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New York Energy Forum
Presentation to:
April 10, 2008
Wall Street and the price of oil
Adam RobinsonEnergy Research [email protected]
Agenda
I. Wall Street and today’s oil price environment
II. Wall Street and the term structure of oil prices
III. Wall Street and the volatility of oil prices
IV. Conclusions
Wall Street and the price of oil
Wall Street’s financial crisis temporarily breaking the links between the physical and financial markets for crude oil
Wall Street facilitating huge financial demand for commodities
The investment vehicles created by Wall Street to express that financial demand are artifacts of a less liquid market and create distortions in the term structure of oil prices
Even when markets are functioning normally, if banks build up a concentrated position in the options market at particular strikes, they can affect crude oil price volatility
1
I. Wall Street and today’s oil price environment
There are two markets pricing oil for delivery in five years
Long-dated NYMEX WTI (and natural gas) have shot up
WTI vs. HH NG 5-yr out in $/boe + 40/60 blended price
________________Source: Bloomberg.
$98.42
$55.01
$72.38
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WTI HH NG 40% oil, 60% gas blended price
$/boe
2
Price of US reserves valued through US M&A activity
________________Source: John S. Herold Upstream M&A Review
$0.00
$2.00
$4.00
$6.00
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$12.00
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Weighted Average Implied ProvedReserve Value US$/Boe
There are two markets pricing oil for delivery in five years
While the price of US reserves has flat-lined
3
The market for US oil assets provides another data point for long-dated crude oil prices, holding US costs and politics constant
Higher costs in the US could explain the difference…
US Oil Production
Costs
US Tax Regime and Political Uncertainty
Global Supply-Demand Balance
Value of a US Oil Field
Value of Long-Dated WTI
Financial Demand for Crude Oil
Global Supply-Demand Balance
These should trend together if fundamentals are behind
WTI price changes
4
But despite what some are saying, US costs are flattening
________________Source: US Bureau of Labor Statistics
US PPI Oil Producer Cost Indices are flattening (3-month moving average)
90
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-02
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Oil Field, Gas Field Machinery (MA) Rotary oil & gas field drilling machinery & parts (MA)
Oil field and gas field production machinery (MA) Support activities for oil & gas operation (MA)
5
US drilling cost rise and fall even more stark
________________Source: US Bureau of Labor Statistics
US Drilling cost PPI (3-month moving average)
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6
Even deepwater drilling costs are flattening
Deepwater Rig Day-Rates
________________Source: ODS-Petrodata and Lehman Brothers Estimates
0
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600
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-01
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-08
Semisubmersible Dayrates, U.S. GOM, 5,000- to 7,499-Foot Semisubmersible Dayrates, U.S. GOM, 7,500-Foot or More
Semisubmersible Dayrates, North Sea, 3,000- to 4,999-Foot Drillship Dayrates, GOM, Dynamically Positioned
Avg dayrates in '000 dollars
7
So with costs flat, what explains the markets’ divergence?
Relative to the fundamentals, either US reserves are undervalued or WTI is overvalued
Index of WTI/HH prices vs US reserves valued through US M&A activity
________________Source: John S. Herold Upstream M&A Review
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Index of weighted average implied proved reserve value
Index of 5-yr out blended oil/gas prices weighted by average share of each fuel in the reserves purchased during the quarter
Index = 100
8
Wall Street turmoil may be allowing an arbitrage between the two markets to open
Rule of thumb for the US: To find the arbitrage equilibrium, multiply reserve valuation by 3-4x to get expected minimum realized blended oil/gas priceAssumptions Cost of proposed reserve acquisition: $15/bbl Lifting cost: $8/bbl R/P Ratio: 10 years Required minimum ROCE: 10% Government take = 40%
Math Total capex = $15/bbl for 10 years = $150/bbl of daily capacity That requires $15/bbl of daily profit to make a 10% return on capex Assuming a 40% tax rate, profit before tax must equal $25/bbl Then you must cover capex of $15/bbl and lifting costs of $8/bbl, meaning your overall realized price must equal $25+$15+$8= $48, or 3.2x your capex cost If reserve owner expects a 20% ROCE, then expected realized oil price is $73 A 30% ROCE could be achieved if $100/bbl is realized
9
How Wall Street may have broken the markets’ link What may be preventing the arb?
– No access to credit to purchase assets
• Many producer hedges already underwater
– Counterparty risk and margin calls
• Grain elevator operators in 2008
– Inability especially of big players to hedge all production
• A big hedge could cause a major price drop (Mexico in Dec-06) Arb may work again if:
– Confidence rebuilds in the US banking system
– Financial instruments to mitigate these risks become more widespread
10
So is NYMEX overvalued or reserves undervalued?
Cost of exploration and price of US oil assets are substitutes
– Could provide an anchor to price of oil reserves as the arb closes, forcing NYMEX WTI down
But in the meantime, in the absence of producer selling or links to the market for physical oil reserves, WTI prices can trade purely on financial flows
11
So what might be fair value for long-dated NYMEX WTI?
Higher US costs appear to explain much of the rise in long-dated WTI prices until the divergence in October 2007.
US monthly PPI data regressed against average monthly 5-yr out WTI prices
$91.19
$70.52
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5-year out Dec avg monthy WTI price Predicted 5-yr out WTI based on PPI cost indices
$/bbl
- R2 through Oct-07 is 96% - Divergence worsens: Dec-13 WTI to average $98 in Mar-08
12
And if natural gas holds its gains, oil could drop even lower
Stronger natural gas prices take pressure off of oil to rise in order to provide an incentive for upstream investment
US monthly PPI data regressed against average monthly 5-yr out WTI prices
$65.62
$55.64
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5-yr out Dec avg monthly blended pricePredicted 5-yr out blended price based on PPI cost indices
- R2 through Sept-07 is 94%- Divergence worsens: Dec-13 averaged $72.51 in Mar-08
$/boe
13
Meanwhile, thanks to Wall Street, financial prices have no physical price ceiling and can trade on almost anything
WTI 1M vs. DXY Index WTI 1M vs. Inflation*
While correlations have recently strengthened, there is no longer-term relationship to justify the moves in the medium-term
________________*Inflation compensation as measured by the difference between 10-year treasuries and 10-year TIPSSource: Bloomberg, Lehman Brothers Estimates
-0.8
-0.6
-0.4
-0.2
0.00.2
0.4
0.6
0.8
1.0
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WTI-10yr Treas/TIPS Breakeven 6-mth rolling correlation
-1.0-0.8-0.6-0.4-0.20.0
0.20.40.60.81.0
Jun-03
Oct-03
Feb-04
Jun-04
Oct-04
Feb-05
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WTI-DXY 6-mth rolling correlation
14
How does this play out? Oil stocks build if the price is too high for the physical market, causing suppliers to over-
produce and consumers to under-consume But eventually inflation will be real or it won’t
– If commodity price inflation leads to core inflation, Fed will have to put a floor on interest rates, the dollar rallies and commodities tank
– If the deflationary impact of the US recession offsets commodity price inflation, then investors have an expensive + unnecessary hedge vs inflation and commodities tank
Meanwhile: High commodity prices may add to other pressures on the economy and aggravate the US
recession and lower physical demand further High commodity prices may aggravate any transmission of US economic weakness to the
rest of the OECD as well as emerging market economies
Investors buy commodities as an inflation hedge, pushing up commodity prices, which then pushes up inflation
What happens when Wall Street turmoil removes the physical ceiling on the financial market?
15
II. Wall Street and the term structure of oil prices
Wall Street as creator and seller of commodity indicesAfter years of Wall Street going after pension funds, they finally started to listen early this decade
Efficiency Frontier for a 60/40 Portfolio of Stocks (S&P500) and Bonds (U.S. Agg.)
Volatility
60% LBCI
0% LBCI
25% LBCI
7%
8%
9%
10%
11%
12%
13%
14%
15%
16%
6% 7% 8% 9% 10% 11% 12% 13% 14%
Return
________________Source: Lehman Brothers estimates
16
Wall Street benchmark commodity indices are channeling investment into the wrong part of the curve
In 1990s, liquidity only in the front
Producer hedging or OPEC’s market power kept curves backwardated
Passive investors are now herded into the front
– GSCI roll has been negative since 2004
GSCI spot and roll returns, 1999-2007
-80%
-50%
-20%
10%
40%
70%
100%
130%
Spot Return 34% 97%
Roll Return 10% -72%
Overall Return 44% 25%
1999-2003 2004-2007
________________Source: Bloomberg, NYMEX, S&P GSCI
Ideally a passive investor would buy a commodity and never sell it. So why invest at the very front of the futures curve?
17
But liquidity should no longer be an excuse
Nymex WTI futures avg open interest
0
100
200
300
400
500
600
700
800
1M 2M-12M 13M-60M
1999 2003 2007
mn bbls
2003-2007 Grow th: 328%
2003-2007 Grow th: 132%
2003-2007 Grow th: 96%
________________Source: Bloomberg, NYMEX, S&P GSCI
Particularly in the energy sub-indices, liquidity in the back of the curve has grown much more quickly than in the front
18
Investing exclusively in the front contract exposes passive investors to unnecessary risks Risk 1: Other investors agree with index players Risk 2: Index overcrowding Risk 3: No way to exit the front contract after a spike
– Indices gave back all of their gains in natural gas after Hurricane Katrina and in oil after the Iraq War of 2003 in the four months following the spike
– If oil spikes, it can hurt performance of non-energy commodities by weakening the global economy
LBCI vs LBPB after 2003 Iraq War LBCI vs LBPB after Hurricane Katrina
________________Source: Lehman Brothers estimates
-5.8% -6.7%
5.3%
10.0%
-10%
-5%
0%
5%
10%
15%
Crude Total LBPB vs. LBCI
Feb-03 returns Cumulative returns for 4 months post Feb-03
-23.9%
-2.6%
28.2%
6.8%
-30%
-20%
-10%
0%
10%
20%
30%
Nat gas Total LBPB vs. LBCI
Aug-05 returns Cumulative returns for 4 months post Aug-05
19
Wall Street and new structured product innovationTo address these risks, Wall Street is designing new indices that are likely to catch on, spreading index length along the oil curve and taking pressure off the front during roll periods New indices should focus on roll methods
– Should balance transaction costs vs footprint New indices should invest in longer-dated
futures but also take open interest into account If the ideal is the spot return ex-roll yield, why
not buy the contract whose spot + roll return best correlates to the spot return?
2007 2005-2007 2002-2007
LBPB outperformance by commodity index (%)
LBPB with LBCI weights 5.2 45.0 119.4
LBPB with DJAIG weights 12.9 70.1 178.8
LBPB with GSCI weights 5.2 36.5 105.8
LBPB outperformance by commodity sub-index (%)
Crude Oil 4.8 31.1 107.3
Natural Gas 6.0 39.6 107.2
Gasoline 7.7 98.2 188.0
Heating Oil -4.6 38.7 125.3
Aluminum 10.4 33.4 53.9
Copper 5.0 49.6 74.0
Gold 0.0 1.1 2.0
Soybeans 2.5 19.3 48.5
Corn 9.8 33.6 35.2
Wheat 25.7 48.6 56.3
Lehman Pure Beta boosts index returns regardless of commodity weights used
________________Source: Bloomberg, Lehman Brothers estimates
20
III. Wall Street and the volatility of oil prices
Oil market volatility likely to stay high for fundamental and flow-related reasons Tight markets become more volatile as demand runs up against supply limits, then retreats with
additions of new capacity Stealth supply + black hole demand obscure signals about tightness Wall Street option-positioning now means that banks will tend to buy in a rising market and
sell in a falling one, accentuating price swings
1M WTI Implied ATM Volatility (30-day rolling average to March 26, 2008)
________________Source: Bloomberg
252729313335373941
Jul-
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Au
g-0
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ATM Implied Volatility, WTI 1M, 30-day moving average
%
21
Telling the 2007 price story as a Wall Street options trader
It all started with producers using options to hedge the falling market of late 2006 Banks sold $50 and $60 puts to producers Producers sold $70 and $80 calls to banks Banks also sold lottery tickets to hedge funds As oil prices dropped in early 2007, banks sold oil to hedge Once oil turned around, banks bought back their hedges As oil pushed to $70, banks started selling to hedge calls bought from producers On the other side of $80, banks had to worry about the calls they sold to hedge funds, buying and pushing prices quickly to $100 If hedge funds roll out their strikes to $120-$150, prices and volatility could continue to run higher
22
0
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ep
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-Oc
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-Oc
t
$/contract
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95$/bbl
WTI Dec 07 90 calls (lhs) WTI Dec 07 futures (rhs)
As WTI approached $90 strike, call options created feedback loop to crude prices
Telling the 2007 price story as a Wall Street options trader
________________Source: Bloomberg, as of 29 Oct 07
WTI Dec 07 vs WTI Dec 07 90 calls
23
IV. Conclusions
To conclude, Wall Street matters on many levels
Wall Street’s current crisis has made it difficult and scary for physical players to access the oil markets
Meanwhile it has made it easier for financial players to enter
And through options it has created more volatility in the market in certain times
24
How will Wall Street change the markets going forward?
As more banks make markets and longer-dated liquidity deepens, it will be easier for producers to hedge oil price risk
– May take some risk premium out of oil prices Wall Street also to convince pension funds to transfer length
from front to back
– Curve may shift to contango Current Wall Street turmoil may exacerbate China overcapacities
vis-à-vis the stock market Refining business about to undergo massive changes
– Requires new risk management solutions from Wall Street
25
________________Source: ODS-Petrodata and Lehman Brothers Estimates
Most critical, Wall Street needs to fund frontier investments
If cost inflation ending, non-OPEC supply may finally respond to higher prices Financing critical to development of the deepwater, arctic, biofuels, GTL and oil shale Wall Street will be critical to financing the supply gap post-2010 if the politics in OPEC do not improve
OPEC production capacity growth vs. global oil demand growth
-500
0
500
1,000
1,500
2,000
2,500
3,000
2008 2009 2010 2011 2012
OPEC crude capacity grow th OPEC NGL grow th Global demand grow th
k/bd
26
Analyst Certification
I, Adam Robinson, hereby certify (1) that the views expressed in this research report accurately reflect my/our personal views about any or all of the subject securities or issuers referred to in this report and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.
"To the extent that any of the views expressed in this research report are based on the firm's quantitative research model, Lehman Brothers hereby certify (1) that the views expressed in this research report accurately reflect the firm's quantitative research model and (2) that no part of the firm's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report."
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Analyst Certification and Disclosures
27
