Title: What is the Price of Oil?
1What is the Price of Oil?
- By
- Dr. Eric Girard
- Professor of Finance
- Hickey Chair in Business
- Director of the Center for Global Financial
Studies
2Crude 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...
3Oil Consumers
4Oil Exporters
5What 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.
6What 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
7Market 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.
8What 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
9Are 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.
102 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)
11Who Leads Who Spot or Futures Prices?
- VAR/Generalized Impulse response
12Pricing 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?
13Spot-Futures parity
14What 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
15Building 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
16Applying 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
17Distribution of Unpredictable MovementsNormality
is rejected at the 99 level
18Predictable 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
19Distribution 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
20Oil Prices and Trading Behaviors
21Of 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!!!
22Concluding 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.