azhan oil economics july 2010

8/8/2019 Azhan Oil Economics July 2010

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OIL ECONOMICS

By Dr Azrai Abdullah/Azhan Hasan


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Learning Outline

l The History of Oill Demand and Supplyl Oil Market and Case Studyl Global Oil Demand & Global Oil Supplyl OPEC and Its Rolesl Peak Curvel Phenomenon of the Perfect Storml Food for Thought Curse or Windfalll Causes of High Oil Prices

l Key Assumptionsl Impact and Implication of High Oil Pricesl Key Issues and Challenges


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The History of Oill 1859 Titusville (Pennysylvania). First oil welll 1864-1911 The Standard Oil of J.D. Rockefellerl 1900-1930 The long quest for oil, power and money

l 1928 Achnacarry : The international oil cartel of theSeven Sisters (1928-1960)

l 1960 The development of the European Oil Companiesl 1960 Creation of OPECl 1973 First oil shock. OPEC becomes a price makerl 1979-80 Second oil shock. OPEC is still a price maker

l 1998 Oil price at 10$/bll 1999-2003 OPEC Price range 22-28 $/bll A structural change in oil markets

Centre de Gopolitique de lnergie et des Matires Premires


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Demand Curve

The x-axis is the price, and the y-axis is the demand.

There is an inverse correlation between price and quantitydemanded.


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Supply Curve

l If the price rises, so will supply.

l In longer-term, higher-prices will feed into firms capital

expenditure decisions- new machines will be bought. Higherprices mean more supply.


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The Meeting of Demand & Supply

l Economists put these two curves together,the demand and the supply to understand a

market:


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How Market Works

l The market price is the point at which demandmeets supply. That is, there is a price level wherethe level of demand is equal to the level ofsupply. This point cannot be emphasizedenough: the market will clear.

l An excess of supply, or shortage thereof, ismerely another way of saying that the clearing

price is moving. And markets will clear.


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Oil Supply and Demand

l The market for oil is unusual, because in the short-term both demand and supply are highly inelastic. Irrespectiveof what petrol costs, your car cannot easily switch to

another fuel.

l Supply of conventional oil is also relatively inelastic,although for a different reason. The actual cost of pumpinga marginal barrel of oil is relatively low, once the capitalexpenses of prospecting and building an oil rig (andassociated infrastructure) has been put in place. An oilfieldwill cost roughly the same to operate whether it isproducing at 50% of capacity or at full capacity.


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Oil Market

l The result of this is that the oil market is one where smallchanges to the supply or demand curve cause largechanges to the clearing price.


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Case Study 1 - The Oil Shocks of the

1970s

l This model can be applied to the oil price shocksof the 1973. Following US support for Israel inthe Yom Kippur war, the newly founded OPECannounced it would stop selling oil to the US,and would restrict its overall oil output. BecauseOPEC supplied so much of the worlds oil, thishad the effect of changing the shape of the

supply curve. In other words, for any given pricelevel, there would be less oil supplied as shownin the next slide.


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The Model [1]


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Explanation on Model

l As can be seen from the chart in the previous slide, thisrestricting of supply caused the blue supply curve to moveto the left, and as the market must clear the price

rocketed. Dropping out of theory and into practice, we seethat this is exactly what did happen. The price of SaudiLight oil jumped from under $3 a barrel in 1971 to almost$40 by 1980.

l It is not only sellers cartels that affect the oil price. When

Hurricane Katrinaknocked out production in the Gulf ofMexico it had a similar effect - the supply curve was shiftedto the left and prices rose.


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Case Study 2 - Short-Term Changes to

Supply and Demand Curves

l The rise of emerging markets has also changed thesupply and demand dynamics. As China, India and

the like industrialize, and their emergent middleclasses buy cars, then the demand curve moves tothe right.

l For any given level of price, more oil is demanded.As the chart in the next slide shows, this has exactlythe same impact on the clearing price of oil as doesreducing supply - the price moves, and sharply.


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The Model [2]


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Crude Oil Prices 1947 - May, 2008Crude Oil Prices 1947 - May, 2008


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Global Oil Demand [1]

l Oil demand as function of income and price

l Oil demand and price usually examined within context of priceelasticity of demand

- Measures relationship between the change in quantity of oildemanded and change in oil price

l Wide variation in estimates

l Some general observations

- Changes in oil prices have small effect on demandespecially in short run

- Long run price elasticity of demand higher than short one

- Due to substitution and energy conservation butelasticity still low

- Price elasticity of demand higher in developed countries


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Global Oil Demand [2]

l Relationship between oil demand and GDP growth studied withincontext of income elasticity of demand

l Change in quantity of oil demanded and change in incomel Estimates vary widely according to method used, period under

studyl General observations

- Oil demand more responsive to income than prices- Long run income elasticity for oil demand higher than short

run income elasticity- Large heterogeneity in estimated income elasticity across

countries and/or regions- Developing countries exhibit higher income elasticity thanOECD

- Responsiveness of oil demand to income declining overtime especially in OECD countries


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Projections of Oil Demand

l Relationship between oil demand, prices & incomeused to project oil demand growth

- Projections highly sensitive to assumptionsmade about economic growth scenarios

- Highly sensitive to income and price elasticity- Highly sensitive to oil price path chosen

- Endogeneity of prices and income bias results- Ignore potential relationship between oil priceincreases and growth


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Projections

Projected Oil Demand (Millions of Barrels per day)

2003

(Actual)

2010 2015 2020 2025 2030

IMF 79.8 92 102.42 113.5 125.5 138.5

EIA

(2006)

80 92 98 104 111 118

IEA(2006)

82.5(2004)

91.3 99.3 116.3

Source: IMF (2005), World Economic Outlook, April 2005, Table 4.5; Energy Information Administration (EIA), International Energy Outlook 2006, Figure 26. InternationalEnergy Agency, World Energy Outlook 2006,


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Global Oil Supply

Modelling oil supply much more complex

- Issue of reserves- Behavior of various suppliers

- Distinguish between OPEC and non OPEC non-

- Different and diverse suppliers outside OPEC rangingfrom national oil companies, IOCs and independents

- Widely assumed that non OPEC behaves

competitively- OPEC behavior much more complex

- Many diverse theories in literature rangingfrom cartel to competitive behavior.


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Determinants of Non OPEC Oil

Supply

l Two General Approaches:- geophysical and economic

l

Geophysical factors determine oil supply- Production governed by historical cumulativeproduction and size of ultimately recoverable reserves(URR)

- Based on specific logistic curve that specifies timepath of cumulative production possible to fit asymmetrical bell shaped curves for annual rate ofproduction

l Hubberts approach been widely criticized- Treatment of URR as static variable- Geophysical models overestimate depletion effect


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Oil Reserves Increasing

Oil Reserves and Production Data

1973 1983 1993 2003WorldReserves(billionbarrels)

635 723 1024 1148

World Output(million b/d)

59 57 66 77

World R/Pratio (years) 30 35 42 41


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Economic Based ModelsEconomic factors

- real oil prices, costs, regulatory factors play an importantrole in determining oil production role

l Various studies attempt to estimate price elasticity for non-OPECoil supply

l Response of non-OPEC production to oil prices especially inshort run is close to zero and even negative- Producers do not necessarily increase production in

face of price rise price

- A decrease in oil prices does not induce producers toreduce production

l Although long run price elasticity is found to be positiveestimates are quite low but not necessarily in all studies


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Non OPEC Oil ProjectionsGiven the different models and the wide range of elasticity estimates, it is

no surprise that non-OPEC supply projections differ considerably across

studies and over time.

2010 2015 2030

EIA (2006) 54.4 58.6 72.6

EIA (2005) 56.6 61.7 66.2

IEA (2006) 53.4 55.0 57.6


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Supply of Oil: Role of OPEC

l Modelling OPEC supply creates serious challenge forcompetitive supply-demand framework

l Describe OPEC as cartel or oligopoly while at same timeuse competitive supply-demand framework for analysinglong run behaviour of oil market

l Close the model by considering :- OPEC acts as swing producer equilibrating demand

and supply with optimal prices/quantity levels- Treat OPEC supply as a residual (Call on OPEC)- Hypothetical amount that OPEC needs to

produce to close the gap between oil demandand non OPEC supply


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OPEC OIL PROJECTION (OPEC CALL)

2010 2020 2025 2030

EIA (2006)

(Upper bound Lower bound)

32.9 37.9 29.3 43.3 29.8 46.9 30.9 51.0

EIA (2005)

(Upper bound

Lower bound)

30.6 32.7 43.5 49.2 51.6 61.0 61.3 74.4

IEA (2006)

(Base linescenario)

35.9 56.3


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LIMITATIONS

l Calculating OPEC supply as a residualovercomes problem of modelling OPECs

complex behaviour

l But creates two problems:

- Is there Incentive for OPEC to expandoutput?

- Will the investment materialize?


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Incentive to Expand Outputl Implicitly assume that OPEC has incentive to increase market share

without any regards to oil prices

l No analysis whether projected output path serves OPEC interests

l Gately (2004) calculates the OPECs net present value of profits fordifferent choices of OPECs market share:

- Aggressive expansion plans to expand output can yield lowerpayoff than if OPEC decides to maintain its market share

- Increase in discounted expected profit from higher output

more than offset by lower prices as result of rapid outputexpansion- projections made by EIA and IEA of rapid increases in market

share are likely to be contrary to OPECs own best interests


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The Underinvestment Probleml Unfavorable geopolitical factors/ sanctions can prevent capacity

expansion

l Relationship between government and national oil company canresult in unfavorable environment for investment

l Relationship between governments and/or national oil companiesand IOCs- As markets have tightened terms and conditions demanded

by owners have been hardening over time

l For OPEC uncertainty about demand for OPEC oil constitutes avery important obstacle for investment- Calls for security of demand


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Limitations of Supply-Demand

Frameworkl Using this framework to project oil prices is likely to result i n mistakes

for a number of reasons in

- highly sensitive to assumptions made about income and priceelasticity of demand, the price elasticity of supply, role of

reserves, OPEC behaviour

- Can not capture impact of unexpected shocks:

- Cashin el at al, 1999: it is incorrect to view shocks tocommodity prices as generally being a temporary phenomenonthat largely reflect short lived variability in supply interacting withrelatively unchanging demand

- Does not take into account general geopolitical context andmarket conditions in which oil prices are determined:

- Supply demand framework analyses oil prices and makes

projections in a neutral context


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What is the shape of the peak curve?- price (demand )- Geology- Climate change(Taxes)- Political turmoil

- Prices (supply )- Technology



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Oil and Gas exporting countries : 43

MB/day at risk

144MUSA:13.5M

B/Day

Europe:13.3MB/

Day

Ormuz13MBD

Malacca

10.3MBD

China+Japan+India

10.3MB/Day

Countries in red89% of World Oil Reserves81% of World Gas Reserves


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Investments of the Future 2005-2030

l Closure of some - International CompaniesCountries to foreignInvestments (Mexico) - National companies (Pemex-

OIL $4000 BILLION Sonatrach)l Political risks (Iraq) GAS $4000 BILLION

POWER $11000 BILLION - New comers (China India)l Financial markets

(Profitability)

Risks are not below the ground, but above the ground

(Daniel Yergin)



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The Origin of Higher Price

l Related to Perfect Storm

- A convergence of 3-Dimensional Forces

(economic, social and political) forcescomprising record breaking oil price rally,surging food (and commodity) prices andfinancial turmoil.

Source : CIRU-CPDD, PETRONAS


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A prolonged period of surging FUEL, FOOD andcommodity prices hasten the build up of the

PERFECT STORM

l The unabated crude oil price rally began in 2005 posthurricane Katrina.

l As an alternative solution to spiraling energy prices, industryplayers accelerate the development of alternative energysources such as renewable energy and bio-fuels.

l This has led to a direct and increased competition betweenfuel and food as more and more grains and oilseed crops arebeing diverted towards bio-fuel production resulting insurging food prices.

l Spillover effects include surging raw material prices foragriculture and industrial sectors.

Source : IMF International Financial Statistics, May 2008


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and rising FUEL and FOOD prices on the back ofFINANCIAL markets turmoil unleashed the

PERFECT STORM

l The cruncher came in August 2007 as financial markets began to crumbleowing to the US sub-prime crisis.

l Price of houses in the US took a steep dive, further deteriorating the sub-prime crisis with astronomical financial losses.

l Escalation of the US credit crunch began to grip the global economy.

l The weakening US Dollar worsens the already soft global economy which hasalready been impacted by rising inflation as a result of higher energy and foodprices.

l The unprecedented convergence of 3-F forces Fuel, Food & Financial

created the PERFECT STORM.

l In the meanwhile, crude oil prices continue with their record breaking pricerally.

Source : Bloomberg


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A combination of traditional drivers (Geopolitics,Supply/Demand and Environment) and new marketfundamentals (financial economics, rising cost and

speculation) have led to oil prices rally

l Since early 2008 until today, oil prices have increased byalmost 50%.

l The magnitude of the record breaking price spike seems

quite unusual as it is being driven by new marketfundamentals which are beyond the traditional supply anddemand drivers.

l Coupled with rising food, commodity and raw materialprices, as well as increasing inflationary pressure, the worldeconomy is seriously bracing the threat of a stagflation

widespread recession if the current record breaking pricerally escalates and does not recede.

Source : AFP & Bloomberg


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Curse Or Windfall?

Food for Thought [1]

l The unabated escalation of oil prices comes at a priceand depending on which context, it can either beconsidered a curse or windfall.

l The curse of oil has often been referred to a situationthat relates to the mismanagement of oil revenues,either for personal gain or lack of transparency in itsutilization. As an example, over the past severaldecades, we have seen the deplorable economic state

of affairs that ensues when tribal kingdoms,authoritarian regimes and left-wing dictatorships, toname a few, lay their hands on national oil revenues.


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Curse Or Windfall?


l Easy oil cash can lead to corrupt establishments,discourage sound long-term economic planning and isalmost never channeled in ways that promote

development for the benefit of the masses.

l On the other hand, if oil revenues are being properlyharnessed and managed with the utmost accountabilityand transparency, it will be regarded as a windfall

provided they are channeled towards developmentprojects, infrastructure and facilities and other relatedsocio-economic activities that will create a better life forthe people and the nation.


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Curse Or Windfall?


l From commercial perspective, high oil prices lead to higherprofit for the IOCs/NOCs and potential higher returns forshare/stakeholders. This will also boost the companys financialleverage to pursue growth and expansion.

l From consumer perspective, high oil prices will mean highercost of doing business, as well as having to brace the risinginflationary pressure.

l From the Governments perspective, high oil prices will impactgrowth, national development plans, as well as enhance theburden of subsidy (in the case of countries with subsidizedenergy prices such as Malaysia, Indonesia, Egypt, etc.)


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Causes of High Oil Prices Geopolitics

[1]

l Continued instability and heightened security concernsin major oil and gas producing countries, particularly inIraq, Nigeria and Iran add jitters to the global market.

- Nigeria:Incessant Niger Delta rebel and militants attackswiped off over 1 million bpd of the countrys total oil

production, thus creating future supply uncertaintyin the global oil markets.


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Causes of High Oil Prices

Geopolitics [2]

- Iran:Increasing speculation of US-Iran militaryconfrontation fuels more uncertainty and

heightens the fear of supply disruption that willsend global oil prices to record highs.

- Iraq:Heightens security concerns owing to protracted

US occupation, as well as threat of sectarianviolence between Sunni and Shiaa.


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Causes of High Oil Prices Financial

Economics/Markets [1]

l Weakening US Dollar continues to put upward pressureon oil prices- Dollar devaluation reduces oil supplies and

increases the demand for oil.- The result is a steady increase in oil prices. Aprolonged decline in the dollar reduces thepurchasing power of oil producing countries andincreases the costs of international oil companies.

- As a result, the amount of money allocated for

reinvestment in oil production declines.Source : Global Insight


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Causes of High Oil Prices Financial

Economics/Markets [2]

l Speculation Weak US Dollar encourages financialinvestors to redirect their capital into commodities,particularly crude oil, which triggers the crude oilprices rally- The root problem is that financial markets have

the leverage to mobilize tens of billions of dollarsfor speculative purposes, anytime, any day.

- Speculation heightens a premium between 40%and 60% to the total crude oil price per barrel.

Source : Financial Times and Bloomberg


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Key Assumptions [1]l Major geopolitical issues such as heightened security concerns in

Iraq and Nigeria, and possible US-Iran military confrontationcontinue to remain uncertain and unresolved over the medium term(3 to 5 years).

l Oil prices are expected to remain high at above $100 per barrel forthe rest of 2008 if the supply/demand imbalance, geopolitical tensionand financial markets turmoil persist.

l Oil prices for 2008 fell to its lowest level of $91.49 on September canbe seen as a temporary correction as oil prices continue to remainon a high plateau where oil is still trading at least than 80% abovethe 2005 price.

Source : CIRU-CPDD PETRONAS


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Key Assumptions [2]

l For oil price to escalate beyond $150 towards $200 per barrel, therehave to be major or sudden supply disruption/shocks from the topoil producing countries, or serious distortion to the markets viaexcessive and uncontrolled speculation.

l Demand for energy, particularly oil, from China and India remainsrobust over a longer period, which is in line with their respectivestrong growth projection.

l Spare capacity will remain marginal at below or almost 2 millionbpd in the medium term that will further squeeze global oil supply.



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Key Assumptions [3]

l Investment in new capacity will continue to lagbehind and eclipse by higher demand from emergingand developing economies.

l Prolonged resource nationalism policy inhydrocarbon-rich countries in Latin America, Africa,Russia and Middle East that continues to serve asbarrier for IOCs and NOCs to access the resources.



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Impact and Implication of High Oil

Prices [1]

l Global Economy- Prolonged high oil price may lower GDP growth

owing to increasing cost of doing business.- Rising inflation.- Asias export-oriented economies are vulnerable

to higher oil prices.- Developed countries will accelerate the

development of alternative fuels.



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Prices [2]

l Socio-Political- Widespread protests against oil price spike

across the major economies (US, France,

Spain, China, India, etc).- Socio-political upheaval that may impact

political stability.- Drastic change in consumer habits becoming

more calculative, efficient and prudent in energy

consumption.Source : CIRU-SPDD PETRONAS


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Prices [3]

l Malaysian Economy- Higher revenues for the government (from CITA, PITA,

royalties, dividends and duties).- Increasing inflationary pressure. Bank Negara stated that the

inflation will increase to more than 6%.- Energy intensive sector will be burdened with higher cost of

doing business.- Exports will soften due to declining demand from trading

partners such as US and EU.- Increased unemployment due to slower economic growth.- The amount of subsidy to be provided by the government for

2008-09 will be much higher.



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Prices [4]

l PETRONAS- Sustained high oil price will lead to higher revenue

and profit for PETRONAS.- E&P investment in domestic deepwater, small

marginal fields and EOR projects become moreattractive.- Better incentives to develop and monetize our oil and

gas reserves in Africa and Turkmenistan.- Drilling, seismic, fabrications, raw materials and other

upstream-related services may cost higher.- Potential development in alternative energy as one of

the sustainable solutions to high energy costs.Source : CIRU-CPDD PETRONAS


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Key Issues/Challenges [1]l Key issues/challenges for PETRONAS evolve around

growth, costs and gaps in technology and skills:- Access to resources in view of rising geopolitical

uncertainty & resource nationalism.- Escalating costs & changing fiscal terms raiseconcerns on margins & viability of existing andfuture investment portfolio.

- Human capital and talent development to managedomestic operations and international expansion.

- Technology as a competitive edge How have weprogressed?Source : CIRU-CPDD PETRONAS


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azhan oil economics july 2010

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