What Drives the Oil Price?

Dr. Behrooz Abdolvand

The Rise And Fall of Oil Prices

1. Demand side arguments Imbalance of supply and demand Increased demand due to emerging markets (China,

India) Therefore OPEC has to increase production Peak Oil (demand outweighs supply) Scarce reserves

2. Supply side arguments Hoarding by OECD countries Speculation Dollar devaluation

Common Explanations for the High Oil Price

Increasing Energy Commodity Prices

Parallel increase of supply and demand

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Produktion

3170.41990599442

3160.50745967752

3190.14402298357

3188.88653774493

3237.38274986747

3281.3285946768

3377.10365961135

3479.93720459129

3547.25444105904

3481.14409834541

3614.08893308808

3600.29405002411

3575.34620273224

3701.06058286264

3866.6672792223

3897.04843379505

3914.30471512478

3905.93667323681

Verbrauch

3154.92250074574

3149.06407629726

3186.26841329224

3162.85264298882

3218.61053089997

3264.22320920861

3346.62855108396

3433.27858100828

3449.32019395667

3518.10760894825

3558.72365416522

3576.17799565385

3611.27066218368

3681.75174672425

3823.72776531711

3871.02088028602

3910.88425426901

3952.82069229712

3100

3300

3500

3700

3900

Parallel development of production and consumption

OPEC - Production capacity

Increasing Prices – Growing Reserves

1990 1995 2000 2005 2006

100000

110000

120000

130000

140000

150000

160000

170000

180000

135734 136890 139626

175384178743

1990

1990

1991

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1997

1998

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2001

2001

2002

2003

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2005

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2007

2008

0

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Hoarding can be one of the reasons for price increases

Jan-

2000

Apr-2

000

Jul-2

000

Oct

-200

0

Jan-

2001

Apr-2

001

Jul-2

001

Oct

-200

1

Jan-

2002

Apr-2

002

Jul-2

002

Oct

-200

2

Jan-

2003

Apr-2

003

Jul-2

003

Oct

-200

3

Jan-

2004

Apr-2

004

Jul-2

004

Oct

-200

4

Jan-

2005

Apr-2

005

Jul-2

005

Oct

-200

5

Jan-

2006

Apr-2

006

Jul-2

006

Oct

-200

6

Jan-

2007

Apr-2

007

Jul-2

007

Oct

-200

7

Jan-

2008

Apr-2

008

400000

600000

800000

1000000

1200000

1400000

1600000

1800000

Gesamtbestände Strategische Reserve

US oil stocks (´000 bbl)

Number of ships used for oil storage

Future Contracts and the Oil Price

0

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Gehandelte Futures-Kontrakte in Mio. Stück

US$/b; Futures Sorte WTI

Intense correlation between oil price and futures

Oil: Price development and number of traded contracts

Trade volume by now 2000 times higher than the production amount

General Trend of Commodity Investments

This trend is apparent in all natural resoures

S&P GSCI breakdown by sector – the most popular commodity index is energy-dominated

ETF-Securities: Amount of capital held by oil funds

The development of the oil price and the capital influx into the ETFS-Oil-Funds

ETF-Securities: Amount of capital held by oil funds

Historic correlation between the „New Economy“ bubble and the oil bubble

Negative correlation between oil and the USD

Euro/Dollar Exchange Rate and Oil Price Growth

3/1/

2000

3/4/

2000

3/7/

2000

2/10

/200

0

1/1/

2001

2/4/

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2001

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1

31/1

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/200

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23/6

/200

8

0

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0.4

0.6

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1

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1.6

1.8

Öl/WTI Euro/USD

Illustration of correlation not only in the oil sector, but also commodities in general

Monetary Policy causes Dollar Devaluation

Historical Process of Dollar Devaluation

Calculation of cumulative inflation illustrates the current value of the dollar

Nominal and Real Price of Crude 2008

Nominal and Real Price of Crude 2007

Nominal price 2007: ca. 93 $Nominal price 2007: ca. 93 $

Nominal Oil Price 2006

Nominal price 2006: ca. 88 $Nominal price 2006: ca. 88 $

From a historical perspective, multinational oil companies dominated the industrial promotion of energy resources in the Middle East and South America up until the 1950’s. Until the early 1970’s, the trade of oil was based on the “Posted Price”, which large mineral oil corporations collectively set; the fees exacted from this “Posted Price” ultimately determined the size of the state budget of the respective countries. As the oil-producing nations increasingly realized how high the profits were from the contributions of the shareholders, they demanded and even higher percentage. The oil corporations, in turn, attempted to decrease the “Posted Price” in order to protect themselves from the consequences of higher demands and to secure their own revenues.

List Price (Posted Price)

In response, OPEC was founded by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela in 1960, which later expanded to include Algeria, Libya, Nigeria, Indonesia, Qatar, and the United Arab Emirates. OPEC was initially founded in order to unify and coordinate members' petroleum policies and to protect against oil price declines and decreases in oil revenues.

The establisment of OPEC

Consequently, OPEC controlled the oil market and price formation from 1973 until the beginning of the 1980’s. The “Posted Price” was initially replaced by the “Government Selling Price”, which was set by the governments of oil producing states. Later, it was substituted by the “Official Selling Price”, whose price was determined by national oil companies.

Government Selling Price/ Official Selling Price

In light of the decrease in oil demand during the mid 1980’s, many OPEC countries were guaranteed a fixed margin of payment in order to secure oil sales; this fixed margin would then have to be transferred to the oil refineries. The price risk was assumed by the so-called “Net back” conditions of oil producing states. The producer states provided the refineries with crude oil and received a percentage of the profits derived from the sale of refined oil minus a margin of profit that remained for the refineries.

Net back

This process, which removes the price risk from the producer and guarantees a margin of profit, led the refineries to increase production levels. This, in turn, tightened competition. Consequently, the price of products declined and the price of crude oil sank to about $10 a barrel within a very short period of time.

Price decline as a consequence of „Net Back“

This induced the OPEC states to introduce production quotas. They curtailed the oil supply and divided the oil output among the member states in order to achieve price stability.

Quota regulation/Price increase

The oil trade had to re-structure itself. Initially, the trade was handled through spot markets. Later ensued-as a reaction to the oil price fluctuations caused by the limited quota discipline of OPEC-the futures market. The oil futures trade served to limit price risks for oil dealers, but also drew the participation of new groups to the international oil futures market.

Futures market

Under this system, the price of the delivered petroleum (for instance West Texas Intermediate (WTI), Brent or Dubai-Oman) orients itself toward the average price of futures markets of the previous month. The WTI generally serves as the benchmark for oil that is sold to North America, Brent Oil for the sale to Europe and Africa and Dubai-Oman for petroleum that is sold in the Asian-Pacific market.

Formula pricing

Based on this mechanism, there will surely be attempts made by OPEC to regulate prices. A triangle will remain between the futures markets, the consumers and OPEC in the future.

The future oil market will not be a producer market, but rather, a consumer market.

Concluding remarks

Thank you!

Questions?