Pops goes the Oil Price Bubble!

Tom McKeown

Chris Metzler

Franklin Hamilton

What is behind the Oil Price Bubble?

• How did Oil prices increase to such a high figure at $145 per Barrel of Oil in July of 2008?

• Why Have Oil Prices decreased to such low figures as what they are now?

• 2004-2008 Tells the Story

What happened?

• Stability-Oil prices were between $25-$30 from 1999-2004.

• What are the possibilities?

- A major increase in demand?

- A major supply constraint?

- Geo political disruption?

- Depreciation of the dollar?

Oil Demand• Myth: Major increases in Chinese and Indian

demand have been the engine behind soaring oil prices

• Fact: Chinese Oil demand rose on an annual basis from 2002-2004 (a 5.3% increase). However, from 2005 on- Chinese oil demand has largely fallen, Growing at 2% annually. Indian demand is not much different.

• Increase in World Oil Demand between 06-07 has fallen: from 8% to 4%

Dollar Depreciation• Myth: The depreciation of the U.S dollar

has led to higher oil prices.

• Fact: The dollar has depreciated by 9 % against the Euro since 2004, when oil prices began to increase. Therefore, Oil prices should have moved by only 9% upwards to preserve the purchasing price in Euros of oil.

• However, since that time until July 2007- the price of oil had increased by between 300-400% (since the time of the article).

Geo-Political Disruption(s)• Myth: Possible Iranian Nuclear Armament

and various Middle Eastern conflicts are leading to a rise in oil prices.

• Fact: From 2007 on there have been no major threats to stability in the Middle East. Iran needs all of the dollars and Euros it can earn from oil to support itself. Iran has never threatened an oil embargo. In fact, the country is increasing oil production.

• Tensions between Israel and Syria has lessoned as Syria has agreed to reduce its support of Hezbollah in Lebannon.

• Short of a virtually complete shutdown of production in the Middle East no plausible price elasticity of demand would justify quadrupling oil prices.

Help! The world is running out of Oil• Myth: Oil prices are as high as they are because of near term supply

constraints.

• Fact: Spare Capacity= Sustainable capacity – Actual Production.

- In 2008, this number equaled approx. 10% of production. This capacity is higher rate is higher than in 2004, 05, and 06.

• Myth: At some point, oil will run out.

• Fact: The U.S Energy Information Agency estimates that reserves have been increasing since 2004 by 2.5% FASTER THAN THE INCREASE IN CONSUMPTION. The oil shales of the U.S and the Sands of Venezuela and Canada are potentially enormous reserves.

• Hotelling’s Rule- A common oil valuation method: the price of reserves should rise with the rate of interest at approximately half the existing rate of Treasury bonds. The increase in oil prices far exceeds any rise in T-Bill rates from 04-08.

Oil is a Speculative Bubble• What is a bubble? A price movement unsupported by market

fundamentalsa a • What has given this idea Credibility?

1) Some Financial Circles- George Soros.

2) Hedge Funds- Large amount of activity.

• What can bring the bubble to an end? 1) An announcement in a production increase.

2) Strategic Petroleum Reserve- Justification from U.S President.

WAY OFF SCALE• Masters Capital Management said investors poured $60 billion into oil futures markets

during the first five months of the 2008 as oil prices soared from $95 a barrel in January to $145 a barrel by July.

• From July of 08 until, September-These investors subsequently withdrew $39 billion from those markets as prices have retreated dramatically, the report said.

• We have clear evidence the fund flow pushed prices up and the fund flow pushed prices down," said Michael Masters of Masters Capital Management, calling the amount of

money moving into oil futures markets by large institutional investors in the early part of the year "way off the scale."

Oil Prices are like Stock Prices• Oil inventories (i.e. oil stocks) are a stock concept : they are defined in

e.g. barrels, and measured at a certain point in time, but they lack a time dimension.

• They have been designated AI= Actual Stocks. DI= Demanded Stocks• Current production (s) and demand (h) are flow concepts: they are

defined and measured in terms of a certain unit of time (e.g. million barrels of oil per day (= mb/d). Microconomics 101 deals almost exclusively with flow variables.

• Stocks and flows are closely related, since the change in stocks is determine by the net investment (or disinvestment) in stocks during a given period,

• s – h: i.e. flow supply (s) minus flow demand (h). • Equilibrium as the situation where desired stocks (DI) are equal to

actual stocks (DI = AI), and the resulting ‘state of rest’ (i.e. equilibrium) is characterized by ?p = 0.

• But if the stock market is out of equilibrium, e.g. DI > AI (because of expectations about present or future demand)

• Then in the flow market we must have s > h in order to close the (DI – AI) gap. To obtain s > h, price must increase.

• The increased price raises flow supply (s) while decreasing flow demand (h). The size of (s – h) says something about how rapidly inventory holders want additional inventories.

• DI will eventually equal AI, and ?p = 0. Please note that the equation, ?p =?(DI – AI), or pt+1 – pt = ?(DI – AI), is a simple linear relationship between excess stock demand and the price change, assuming ? is a constant. Now let us look at the diagram.

Conclusion

• What happens? The current (or flow) supply (s) goes into stocks (i.e. inventories) and current (i.e. flow) demand (h).

• Price is formed by the relation of actual stocks (AI) to desired stocks (DI), with the flows playing a secondary (but important) role.

• The equilibrium expression is AI = DI, and when this situation prevails, s = h, and price is constant (i.e. ?p = 0)!

• Put another way, a stock equilibrium implies a flow equilibrium, while a flow equilibrium does not imply a stock equilibrium. In this type of model expectations are very important because of their influence on desired stocks, and futures (i.e. paper) prices have some influence in forming price expectations in the physical market.

• Expected prices are undoubtedly more difficult to describe than via the simple implicit expression shown in the figure – i.e. pe = f(p) – but the main thing to recognize is the non-trivial role of expectations in determining the oil price, even if it was only when the oil price moved past $100/b that they received their true weight in the scheme of things.

Sources

• http://www.energypulse.net/centers/article/article_display.cfm?a_id=1775

• http://www.cleveland.com/nation/index.ssf/2008/09/study_links_oil_prices_to_inve.html