price needed to balance oil markets is set to rise, reflecting the growing insensitivity of both demand and supply to price. The growing concentration of oil use in transport and a shift of demand towards markets where subsidies are most prevalent are limiting the scope for higher prices to choke off demand and discouraging fuel switching. At the same time constraints on investment mean that higher prices lead to only modest increases in production.
OPEC: The prices in the OPEC WOO are not so much projections as assumptions of possible price scenarios. Prices must be sufficiently high to provide an incentive for the incremental barrel to be developed and supplied. Equally, sustainable oil prices cannot be so high as to impair global economic growth. The Reference Case assumes a nominal price that remains in the range $75–85 per barrel over the years to 2020, reaching $106 per barrel by 2030. It is important to stress that this does not reflect or imply any projection of whether such prices are likely or desirable; it is assumed that the price path will be driven by a return to fundamentals-driven market behaviour, as well as a gradual move towards healthier economic conditions.
For more detail on any of these, see the EIA’s “Models Used to Generate the IEO2010 Projections”, the IEA’s “World Energy Model – Methodology and Assumptions” or “OPEC’s World Oil Outlook”.
- Mary Haddican, National Energy Policy Institute
As part of our ever-expanding series on the possibility of speculation in oil, we’ve decided to add a number of items to our to-do list.
The contracts in oil are difficult to fathom for most people; the various trading possibilities in Brent oil, which is a benchmark for 70% of world oil, can be particularly opaque. But there are lots of questions too about how exactly the spot oil price is determined, and if “spot price” really means anything.
To that end, we’ll be offering up a number of “Energy Explainers” over the next few weeks. Here’s a partial list of what we’ll be examining:
- What is the 21 day Brent contract? And why is it called “21 day”?
- What is the Brent contract for differences?
- What is the Brent “exchange for physicals” market?
- What is the Dubai-Oman benchmark?
- How are oil imports to the US priced? That is, how does Saudi Arabia decide to charge a US importer a particular amount?
- What is the role of price reporting agencies like Platt’s and Argus?
- What is the liquidity in the various spot and forward/futures markets?
This is just a start though, and we’ll be adding to it, that’s for sure.
As gasoline prices climb ever higher, the issue of oil speculation rears itself again. There have been several bloggers who have unequivocally suggested that rising prices are a result of speculation. But now, surprisingly, Goldman Sachs has weighed in on the issue. That organization should know a thing or two about speculation. Its conclusion? Speculation is for real. (Hat tip: Climate Progress.) Indeed, Goldman Sachs is saying that every million barrels of oil held by speculators contributes to an 8 to 10 cent per barrel rise in the oil price.
As we’ve discussed here on this blog before, the definition of speculator is a little tricky. But Reuters reported that, according to its own calculations (using the Goldman Sachs premium estimates), the speculative premium in US crude oil is between $21.40 and $26.75. That’s big! Goldman disputes this calculation, though, according to Reuters:
Goldman Sachs disputed the Reuters calculation on speculative premium. The bank clarified that the 8- to 10-cent estimate it provided is only meant to reflect the impact of incremental barrels added — or sold — by speculators in relation to defined events over a given time period. It was not meant to be applied to the total number of speculative positions held as these tend to vary across various CFTC measures of net speculative positions.
We’ll try to track down the Goldman Sachs research report and report more on it here as part of our continuing series. We’ve been reading a lot on this issue and the backlog accumulates!
Also, note that we’re finding more and more material to add to our reading list, so we’ll be publishing updates regularly!
Of course the oil price spike of 2008 was a worldwide phenomenon and has attracted interest from scholars across the globe. In 2009, two Italian academics, Giulio Cifarelli and Giovanna Paladino (C & P hereinafter) looked at oil prices in an article called “Oil price dynamics and speculation: A multivariate approach,” published in Energy Policy. Unlike the earlier articles that we’ve looked at here on EFO, C & P believe speculation has played a significant role in commodities markets.
C & P make a few interesting points that help frame their otherwise rather technical analysis. Notably:
- Investment funds poured lots of money into the commodity markets and raised their holdings to $260 billion in 2008, up from $13 billions in 2003.
- For decades, commercial operators only were allowed to buy nearly unlimited amounts of oil. In 1991, however, the Commodity Futures Trading Commission (CFTC) allowed financial firms to enter the market.
- In July 2008, a CFTC report concluded that speculators were not systematically driving oil prices. A few days later, however, data revision showed that just four swap dealers held 49% of all the NYMEX oil contracts that bet on oil price increases, providing clear evidence of concentration of power in the market.
- The growing presence of financial operators in the oil markets has led to the diffusion of trading techniques based on extrapolative expectations, where a price trend is assumed to be lasting. Strategies of this kind tend to foster feedback trading: “positive” whenever investors buy when prices rise and sell when they fall, and “negative” if investors buy when prices fall and sell if they rise.
- The value of the dollar influences oil (and other commodities) in two ways. First, higher oil prices lead to higher trade deficits in the United States, which tends to depreciate the dollar. This requires oil exporters to raise the price of dollar-denominated oil in order to maintain its real value to themselves. Second, commodities offer some unique diversification opportunities for traders; traders that are bearish on the dollar will sell dollar-denominated stocks and buy commodities (as oil will likely rise when the dollar falls, for the reason noted in #1). (EFO: Third, but not mentioned by C & P is the feedback effect here: fear of depreciation means a selling of dollar-denominated stock assets, which leads to a further weakening of the dollar. Fourth, and in another form of transmission not part of C & P, is the fact that, as the dollar declines in value, the cost of oil to non-dollar countries declines, which increases oil demand and sends its price upward. Fifth, a decline in revenues to oil-producing countries, which would result from a depreciating dollar (but a stable nominal oil price in dollars) results in less capital available for oil infrastructure, and will over time lead to decreased oil supply.)
C & P investigate the weekly changes of the WTI oil price, the Dow Jones stock index, and the dollar exchange rate. The DJI and dollar exchange rate affect the “opportunity set” for investors. In other words, as the DJI or dollar moves, oil as an asset changes its attractiveness.
C & P use a variant of Merton’s Capital Asset Pricing Model (CAPM) and posit two types of traders, “smart money investors” and “feedback traders.” For the first type, the amount of oil desired in a portfolio is determined by wealth, the return on oil, and the volatility of oil prices. The volatility is important in the CAPM as it increases the risk premium demanded by investors in oil. “Feedback traders,” on the other hand, are driven by price changes in oil; positive feedback traders buy more oil when the price is rising, while negative feedback traders sell oil when the price rises.
The results of this fancy econometric approach? A few things stand out. First, C & P find that futures oil markets are leading with respect to oil price changes, while the spot price never leads the futures price. Second, they find that traders use oil to hedge their portfolios; oil prices increase as the US stock market declines. This is consistent with the notion that oil prices should increase as the appeal of other investments falls. Third, they find that feedback trading does impact oil markets. The best evidence of this, according to C & P, is the big changes often seen in the daily oil market, which is behavior inconsistent with fundamentals. The speculative price increases can persist for a very long time before being driven down by oil market fundamentals. In a very brief summary, C & P say that we should as a result welcome “policy actions aimed at restricting speculators’ activity.”
In sum, C & P conclude that speculators played a role in the 2008 price spike. Their paper is technical enough to rebuff a lay reader and they don’t put much flesh on their skeletal conclusions. Nevertheless, this is the first paper we’ve looked at so far that unambiguously supported a role for speculators in price formation. Unfortunately, there is little discussion about what constitutes “fundamentals” in the oil market and no attempt to explain more deeply the policy insights to be drawn from their econometrics.
We’re continuing with our series on speculation. But the last couple of days has brought in two additions to our ever-expanding reading list.
The new Energy Journal has an article by Bahattin Bukuksahin and Jeffrey H. Harris entitled “Do Speculators Drive Crude Oil Futures Prices?“ (sorry: for access you need to be a member of the International Association for Energy Economics). You can’t get more on point that that, and we’ll discuss the article in full later in this series. But to preview their findings: they say there is no evidence that speculators played a role in the price of oil during the 2008 run-up.
Also added to the list is a new book, The Asylum: The Renegades Who Hijacked the World’s Oil Market by Leah McGrath Goodman. Ms. Goodman was on C-SPAN over the weekend discussing the book, and, while we at EFO have yet to read the book (just wait!), it would appear that she does think that the speculators play a key role in oil price movements.
Both books have been added to our master reading list.
Robert Kaufmann, a professor at Boston University and director of the Center for Energy and Environmental Studies at the school, is one of the most expert and prolific analysts of the world oil market. He will be at NEPI on March 22-23, 2011, as part of the conference, OPEC at 50: Its Past, Present, and Future in a Carbon-Constrained World. Today, we’d like to look at one of his many contributions to the literature about price discovery in the oil market: a paper, published in Energy Economics and co-authored with his BU colleague, Ben Ullman. The paper is entitled “Oil prices, speculation, and fundamentals: interpreting causal relations among spot and futures prices.” Its conclusion? Both fundamentals and speculation have had a role in oil price formation over the last few years.
Kaufmann and Ullman begin by noting the debate over whether the world oil market is regionalized or unified. The latter view — that the world oil market is unified — seems to have prevailed among commentators. But Kaufmann and Ullman ask a slightly different question. If the world oil market is unified, how do price innovations enter the market? They suggest two alternative hypotheses. First, prices could change simultaneously in all markets when new information about supply/demand balance becomes available. Second, and alternatively, changes may first appear in the price of one or more crude oils (there are more than 150 different types of crude oils) and then spread to other types of crude oil. To investigate the issue of price innovation in the oil market, Kaufmann and Ullman examine, using econometric analysis, the causal relationship between and among five types of oil: West Texas Intermediate (39.6°), Brent–Blend (38.3°), Maya (22°), Bonny Light (37°), and Dubai–Fateh (32°). Numbers in parentheses are the API gravity index value for each type of crude oil. Futures price data was compiled from Bloomberg, with maturities of the futures contract ranging from 1 month (the “near-month contract”) to 5 months (the “far-month” contract for Kaufmann and Ullman).
What did they find? The crude oils could be divided into three classes. The first of these were crude oils whose price caused changed in other crude oil prices, but which were themselves unaffected by other crude oil’s price changes. This class is considered by Kaufmann and Ullman to be a “gateway” through which price innovations enter the oil market. The far-month contract for WTI and the spot price of Dubai-Fateh fall into this group, with the latter being especially powerful.
The second class included crude oils that both caused, and were affected by, changes in the price of the other crude oils. The spot price of Nigerian Bonny Light and the near-month contract for Brent Blend are in this group.
The third class was comprised of crude oils that did not cause price changes in other crude oils, but were affected by changes in the price of the other types of crude oil. The spot price of WTI and Maya are part of this group. Kaufmann and Ullman characterize these types of crude as “dead ends” — they receive innovations from other crude oil but do no affect the price of other types of crude oil (or at least of those examined in the paper). They explain:
Maya spot is illiquid (it is not traded on any futures market) and this would tend to weaken its ability to influence the price of other crude oils. WTI is considered a ‘broken’ benchmark by many, in part because of declining output and bottlenecks in transportation networks that reduce arbitrage opportunities relative to other crude oils. For example, the pipeline that transports WTI can only move the crude north towards Cushing, OK—WTI cannot be moved south towards the Gulf of Mexico; therefore it cannot be exported outside the US.
We here at EFO discussed the problems of Cushing bottlenecks in an earlier post.
Kaufmann and Ullman argue that the source of price innovation can speak to the question of whether market fundamentals or speculation drove the oil price spike of 2008. If speculation played a key role, price innovation should have entered the oil market through the various contracts traded on the futures market, which would then have driven the spot price. If market fundamentals were key, the spot price should have driven the futures price, as speculators play a fairly insignificant role in the spot market (according to Kaufmann and Ullman).
As I noted above, Kaufmann and Ullman find the spot price of Dubai-Fateh to have had the greatest role in transmitting price to other types of crude oil. This suggests, for them, that market fundamentals drive price changes in world oil, including the 2008 highs. As they write:
That the spot price for Dubai–Fateh is a ‘gateway’ for innovations to crude oil prices is consistent with arguments for the importance of demand growth in developing nations, especially the Asian nations of China and India. Most of Middle East oil is represented by this benchmark, both as oil reserves or exports. A large fraction of the crude oil shipped to Asian nations from the Middle East (more than 10 mbd) uses the spot price for Dubai–Fateh as a benchmark. As such, innovations in the spot price for Dubai–Fateh may reflect increasing demand in Asia. The role of the spot price for Dubai–Fateh also is consistent with arguments about changes on the supply side. According to the supply side hypothesis, the recent price rise is caused in part by a shift in the source of crude oil from non-OPEC to OPEC nations. Production of crude oil by non-OPEC nations grew from 34.2 mbd in 1993 to 41.01 mbd in 2004—3 years later (2007) it was 41.09 mbd. This stagnation, along with demand growth forced OPEC to increase production, which allowed OPEC to regain control over the marginal supply of oil. In this role, OPEC can influence oil prices by managing production quotas and/or capacity utilization. Consistent with this hypothesis, changes in OPEC capacity utilization or quotas may enter the market as innovations to spot prices for crude oils that are produced by the OPEC nation (the United Arab Emirates) which is the source for Dubai–Fateh. Moreover, this oil lies in an area that witnessed two important wars, lengthy embargos, and chronic potential conflict, which make its price very sensitive to shocks.
So, looking at the role of Dubai-Fateh, which is admittedly the most powerful transmitter of price innovation in the Kaufmann-Ullman modeling, it appears that fundamentals matter most.
But remember: the far-month WTI contract was also shown to be a major source of price innovation. This suggests a role for the futures market in setting oil prices, too. How does this happen? Well, while doing grievous damage to the complexity of the analysis, it is nevertheless possible to summarize Kaufmann’s and Ullman’s argument. First, they observe that, in most cases, innovations in price that come through the futures market are “asymmetric,” meaning that they transmit price increases (usually) but not decreases. Second, increases in futures markets prices are only partially transmitted to the spot market. This means that the futures market can diverge significantly from the spot market, leading to a rise in price in markets used as financial instruments (the futures market) relative to markets where purchasers generally take physical possession (the spot market).
We’ve now covered three articles. The first two — both by Hillary Till — utilized Working’s speculative T index, and found little evidence of “excessive speculation.” Kaufmann and Ullman don’t invoke Working, choosing instead an econometric approach. They do find, like Till, that market fundamentals play a key role. But they also leave open the possibility — indeed suggest it is quite real — that speculation plays a role in oil price setting. Speculation ultimately affects the spot market, but sometimes imperfectly, leading to anomalous divergences between the futures and spot prices. As the futures price can adjust rapidly — due to its role as a financial market — changes in expectations about supply and demand can quickly take root there. These expectations will alter the spot price, at least over time.
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- U.S. energy-related carbon dioxide emissions in recent AEO Reference cases
- U.S. Shale gas production
- Diagram of a typical Hydraulic Fracturing Operation
- Projections of U.S. natural gas production
- Shale plays in lower 48 states
- Hydraulic fracturing
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