the 2007/2008 increase in crude oil prices can be fundamentals
TRANSCRIPT
The 2007/2008 Increase inCrude Oil Prices Can Be
Explained by “Fundamentals”
Philip K. Verleger, Jr.David Mitchell EnCana Professor
Haskayne School of Business, University of Calgary
If there is a shortage of supply capable of being remedied insix months but not at once, then the spot price can rise above theforward price to an extent which is only limited by the unwillingnessof the buyer to pay the higher spot price rather than postponethe date of his purchase.
J.M. Keynes, A Treatise on Money
The world experienced a shortageof light sweet crude in 2007/2008.
• All crude oils are not identical.
• Heavy sour crude oils such as those produced by Saudi Arabia cannot be processed into transportation fuels meeting EU/US standards when capacity to remove sulfur from crude and products is exhausted.
• The shortage was anticipated in late 2005 and the increase in price predicted in The International Economy.
• Evidence of the shortage is found in the rise of diesel fuel relative to gasoline.
• In a bubble, all product prices would have increased at the same rate.
Exhaustion of desulfurization capacity leavesthe world with four, not three hydrocarbons.
• Coal
• Natural Gas
• Sour Crude Oil
• Sweet Crude Oil
Sweet crude oil makes up less than
25 percent of world supply.
0
10
20
30
40
50
60
70
0 1 2 3 4 5 6
Sulfur Content (%)
Mill
ion
Bar
rels
per
Day
Source: PKVerleger LLC.
Cumulative World Oil ProductionSorted by Sulfur Content
Nigeria accounts for a large share ofthe world’s sweet crude supply.
In good times, when production is not disrupted,
Nigeria dominates the sweet crude market, producing
• 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 avery high yield of low‐sulfur diesel fuel.
0.1427.244.8
2.9417.418.5
Crude Sulfur Content (%)Volume of Gasoline (%)Volume of Diesel (%)
Bonny Light(Nigeria)
Arab Heavy (Saudi Arabia)
Product Distillation Yields from a Standard Complex Refinery
Source: EIG.
Much less sulfur must be removedto produce diesel from Nigerian crude
• 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 is limited.
Nigerian crude production hasbeen disrupted by civil war.
1.4
1.6
1.8
2.0
2.2
2.4
2.6
2.8
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Mill
ion
Bar
rels
per
Day
Source: PKVerleger LLC.
Nigerian Monthly Crude Output, 1999-2009
Regulations limiting sulfur content ofdiesel boosted demand for sweet crude.
• US regulations requiring 10 ppm (parts per million) took effect in 2006.
• European rules requiring 10 ppm took effect in 2009 with transition in 2008.
• The European shift created a squeeze on light sweet crude.
Evidence for the squeeze is found in therise of diesel price relative to gasoline.
0.80
1.00
1.20
1.40
1.60
Jan‐06 Jul‐06 Jan‐07 Jul‐07 Jan‐08 Jul‐08 Jan‐09 Jul‐09
Euros pe
r Liter
Source: PKVerleger LLC.
Monthly Diesel and Unleaded GasolineRetail Prices in Germany, 2006-2009
Gasoline
Diesel
In Germany, diesel prices rose to paritywith gasoline at retail during the squeeze.
0.70
0.75
0.80
0.85
0.90
0.95
1.00
1.05
1.10
Jan‐06 Jul‐06 Jan‐07 Jul‐07 Jan‐08 Jul‐08 Jan‐09 Jul‐09
Ratio
Source: PKVerleger LLC.
Ratio of German Retail Diesel Price toGerman Retail Gasoline Price, 2006-2009
The US became an exporter of diesel, furtherconfirming that diesel led the shortage.
The evidence of the sweet crude squeeze is clear.
• If the increase in crude prices was caused by a bubble, not a squeeze, all product prices would have increased in parallel. The German (and all European) data show this did not happen.
• If the increase was caused by a bubble, not a squeeze, trade patterns would not have changed. Instead, the US became a major exporter of diesel. The exports went to Europe.
Monthly Net Distillate Imports/Exportsto/from U.S. January 1990‐October 2008
-800-600-400-200
0200400600800
1000
1990 1993 1996 1999 2002 2005 2008
Impo
rts/
Expo
rts
(Tho
usan
d B
arre
ls p
er D
ay)
Source: U.S. DOE.
Exports
Imports
Saudi Arabia forced high‐sulfur crudeprices to follow those of sweet crude.
Saudi Arabia administers the sour crude market bysetting differentials 30 days in advance of liftings.
• Refiners are advised of the differentials that will apply, just as customers of DeBeers were once advised of diamond prices.
• Refiners nominate amounts to be lifted.• It seems to be an efficient way of running the cartel.• There is a high correlation between OPEC liftings and the
differentials announced one month in advance.• In 2008, Saudi Arabia cut differentials even as crude prices
rose. Sour crude sat unsold on ships.
Discount to Brent Bwave of Arab Heavy Cargoes Delivered to Western Europe, January 2003‐June 2009
-16-14-12-10-8-6-4-20
Jan-
03
Jul-0
3
Jan-
04
Jul-0
4
Jan-
05
Jul-0
5
Jan-
06
Jul-0
6
Jan-
07
Jul-0
7
Jan-
08
Jul-0
8
Jan-
09
Dol
lars
per
Bar
rel
Source: PKVerleger LLC.
Price Spread Set by Saudi Arabia for Arab HeavyDelivered to Europe vs. Adjusted OPEC Output, 2002‐2009
23242526272829303132
-16 -14 -12 -10 -8 -6 -4 -2 0
Price Spread Set by Saudis for Arab Heavy ($/bbl)
OPE
C P
rodu
ctio
n ex
clud
ing
Gab
on a
nd E
cuad
or(M
illio
n B
arre
ls p
er D
ay)
Source: PKVerleger LLC.
RecentObservations
The US government contributed to the squeeze.
The US government started taking sweet crude from the market
in August 2007 for storage in the Strategic Petroleum Reserve.
• The cuts amounted to 50,000 barrels per day.
• The cuts lasted until June 2008 when Congress ordered the DOE to stop filling the SPR.
• The oil price increase began when the filling started and ended when the filling stopped. Perhaps this was coincidental.
Oil buyers recognized that thesqueeze would not last indefinitely.
• By the summer of 2008, several refiners had changed catalysts to cut gasoline production and boost diesel output. (It took many months for this transition.) Other changes in refineries were made as well.
• As a consequence, the forward price of WTI did not reflect the rise in cash prices.– The best indicator of expectations is the BP Prudhoe Bay
Royalty Trust (NYSE symbol BPT) created by John Browne, later CEO of BP, in 1989.
– The instrument is tied directly to WTI prices. Only changes in expectations for WTI prices move share prices.
Spot WTI Price vs. BPT Share Price, 1997‐2009
Source: PKVerleger LLC.
0
20
40
60
80
100
120
140
160
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Dollars per Barrel/Share
WTI BPT
Passive investor buying ofoil futures is countercyclical.
• Empirical data show that investors sell futures when oil prices rise.
• Empirical data show that investors buy futures when oil prices fall.
• These results suggest that investors are a stabilizing force.
Limited data from CFTC show a negativecorrelation between price levels and positions.
340
360
380
400
420
440
460
20 40 60 80 100 120 140 160
Spot Crude Price ($/bbl)
Investor Position
(Tho
usan
d Co
ntracts)
End-Quarter InvestorPositions in WTI Futuresas Reported by CFTC
Proprietary data developed from CFTC data for2006‐2009 also show a negative relationship.
-20-15-10-505
10152025
-30 -20 -10 0 10 20 30
% Change in WTI Price
% C
hang
e in
Ope
n In
tere
st
Source: PKVerleger LLC.
Conclusion: The hard data confirm priceincrease was caused by fundamentals.
• The price increase was predicted in late 2005.
• New EU environmental regulations created a demand for low‐sulfur crude.
• Supplies of low‐sulfur crude were reduced by war in Nigeria and by the US DOE.
• The rise in diesel prices relative to gasoline confirms the nature of the squeeze on crude supply.
• Buyers of crude recognized the situation to be temporary. Long‐term prices did not rise.
• CFTC data show that investor purchases of futures moderated the price increase.
The International Economy, Winter 2006
Proprietary data developed from CFTC data for2006‐2009 also show a negative relationship.
-30
-20
-10
0
10
20
30
-20 -10 0 10 20 30
% Change in Open Interest
% C
hang
e in
WTI
Pric
e
Source: PKVerleger LLC.