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What is the Price of Oil?

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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 ... – PowerPoint PPT presentation

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Title: 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)

11
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

17
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!!!

22
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.
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