Philip K. Verleger, Jr. Haskayne School of Business, University of Calgary, and PKVerleger LLC

Oil Prices: The Short Run, the Long Run, and the Role of Policy

NABE Annual MeetingDenver, ColoradoOctober 11, 2010

Philip K. Verleger, Jr.

Haskayne School of Business, University of Calgary, and PKVerleger LLC

Outline

Short-run Oil Prices: Set in Europe Long-run Oil Prices: Shale gas may be a game

changer Energy Policy: Nothing but a potpourri of

gimmicks

Short-run Oil Prices

Europe has emerged as the marginal market and, to quote Marshall, we go to the margin of the market to discover prices.

The marginal product in Europe is diesel fuel (or gasoil). Demand is surging due to dieselization. European refiners are not capable of making product.

Europe has become heavily dependent on diesel exports from the U.S.

In 2008, Europe’s thirst for low-sulfur diesel caused oil prices to rise to $145 per barrel.

In 2010/2011, “benign neglect” of dollar could send oil over $100.

Short-run Oil Prices:Oil Prices Have Been In A “Rut”

Oil prices have been in a rut for several years. The price spike in 2008 as an anomaly. Much of the stability is due to higher inventories

and lower volatility in consumption. Passive investors have promoted inventory

accumulation. Substitution of natural gas and coal has captured

seasonal markets. A weak dollar could change the situation.

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lDated Brent Spot Price andNormal Range, 2005-2010

Normal Range

Note: Normal range excludes 2007/2008 and the financial collapse that followed.Source: Platts; PKVerleger LLC.

U.S. Distillate Product Supplied,Monthly Data, 1960-2010

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Source: U.S. Department of Energy.

Range in U.S. Distillate Consumption, 1960-2009 – High, Low, and Average of Product Supplied by Year

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Source: PKVerleger LLC.

High/Low

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Percent of Long Open Interest Attributable to Passive Investors in Certain Commodities, End-July 2010

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Source: CFTC index investment data.

Usable Commercial Stocks in OECD Countries – History and Normal Range

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Source: EIG; PKVerleger LLC.

Normal Range

Short-run Oil Prices:High Stocks Moderated Price Volatility

Record cold occurred in January 2010 in both the US, Europe and Asia.

There was no price spike, unlike prior episodes. The absence of price “spikes” is explained by

very high inventories. The very high level of inventories was linked to

passive investors.

PADD I Heating Oil Stocks, Weekly Data – 1989, 1999, 2009, and Normal Range

Note: Normal range computed from DOE data for years 1990 to 2009.Source: PKVerleger LLC.

Normal Range

Open Interest in Distillate Futures vs. Distillate Inventories, 2000-2010

Source: DOE; NYMEX.

Open Interest in Distillate Futures vs. Distillate Inventories, 2000-2010

2008-2010Observations


Distillate Forward Price Curve – End-December 1989,Second Week of January 2000, and End-December 2009


Short-run Oil Prices:Currency, Not “Fundamentals” The Risk

Today, oil price fluctuations are not caused by fundamentals. Inventories are high. Refinery capacity is in excess. Consumption is stable.

The marginal market has moved from the US to Europe. This will leave the price of oil in dollars subject to fluctuations in the euro.

Short-run Oil Prices:Europe Needs Diesel Imports

European energy policy has emphasized dieselization. European environmental policy emphasized ultra-low-

sulfur diesel fuel. European refineries are built to make gasoline, not

diesel. Diesel production can be boosted by using very light sweet

crude. However, European refiners cannot meet local demand.

Trade has solved the problem. The U.S. exports diesel to Europe. This makes the euro price of diesel the key determinant of crude prices.

U.S. Exports of Distillate Fuel Oilto the Netherlands, 2005-2010

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Short-run Oil Prices: Europe’sDiesel Thirst Caused ’08 Oil Spike

The 2008 crude price increase was caused by Europe’s shift to ultra-low-sulfur diesel.

EU environmental authorities ordered conversion by January 2009. However, the global refining industry was short of capacity.

Refiners bid up prices of sweet crudes with high distillate yields. Troubles in Nigeria added to the market squeeze.

Empirical proof of causality rests on the fact that cargos of heavy sour crudes could not be sold in the spring of 2008 at any price and the rise of retail prices relative to crude prices in Europe.

Short-run Oil Prices:Exhaustion of Desulfurization

Exhaustion of desulfurization capacity in 2008 at refineries left the world with four, not three, hydrocarbons. Natural gas Coal Sour crude Sweet crude

Sour crude could not be used to produce diesel fuel meeting European requirements.

Sweet crude oil makes up less than25 percent of world supply.

Cumulative World Oil ProductionSorted by Sulfur Content

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Sulfur Content (%)

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Nigeria accounts for a large share ofthe world’s sweet crude supply.

In good times, when production is not disrupted, Nigeria dominates the sweet crude market, producing 20% of crude with 0.1% sulfur or less 25% of crude with 0.2% sulfur or less 19% of crude with 0.5% sulfur or less

Sweet crude is valuable because it has avery high yield of low-sulfur diesel fuel.

Product Distillation Yields from a Standard Complex Refinery

Arab Heavy (Saudi Arabia)

Bonny Light(Nigeria)

Crude Sulfur Content (%)Volume of Gasoline (%)Volume of Diesel (%)

2.9417.418.5

0.1427.244.8

Source: EIG.

Much less sulfur must be removedto produce diesel from Nigerian crude.

3.5 kilograms of sulfur must be removed to make one metric ton of low-sulfur diesel from Nigerian crude.

180 kilograms of sulfur must be removed to make one metric ton of low-sulfur diesel from Arab Heavy crude.

Refiner capacity to remove sulfur from crude was limited.

Short-run Crude Outlook:Retail Prices in 2008 Provide Key Evidence

Some economists (Hamilton, for example) claim the price increase was caused by a global crude shortage. Their assertion implies that all product prices should have

increased in parallel. The evidence refutes this.

In Europe, retail diesel prices rose from 75 percent of gasoline to 110 percent of gasoline, suggesting it was diesel, not crude, that was in short supply.

Prices of light sweet crude followed gasoil (diesel) prices.

Evidence for the squeeze is found in therise of diesel price relative to gasoline.

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Monthly Diesel and Unleaded GasolineRetail Prices in Germany, 2006-2009

Gasoline

Diesel

In Germany, diesel prices rose to paritywith gasoline at retail during the

squeeze.

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Ratio of German Retail Diesel Price toGerman Retail Gasoline Price, 2006-2009

Short-run Crude Outlook: Civil War in Nigeria Contributed to Squeeze

Nigeria dominates world sweet crude market. Nigerian production collapsed in 2008 due to

civil war. The United States made matters worse by taking

sweet crude from the market and putting it in the Strategic Petroleum Reserve.

Nigerian crude production hasbeen disrupted by civil war.

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Nigerian Monthly Crude Output, 1999-2009

Short-run Crude Outlook: European Gasoil Demand Again Driving Crude

European gasoil consumption has increased with economic recovery.

Once again, buyers must turn to other markets. Product spot prices in Europe trade at a premium to

U.S. prices. So far, European prices are stable when measured in

euros. European prices are at a premium to U.S.

Oil prices measured in dollars have moved up as dollar has weakened.

Premium or Discount between European Gasoil and U.S. Gulf Coast Distillate, 2009-2010

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Dollar/Euro Exchange Rate vs.U.S. Gulf Coast Ultra Low Sulfur Diesel Price, 2010

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Short-run Crude Outlook: Expect Crude Prices to Move Inversely with Euro

Crude prices will likely continue to move in the opposite direction from the euro.

The failure of IMF meetings this weekend suggests the dollar will decline further.

U.S. policy to let the dollar fall seems aimed at isolating China just as Iran has been isolated.

Oil prices can be expected to rise as dollar declines in value. A dollar/euro exchange rate of 1.75 would yield $100-per-barrel crude.

Short-run Crude Outlook: Saudi Arabia Will Try to Stabilize Markets

Saudi Arabia has become skillful in managing the market by applying a De Beers-type procedure.

Saudi Arabia sets differentials for its crude relative to traded crudes in each market. Buyers nominate purchases based on premiums or discounts.

Other OPEC producers follow Saudi Arabia’s lead to avoid a price war.

The discounts influence OPEC volumes.

Discount to “B-Wave” for Cargos of Arab HeavyDelivered to Western Europe, January 2003 to October 2010

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Price Spread Set by Saudi Arabia for Arab HeavyDelivered to Europe vs. Adjusted OPEC Output, 2002-2009

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Price Spread Set by Saudis for Arab Heavy ($/bbl)

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Short-run Crude Outlook: OPECProbably Cannot Prevent Price Rise

Saudi Arabia is taking steps to limit price increases by raising discounts.

However, the principal market for Middle Eastern crude is in Asia. Prices now are being set in Europe.

Long-run Crude Outlook

Key factors influencing long-run crude prices: Global agreement on climate change World economic growth rates Expansion of natural gas production from shale Expansion in global supply

Long-run Crude Outlook:Shale Gas is a Real Game Changer

Natural gas production in the U.S. was supposed to end. New technical discoveries have vastly expanded

reserves. Increased availability of gas could threaten the position

of oil in many uses. On Friday, gas could be purchased for $23.50 per barrel while oil

sold for more than $80 per barrel. Forward natural gas prices have declined even as forward oil

prices have increased. The development of “fracking” could match the

development of the PC or the cell phone as a game changer.

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Natural Gas Daily Spot Price andNormal Range, 2005-2010

Normal Range

Note: Normal range excludes 2007/2008 and period before March 2006.Source: Platts; PKVerleger LLC.

WTI Forward Price Curve vs. Natural Gas ForwardPrice Curve, End-August 2007 vs. End-August 2010

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Long-run Crude Outlook:Shale Gas Could Change Economy

Availability of very low priced natural gas could improve U.S. competitiveness.

Other countries, particularly China, can be expected to apply the same technology aggressively.

History suggests that price differences of 5 to 1 will accelerate change.

Long-run Crude Outlook:Slow Global Growth Will Affect Prices

The global slowdown following 2008 will limit growth in oil use through 2015.

Lower demand combined with increased natural gas supplies could leave the oil market stuck at current demand levels.

Stagnation does not, however, necessarily imply that prices will fall. OPEC is much more sophisticated.

Long-run Crude Outlook:Outlaw Production Will Affect Prices

The current OPEC members, except Iraq, have been very disciplined since 1999.

Russia and Iraq, however, threaten OPEC’s ability to maintain price stability, just as De Beers’ control of diamonds was undermined by outsiders. Iraq intends to boost production to 12 million barrels per day from

2.3 million barrels per day, an increase that cannot be accommodated.

Russia, too, wants to boost production and build sales in Asia. It has opened a new pipeline and port.

Slow growth, increased supply, and competition from natural gas could break crude prices.

Long-run Crude Outlook: Global Warming Limits Could Have an Effect

Agreements to limit global energy use in 2050 to a fraction of 2000 use would depress oil demand and prices.

Prospects of agreements could, in theory, lead to lower levels of investment and lower supply.

The absence of agreements, on the other hand, could lead to supply squeezes of the type imagined to have occurred in 2008.

Any answers are unlikely before 2020.

Long-run Crude OutlookDodd/Frank Could Change Market

Dodd Frank could reduce the size of energy commodity markets. Congress wrongly blamed speculators for the price

spike. Position limits are required for energy commodities.

Regulators could force passive investors from markets.

The loss of passive investors would lead to lower inventory levels resulting in more price volatility.

Energy Policies:Almost All Gimmicks

For almost 40 years, the politicians and policymakers have refused to address the energy problem. Gimmicks have again and again substituted for serious action.

Free trade has been the rule. Energy has been the exception.

The consequences have been environmental disasters, bankruptcies of major auto companies, and the loss of manufacturing jobs.

The future promises to be full of more gimmicks and more economic losses.

Documents

Philip K. Verleger, Jr. Haskayne School of Business, University of Calgary, and PKVerleger LLC