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Peak Oil & its impact on Financial MarketsPeak Oil

Jaipal Naidu and Vivek Aiyappa11/3/2009

P E A K O I L & I M P A C T O N F I N A N C I A L M A R K E T S V E R S I O N 1 . 2

1. Introduction“In 2008, every barrel of oil was traded 27 times on an average before being actually delivered and consumed.” Believe it!!

It’s a scary feeling to imagine a world with no oil in the near future and no alternate energy to fall back on. Have we reached the point in time when the supply of oil can only decline? Last year we saw the oil price soar to record levels and then crash spectacularly. Is it truly the Peak oil phenomenon that is pushing the oil prices high or is human greed one of the reasons. Let us critically look at this phenomenon to try and understand how financial markets play their part in aggravating the situation.

To understand this better, let us look at the Global Oil Demand and supply for the past 3 years:

• 2008 Q2 Worldwide Crude Oil Supply is at 86 MBPD (million barrels per day)• 2008 Q2 Worldwide Crude Oil Demand is at 85.5 MBPD

If the Demand for oil in the global markets never exceeded the Supply, why did the price of oil shoot from $70 per barrel to $143 per barrel?

2.What is Peak Oil?Peak oil is the simplest label for the problem of Crude Oil depletion, or more specifically, the peak in global oil production. The rate of oil 'production', meaning extraction and refining has grown almost every year of the last century. Once we have

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2004 2006 2008 2010

8282.5

8383.5

8484.5

8585.5

8686.5

87

Demand

Oil Demand

Year

MB

PD

2004 2006 2008 2010

83.5

84

84.5

85

85.5

86

86.5

87

Supply

Oil Supply

Year

MB

PD

P E A K O I L & I M P A C T O N F I N A N C I A L M A R K E T S V E R S I O N 1 . 2

used up about half of all Oil reserves, the production is likely to stop increasing and begin a terminal decline. This point in time when oil production is at its peak and will only decline from then on is termed as Peak Oil.

The peak in oil production does not signify 'running out of oil', but it does mean the end of cheap oil, as we switch from a buyers' to a sellers' market.

A number of experts project that a peak in the world production of oil could occur in the relatively near future. A few projected dates for peak oil are mentioned in the table below:

Such projections are fraught with uncertainties because of poor data, political and institutional self interest, and other complicating factors. Having said that, it is important to note that most of the projections indicate the years 2007 – 2010 as the Peak Oil period.

In line with the economics of demand of Supply any commodity in a competitive market with depleting quantity and high utility is bound to have its price shooting up the roof. But have we really reached the peak or is it the market players who created a sense of peak to cash in on the already booming market?

3.Financial markets role in the Peak Oil Rush

Before we get into the details of the role Financial Institutions played in the Oil price hike let us understand the basic concepts of commodity trading:Commodity: A commodity is a good for which demand exists, but which is supplied without qualitative differentiation across a market. It is a product that is the same no matter who produces it.

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Projected Date Source of Projection2006-2007 Bakhitari

2007-2009 Simmons

After 2007 Skrebowski

Before 2009 Deffeyes

Before 2010 Goodstein

Around 2010 Campbell

After 2010 World Energy Council

2010-2020 Laherrere

2016 EIA (Nominal)

After 2020 CERA

2025 or later Shell

No visible Peak Lynch

P E A K O I L & I M P A C T O N F I N A N C I A L M A R K E T S V E R S I O N 1 . 2

Commodity Market: Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities and futures exchanges, in which they are bought and sold in standardized contracts.

There are 2 basic ways of trading and they are Spot trading and Forward/ Future Contracts. Spot Trading: Spot trading is any transaction where delivery either takes place immediately, or with a minimum lag between the trade and delivery due to technical constraints.Forward/ Future Contract: A forward contract is an agreement between two parties to exchange at a fixed future date a given quantity of a commodity for a price defined today. Future contracts have the same basic principle with the only difference that they are traded in Futures exchange.

The idea that we have reached the point of Peak Oil and the supply of oil can only decline from now on spurred the Wall Street bankers to speculate high prices for this commodity. Assume that the spot trading rate of Crude oil is 60 $/barrel. Financial Institutions and trading companies speculate that the oil price might hit $75 in the next 3 months and buy huge quantities of oil in futures contract at $65. Since these institutions have no use for this commodity (except for the monetary value) it is then re-traded to another financial institution at a profit. This chain of speculation and holding of the commodity by these institutions continues and by the time the commodity reaches the hands of the actual Oil companies, the market price would have substantially gone up.

Consider the following facts:• Between 2003 and 2008, the amount of speculative money in commodities grew

from $13 billion to $317 billion, an increase of 2,300 percent• By the summer of 2008, in fact, US commodity speculators had bought and

stockpiled enough oil futures to fill 1.1 billion barrels of crude, which meant that speculators owned more future oil on paper than there was real, physical oil stored in all of US commercial storage tanks and the Strategic Petroleum Reserve combined

• This artificial speculation and hoarding of oil resulted in price of oil shooting up from $ 65in 2007 to $147/ barrel during mid 2008

• Since Financial Institutions had no use of this oil they hoarded, they either had to take the delivery of the Oil or re- sells it to another institution at the end of the Futures contract period. Early 2008 - there were a slew of institutions trying to sell off the oil. Suddenly there was a glut in the market

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P E A K O I L & I M P A C T O N F I N A N C I A L M A R K E T S V E R S I O N 1 . 2

• The financial meltdown of 2008 -09 further reduced the global oil appetite and the commodity which was once thought to have reached point of terminal decline, was suddenly abundant

• The summer of 2008 saw oil prices crash from $147/barrel to $33/barrel.

Whether we have reached the period of Peak Oil or not is a matter of debate, however the fact that Financial Institutions used this fear for their benefit should be realized. Global prices of essential commodities like food grains, fruits and vegetables also shot up and the reason cited was the increase in transport costs. End of the day, it was the common man who bore the brunt of this carnage. He had to pay more not only for his fuel but also for his food and this was during the period when world saw the highest rates of unemployment and redundancies.

Most commodity speculators are "long only" bettors, who seldom if ever take short term view— meaning they only bet on prices to rise. While this kind of behavior is good for a stock market, it's terrible for commodities; because it continually forces prices upward. The experience of 2008 has shown the world the great danger in using long-term, long-only commodity futures positions as an investment asset class. It is essential to realize that if we’re going to trade crude oil like a currency, we should regulate it like a currency, too.

To counter such a phenomenon, we have to look at tighter market regulations that will help us stabilize the price fluctuations. • There is a fundamental difference between a Securities/ Share and commodity

which we have to respect. A commodity can be traded with or with out an exchange in any part of the world where as securities cant be. This fundamental difference calls for market regulations governing the Commodities and Futures Exchanges all over the world to be in unison to have a holistic view and provide a level playing ground all across.

• Prices of commodities decide the WPI (Wholesale Price Index) which has a direct direct impact on Inflation. Health of nation is dependent on this figure. Heavily traded commodities have higher fluctuation in prices and hence they push the prices of other commodities in the same exchange higher or lower. The basket of 400 commodities that determines the WPI can be reworked upon to provide immunity to other not so heavily traded commodities

It might be a herculean task to implement what has been suggested above and might lead to situations where there might be less liquid markets leading to commodity prices stagnating at certain levels, but we have to take a utilitarian view of the situation and do what’s best for a majority of the population. And this is especially holds good in the case of the Crude oil.

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P E A K O I L & I M P A C T O N F I N A N C I A L M A R K E T S V E R S I O N 1 . 2

There is no denying the “Peak Oil” phenomenon and the fact that there is a dire need to address this issue by investing in the alternate sources of energy. Alongside it is also critical to bring greater regulation and control in the Commodity markets to prevent speculative Oil shocks in the future.

Source of information: Inflationdata.com

International Energy AgencyRolling stoneOilmarketreport.comMiddle East Economic Survey

Compiled By: Jaipal Naidu and Vivek Aiyappa

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