Crude Oil/USD

Agenda1.Introduction2.Supply & Demand3.US Economy & Dollar Devaluation4.Paper Trading5.Risk Premium6.Forecast7.Will OPEC change USD denomination of oil?8.Key Takeaways

Crude oil, commonly known as petroleum, is a liquid found within the Earth comprised of hydrocarbons, organic compounds and small amounts of metal. Crude oil is refined into diesel, gasoline, heating oil, jet fuel, kerosene, etc.

Classification by:

• Origin (e.g., West Texas Intermediate, WTI or Brent)

• Weight (light, intermediate or heavy)

• Sulfur content (sweet /sour). Crude oil production: • Extraction/ drilling from oil reserves.

• About 80% of the world's readily accessible reserves are located in

the Middle East.

• Top 5 oil producing countries: Saudi Arabia, Russia, United States,

Iran, and China.

What is crude oil?

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T ypes of T ransact ion Spot T ransact ion F utures Contract

Major T rading Plat for m:Intercontinental Exchange ( ICE)New York Mercanti le Exchange (NYMEX)

Major Oi l Pr ice BenchmarkLondon-based BrentUS-based West Texas Inter mediate (WTI)OPEC Contract

Trading of Crude Oil

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1. Balance of Supply & Demand

2. Dollar Strength

3. Paper trading

4. Risk Premium

4 Key Determinants

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Oil SupplyOPEC

•! Cartel of 12 countries : Algeria,

Angola, Ecuador, Iran, Iraq,

Kuwait, Libya, Nigeria, Qatar,

Saudi Arabia, UAE, Venezuela

•! To regulate supply and price of oil

•! Produced 42% of the world's oil

production

•!Account for 78% of world’s proven

oil reserve

•! OPEC Production Allocation

Oil Producers

•! Russia and Saudi Arabia produced

25% of world’s oil production

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Oil Supply Factors affecting Supply

•! Oil Demand

•! OPEC policy

•! Unforeseen Situations (E.g. Damage Oil Facilities, War)

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Production cut by OPEC

Unforeseen Situation

Pipeline Closure

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Oil DemandFactors affecting Demand GDP growth Seasons of the Year Demand for Petroleum-based product (e.g. Heating oil, Gasoline)

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Oil DemandWorld GDP

0.7166Developed GDP

0.6757Developing GDP

0.7617Emerging market GDP

0.7770

World Production0.5646

Opec Production0.5384

Non-Opec Production 0.5319

World Consumption0.5815

OECD Consumption0.3489

Non OECD Consumption0.7229

World Reserves0.5184

OPEC Reserves0.3367

World Inventories (Year end)0.6299

Average Inventories0.6224

GDP

•! Strong positive correlation (r =0.71) between World

GDP and oil price

•! Emerging countries has a higher correlation, r = 0.78

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US Economy & Dollar Devaluation

•!GDP!

•!Unemployment rate!

•!National debt!

•!Interest rate!

•!Inflation rate!

•!Trade!

Dollar Value Determinants

US Dollar Strength

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- Increased 1.6% in Q2!

- 9.6% in Sep 2010!

- Over $13 trillion!

- 89% of GDP in Q1!

US Economic Growth

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US Economic Growth

- Benchmark interest rate: 0.25%!

- Inflation rate last reported at 1.1% in Aug 2010, down from a peak of 5.6% in Jul 2008!

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US T rade

Main Imports !

•!F uels !

•!Non-auto consumer goods !

•!Produc t ion machiner y & equipment !

•!Non- fue l ind us tr ia l suppl ies !

•!M otor ve hic le s & par ts !

•!Food, feed , b ever age s !

Main Exports !

•!Machine r y & Equi p m e nt !

•!Industr i a l Suppl ies !

•!Non-auto consumer g oo d s !

•!Mot or ve hic les & par ts !

•!Airc raf t & par ts !

•!Foo d , fe ed , beverages !

Main Trading Partners !

•!Canada !

•!European Union !

•!Mexico !

•!China !

•!Japan !

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US T rade- Increased to $123 billion in Q2 from $109 billion in Q1!

-!Trade deficit dropped 14% to $42.8 billion in July 2010!

-!Total July exports rose 1.8% to $153.3 billion!

- Total Imports fell 2.1% to $196.1 billion!

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Expansionary monetary policy results in an economy based largely on debt

Increase in money supply leads to dollar declineTo bring trade imbalance under controlLeads to higher commodity prices

Recent Federal Reserve rate cuts to boost US economy accelerated dollar devaluation

Investors move capital out to avoid losses leading to further dollar decline

Recent FOMC meeting: Fed may add new stimulus measures to boost sluggish

economy (quantitative easing) High unemployment rate at 9.6% Weak housing market

US Monetary Policy

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•Heavy reliance on fiscal policy during latest recession

•Huge stimulus bill: American Recovery & Reinvestment Act (2009)

•$787 billion in personal & corporate tax cuts•Increased federal aid & direct federal spending

•Federal revenues falling due to recession & ARRA tax cuts

•Increased fiscal deficits associated with depreciating exchange rate

US Fiscal Policy

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The Dollar Index

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Impact of Dollar Devaluation

I/ SHORT TERM IMPACT

•Increased speculation and investment in oil futures:•Hedge against weakening dollar •High profit potential

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Impact of Dollar Devaluation

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II.! LONG TERM IMPACT!

Reduces purchasing power and

increases domestic inflation!

Reduce real income!

Lesser investment in additional capacity and maintenance!

Reduced oil production!

Varying impact on OPEC members!•! Countries that import more from US stand to lose less!

Cheaper oil in countries with appreciating currencies!

Higher demand for gasoline in US due to reduced number of US

tourists abroad!

Increased oil demand!

Impact of Dollar Devaluation

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EFFECTS OF SUPPLY & DEMAND!

Reduced oil supply!Increased oil demand!

Increase in oil prices!

Higher oil prices!

Higher US trade deficits!

Weaker dollar!

What caused the abnormalities in price?

Consumption: ~ 86 mb/d

Production: ~ 86 mb/d

USDX: decrease ~ 12%

Oil Price: Quadruple - 400%Oil futures traded volume nearly quadruple from 4.5 -> 15.3

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The Bubble? (dual characteristics)

ICE employed partial electronic trading on November 1, 2004

and shifted its benchmark ICE Brent crude to an all-electronic format on April 7, 2005

NYMEX started electronic WTI futures in 2006

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Oil Futures Contracts

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Oil Futures Curve

The burst of oil bubble?

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The burst of oil bubble?

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Crude Oil Price ($/barrel)

Risk Premium = Stability Level of Geopolitical situation

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•Oct 5, 1973: Yom Kippur War started. The United States and many western

countries showed support for Israel

•Embargo on the countries supporting Israel curtailed production by 5 million

barrels per day

•Other countries were able to increase production by a million barrels Net loss

of 4 million barrels per day extended through Mar 1974 and represented 7%

of the free world production. 

•The market price for oil immediately rose substantially, from $3 a barrel to

$12.

•The extreme sensitivity of prices to supply shortages became all too apparent.  

Any doubt the ability to control crude oil prices had passed from the United

States to OPEC was removed during the Arab Oil Embargo. 

Arab Oil Embargo – 1973 Oil crisis

•In 1979 and 1980, events in Iran and Iraq led to another round of crude oil price

increases.

•Iranian revolution resulted in the loss of 2 to 2.5 million barrels per day of oil

production between Nov1978 and Jun 1979.  At one point production almost

halted.

•Sep1980, Iran was invaded by Iraq. By Nov, the combined production of both

countries was 6.5 million barrels per day less than a year before.

•Consequently worldwide crude oil production was 10% lower than in 1979.

•The combination of the Iranian revolution and the Iraq-Iran War cause crude oil

prices to more than double (from $14 in 1978 to $35 per barrel in 1981).

1979 Energy Crisis

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•Declining world oil demand and increasing non-OPEC production OPEC cut

output significantly in the first half of the 1980s to defend its official price

•Saudi Arabia bore most of the production cuts (from over 10 million barrels

per day for the period Oct 1980 through Aug 1981 to just 2.3 million by

Aug 1985)

•Late 1985, Saudi Arabia increased production, and aggressively moved to

increase market share.

•In response, other OPEC members also increased production and offered

netback-pricing arrangements to maintain market share and to offset

declining revenues.

•These actions resulted in a glut of crude oil in world markets, and crude oil

prices fell sharply in early 1986.

1986 Oil Price Collapse

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•Iraqi invasion of Kuwait

•Followed 6 months of extreme turbulence in world oil markets.

•3-year peaks in Jan1990 and then plunged to levels comparable to their 1986 lows by Jun (primary

cause: overproduction by Kuwait and the UAE)

•Gulf war

•Waged by a UN-authorized coalition force from 34 nations led by the US and UK, against Iraq.

•6/Aug/1990: UN imposed an immediate and nearly total embargo on oil exports from Iraq and Kuwait,

which Iraq had by then absorbed removed almost 5 million barrels a day from the world market.

•Government’s Reaction:

•Emergency Programs failed

•Market interference drove prices even higher.

•Prices rose from $21 per barrel at the end of July to $28 on August 6, reaching $46 by mid-October.

Gulf War - 1990 Oil Crisis

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•OPEC 10% increase in production quota coupled with Asian currency crisis which reduced demand low point of oil price in 1999

•9/11 attack had no major effect on oil price

•2005: Damages by Hurricane Katrina led to sudden drop in oil supplies and sent oil price to a high.

•Financial crisis 2008 and the ensuing economic recession held down demand

Other events

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24-month Crude Oil Spot Price

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One-week Forecast

Support

Resistance

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One-week ForecastPrice: $83.00

One-month Forecast

Support

Resistance

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One-month Forecast Price: $82.66

76.4% (81.91)

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One-year ForecastAlquist and Kilian (2010) found that no change forecast is more accurate than most forecasting models.

Random Walk Modely(t)=y(t-1) +ε(t)

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“Changes in the spot price are unpredictable, so the best forecast of the future spot price of the crude oil is simply the

current spot price.”

Price volatility: SD = 17.67

Price Range: $47.72 - $118.40

Price: $83.06

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“It’s an ideal situation we are in now,” says Ali Naimi, Saudi oil minister. “Consumers are happy, producers are happy. Companies are investing.”

"Energy developments in

2009 were dominated by a

global recession and, later in

the year, a tentative recovery

and we can't know how

durable this recovery will

be," said Tony Hayward, BP's

embattled chief executive

Voser warned of a

challenging year ahead. ‘So

far in 2010, oil prices have

remained firm, and demand

for petrochemicals has

increased, but refining

margins, oil products demand

and spot gas prices all remain

under pressure,’ he said.

Société Générale SA cut its oil price forecast $88 a barrel for 2011 to $85 as demand growth slows and production outside OPEC expands.

Will OPEC denominate oil price not in USD?

•Oil prices are highly volatile and are affected by supply & demand, dollar strength, oil speculation and risk premium

•Oil is politically driven as it is an essential commodity and it is unequally distributed in the world

•Oil has emerged as a separate asset class due to its negative correlation with the dollar and stock markets

•In recent years, oil prices are becoming more “forward looking” as speculators increased their share of trading dramatically

Key takeaways

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