The energy crisis: Background and outlook

Short courses for Permanent Missions in GenevaAdapting to the new energy realities: trade and

development perspectives31 October 2008

Olle Östensson

Outline

• A short history of the oil price boom

• Why did oil prices rise and why did they rise by so much?

• How high is high? The argument for continued (relatively) high oil prices

In the general commodity boom, energy prices stood out

Source: IMF, International Financial Statistics database.

Figure 1: All commodity and energy prices, 1993–2007(index numbers, 2000=100)

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50

100

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1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Energy All commodities

Oil prices increased most: Crude oil prices 1960 to mid-2008,

US$/barrel

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2Q1962

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Nominal Real

Source: UNCTAD Commodity Price Bulletin

Price increases for coal and natural gas were more modest

Source: UNCTAD secretariat calculations based on IMF, International Financial Statistics database.

Coal price is for Australian coal. The real price is the nominal price deflated by the United States Consumer Price Index (CPI).

Figure 2: Coal prices, nominal and real, annual, 1970-2007 (Dollars per metric ton)

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1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006

Nominal price Real price

Source: UNCTAD secretariat calculations based on BP (2008) and IMF, International Financial Statistics database.Gas price is natural gas European Union cif; the real price is the nominal price deflated by the United States Consumer Price Index (CPI).

Figure 3: Natural gas prices, nominal and real, annual, 1985-2007 (Dollars per million Btu)

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1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Nominal price Real price

Reasons for the price increase

• Demand– Two years – 2003 and 2004 – with above trend increases– Geographical differences– Expectations

• Supply– Slow capacity expansion– Low spare capacity, concentrated in one place– Inventories

• Supply-demand imbalances and price spikes in commodity markets

• Other factors– US$ depreciation– Mismatch of refinery capacity– Speculation?

Global oil demand, change on previous year, %

Source: International Energy Agency, Oil Market Report, various issues

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-1

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1

2

3

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5

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Forecast September 2008

Shares of increase in global oil demand 2001-2007, %

21%

2%

19%

26%

19%

13%North America

Europe

Other Asia

China

Middle East

Others

Source: International Energy Agency, Oil Market Report

Large share for China, Middle East and Other Asia – but also for North America

Developed countries still dominate total demand

29%

18%10%9%

11%

5%

8%4% 6%

North America

Europe

OECD Pacific

China

Other Asia

Former Soviet Union

Middle East

Africa

Latin America

Energy intensity, metric tons oil equivalent per thousand US$ in nominal and PPP 2000

exchange rates

OECD MiddleEast

Ex-USSR

China Asia Africa

US$ 2000 PPP

US$ 20000

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

Source: International Energy Agency

China was expected to follow “the Korean path”

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China

India

Japan

Republic of Korea

USA

Russian Federation

Supply side factors: Capacity developments

• Slow capacity increase– Low oil prices in the 1990s reduced the incentive to

add to capacity – There was no spare capacity among non-OPEC

producers

• OPEC spare capacity– In the 1990s, OPEC had cut back production– As late as 2001, OPEC spare capacity was 5.6 million

barrels/day– In June 2008, it was 1.5 million barrels/day (less than

a week’s world consumption), all in Saudi Arabia

Supply side factors: Production costs

• Production costs rose rapidly after 2000, both reducing incentives to invest and creating expectations about future price increases

• The “peak oil” theory made arguments based on rising costs of production more credible

Production costs, conventional oil

Source: US Energy Information Administration

Supply side factors: Inventories

• The history of inventory changes is ambiguous – total OECD stocks were actually higher than normal in the first half of 2007

• OECD stocks fell in early 2008, particularly in Asia, creating an imbalance

• Official stock build ups took place throughout the period of price increases and rumours of massive increases in Chinese stocks abounded

• Very little information was available about stocks in producing countries

• It is likely that a general atmosphere of uncertainty contributed to precautionary stocking behaviour

Reasons for price spikes in commodity markets

• Very low short term price elasticity of demand because of lack of substitutes and because use cannot be postponed

• Very low short term elasticity of supply because of fixed capacity and high capacity utilization

• When prices are perceived to be rising, target inventory levels are raised because buyers want to avoid paying higher prices

• If there is a perceived risk of shortage, target inventory levels are raised to avoid having to default on deliveries

• Precautionary stocking is insensitive to price increases and will continue long after prices have exceeded “reasonable” levels

A source of uncertainty: Estimates of non-OPEC supply growth have been too

optimistic in recent years

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2003 2004 2005 2006 2007 2008

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Estimate 1 year ahead

Estimate end of current year

Sources: December editions of IEA’s Oil Market Report.

Summary of factors

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WTI Spot ($2008)

OECD Days Supply

World Excess Production Capacity (right axis)

Sources: WTI: Reuters; OECD Days Supply: International Energy Agency and U.S. Energy Information Administration estimates; World Excess Production Capacity: U.S. Energy Information Administration estimates.

Other factors

• US$ depreciation

• Demand rose particularly fast in the transportation sector

• Refineries produce products in fixed proportions, composition of crude oil is crucial

• A shortage of light crude oil may have further fuelled the price increases

Speculation?

• Financial speculation involves the buying, holding, selling and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividends or interest. (Wikipedia)

• Distinction between speculation and manipulation: speculators benefit from market variations, market manipulators attempt to influence variations

Speculation?Argument 1: Direct influence of

futures markets

• Low returns on stocks and other assets led hedge funds and other investors to invest in commodity markets, particularly oil

• The volume of investment was very large and, it is argued, drove up prices

How do futures markets for commodities work?

• Futures markets trade contracts for future delivery of a certain quantity of a commodity

• The contracts are almost always cashed in and very seldom do buyers actually take delivery in commodities

• The attraction to investors or speculators compared to dealing in the physical commodity is (1) you avoid storage and handing costs and (2) you only have to pay a small part, usually 10 per cent, of the total price in advance; therefore the potential for profits is very large

Who invested in oil futures and what was the effect? (1)

• Banks and others sold “commodity index funds”, that is, financial instruments that were intended to replicate the price movements of commodities

• Oil is usually a large component in the indices, since it is an important commodity in world trade

• Since the sellers of commodity indices wanted to avoid losses, they hedged by buying contracts on commodity exchanges that corresponded to the indices that they sold – thus they would be able to pay off the investors; this activity was responsible for the vast majority of futures market investment

• The sellers rolled over their hedges, that is, they sold the contracts for cash before the due date and bought new ones for more distant dates

• Accordingly, no oil ever changed hands and the price of physical oil was not affected

• The process can be compared to betting on the outcome of a tennis tournament – the bettors do not decide who wins the Wimbledon

Who invested in oil futures and what was the effect? (2)

• During most of the period of price increases, the oil futures markets were in backwardation, that is, the prompt price was higher than the future price

• The backwardation meant that the banks made a profit from their hedges

• Other investors, who bought futures contracts directly, rather than as part of an index, also profited from the backwardation

Who invested in oil futures and what was the effect? (3)• No correlation

between the amount invested in futures contracts and the price level• Changes in positions did not precede price changes, but followed them (US Commodity Futures Trading Commission)• Backwardation is the classical indication of a physical shortage, speculators benefit from physical shortages

Who invested in oil futures and what was the effect? (4)

Source: CFTC Fact Sheet – Speculative Trading in Crude Oil Market, June 23, 2008

Speculation?Argument 2: Indirect influence of

futures markets• “Herd” behaviour

– Holders of physical commodities observe that speculators are buying futures and conclude that prices are going to rise

– They therefore hold onto their commodities or try to acquire more– The additional demand stimulates speculators to buy more futures and a price spiral results

• Physical stocks are built up • The process continues as long as holders of physical commodities stand to gain from

holding on to them, that is, as long as the market is in contango (future prices are higher than prompt prices), since otherwise they could earn more from selling

• However, there was no sign of stock build up; in fact, stocks declined in 2008: and the market was in backwardation

• The hypothesis that herd behaviour contributed to the price rise in a situation of physical shortage is consistent with the inventory data, although the hypothesis can not be supported by any positive evidence (this would require knowledge of the motives guiding the behaviour of holders of physical oil)

• However, changes in speculative positions followed price movements• Moreover, since prices of commodities that are not traded on futures exchanges rose

at least as much as those of commodities traded on exchanges, the hypothesis assumes two causes for the same effect, depending on whether a commodity is traded on a futures exchange

The “yield curve” for crude oil- the market was in backwardation

except in early 2007

Where are oil prices going?

• Demand– The rate of increase in oil demand has been modest

compared to other commodities (only 2.2 %/year 2002-2007, the period of large price increases) and is unlikely to accelerate

– Demand may be more sensitive to price increases than often thought

– Developing Asia will account for most of the demand increase, but income elasticity is low (0.4 in China) and falling

– The current oil price hike represents the strongest support programme that has ever existed to develop alternative energy sources and embark on a less carbon-emission-intensive economic development path

– Governments may be prepared to commit to making high fossil energy prices permanent in order to stop climate change

Where are oil prices going? (cont’d)

• Supply– Almost all energy production is extremely capital intensive and

has low variable costs – this means that prices can vary dramatically in the short term, but in the long term all costs have to be covered

– Increasing cost of non-OPEC conventional oil: low lifting costs, high finding and development costs

– Non-conventional oil (heavy oil, bitumen, tar sands) has total costs of $70-90/bbl, high operating costs, environmental impacts are important and may constrain expansion

– Non-oil alternatives (biofuels) have high costs – although Brazilian ethanol from sugar cane has production costs of $25-30/bbl - and capacity is constrained by availability of land and water, trade barriers and standards

– OPEC oil can not be taken for granted

US Energy Information Administration:

International Energy Outlook 2008 • Liquids production in reference case 112.5 Mb/day in 2030 (increase 1.2

%/year)• 9.7 Mb/day are projected to come from non-conventional sources, accounting

for a quarter of the production increase• OPEC’s share of production increases very slightly (from 41 to 42%), the share

of non-OPEC conventional oil falls

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Reference

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Prices are assumed to remain relatively high

EIA forecast, Mb/day

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OPEC production

• OPEC is an intergovernmental organization operating on the basis of consensus, decisions are usually the result of compromises

• Several OPEC producers are experiencing cost increases

• Only a few have large enough reserves to be able to increase production significantly in the long term (Iran, Iraq, Kuwait, Sadi Arabia)

• Iran and Iraq have large populations and could use additional income – but is such income better generated by increased market share or (continued) high prices?

• Kuwait and Saudi Arabia have small populations and no need to increase their market share

• Conclusion: OPEC can not be counted on to automatically make up the shortfall in world production, that is, act as swing producers

Conclusion: a realistic (?) assumption

• The long term production cost of alternatives to conventional oil will set a floor for crude oil prices at US$ 60-80/bbl in today’s dollars

• The price can and will fall below this floor, but only for limited periods

Thank you!