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Energy and Financial Markets Overview

:
Crude Oil Price Formation

Richard Newell, Administrator
May 5, 2011

www.eia.gov

EIA’s Energy and Financial Markets
Initiative
• Collection of critical energy information to improve market
transparency
– improved petroleum storage capacity data
– other improvements to data quality and coverage

• Analysis of energy and financial market dynamics to improve
understanding of what drives energy prices
– internal analysis and sponsorship of external research

• Outreach with other Federal agencies, experts, and the
public
– expert workshops
– public sessions at EIA’s energy conferences
– solicitation of public comment on EIA’s data collections

Richard Newell, May 5, 2011

2

Synthesis of current perspectives on oil
price formation

Richard Newell, May 5, 2011

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speculators. and others • commodity trading advisors. and individuals • swap dealers: typically banks and merchants serving customers • Policymakers – demand-side (subsidies).Who’s who in global oil markets • Producers – international oil companies (private) – national oil companies (government-controlled) • Consumers – individuals (autos and space-heating) – transportation fleets (trucking. endowments. 2011 4 . supply-side (OPEC quotas). shipping. and investors – merchants: firms facilitating physical trade – financial market participants • index investment by pensions. air) – industrials (chemicals and plastics manufacturers) and power generation • Traders. hedgers. May 5. market regulation (position limits) Richard Newell. hedge funds.

Many factors influence the formation of oil prices and other energy prices Supply Physical balancing Demand Affected by current conditions and future expectations for: • Inventories Affected by current conditions and future expectations for: • • • • • • • • • • Energy prices ‐ spot ‐ futures ‐ options ‐ spreads ‐ swaps energy prices OPEC supply capacity usable spare capacity non-OPEC capacity geopolitics weather E&P costs E&P investments E&P innovations Richard Newell. 2011 Markets & market behavior • Other financial markets ‐ other commodity prices ‐ commodity investment ‐ currency exchange rates ‐ stocks and other assets ‐ interest rates • • • • • • • energy prices economic growth industrial production goods transport personal transport weather innovation in energyusing equipment 5 . May 5.

and commodity index funds). 2011 6 . but still at an early stage • Some researchers are finding evidence that factors including unexpectedly strong economic growth in China and stagnant supply were at least associated with. perhaps triggered by fundamental factors in both the oil market and the broader global economy • As discussed later in the presentation. and increased correlation of oil and other markets over the past several years Richard Newell. significant change in the composition of derivatives traders (such as the growth of swap dealers. the sharp oil price run-up and subsequent decline during the 2007-2008 period • The researchers are also finding some evidence suggesting that the price run-up and decline may have been exacerbated by the formation and collapse of an oil price bubble.EIA is actively examining the role of both supply-demand fundamentals and other factors in oil price formation • EIA has asked several academic partners to conduct thorough reviews of economic literature regarding supply-demand fundamentals and the role of financial market speculation and investment in the oil-price formation process – the work is ongoing. May 5. and may have contributed to. both internal EIA and academic research is also addressing the major increase in oil derivatives trading. hedge funds.

Crude oil prices react to a variety of economic and geopolitical events price per barrel (real 2009 dollars. Thomson Reuters Richard Newell. quarterly average) 140 Global financial collapse Imported ref iner acquisition cost WTI crude oil 120 Iran-Iraq War 100 Low spare capacity 80 9-11 attacks Saudis abandon swing producer role 60 Asian financial crisis U. 2011 7 . spare capacity exhausted 40 OPEC cuts quotas 4.7 mmbpd 2000 2005 2010 Sources: EIA.S.2 mmbpd Iranian revolution 20 Iraq invades Kuwait Arab Oil Embargo 0 1970 1975 1980 1985 1990 1995 OPEC cuts quotas 1. May 5.

2011 8 . May 5.World oil prices move together due to arbitrage price per barrel (real 2009 dollars. monthly average) 160 140 120 100 WTI crude oil Brent crude oil MARS crude oil Tapis crude oil Dubai crude oil 80 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Sources: Bloomberg. Thomson Reuters Richard Newell.

Crude oil prices are the primary driver of petroleum product prices price per gallon (real 2009 dollars. May 5.00 160 100 Hurricane Katrina shuts down refineries & pipelines 80 1. Thomson Reuters Richard Newell.00 40 gasoline wholesale (left axis) diesel wholesale (left axis) 0.00 120 2.50 60 1. 2011 9 . monthly average) price per barrel (real 2009 dollars) 4.00 Forecast Unplanned refinery down-time 3.50 20 WTI crude oil (right axis) 0.50 140 Post-hurricane refinery repairs 3.00 2001 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Sources: EIA.50 2.

2011 10 .Oil demand Richard Newell. May 5.

led by China – growth expectations for Asia ex-Japan approached 10% by 2010 • Price increases tamp-down fundamental demand drivers – the net effect on consumption depends on the relative strength of price impacts and economic growth Richard Newell. 2011 11 . May 5.Oil demand and consumption: What matters? • Oil consumption is determined by demand drivers and price • Demand is closely related to the state of the global economy – oil is an input into industrial production and the transport of goods – household income and employment drive personal transport demand • Demand in recent years has come increasingly from nonOECD countries.

2011 12 . economic growth has a strong impact on oil consumption percent change (year-on-year) 12 Forecast 10 8 6 4 2 0 non-OECD oil consumption non-OECD GDP -2 -4 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Sources: EIA. IHS Global Insight Richard Newell.In non-OECD countries. May 5.

2011 13 . 2009 2010 0 2007 2008 2009 2010 2011 Source: IHS Global Insight Richard Newell. which tends to move toward the actual realized growth outcome 2 as the year progresses..Economic growth in Asian economies surprised to the upside in 2007 and 2009 and to the downside in 2008 percent GDP growth in Asia-ex Japan (annual expectations) 10 9 8 7 6 2007 5 2008 4 Starting in January of each year. Expectations continue to evolve into the next calendar year as revised GDP data become available (e. 2007 GDP 1 expectations are revised even during 2008). each line shows the expected forecast of GDP growth for 3 the specified calendar year. May 5.g.

2011 14 . May 5. Thomson Reuters Richard Newell.In OECD countries. price increases have coincided with lower consumption percent change (year-on-year) price per barrel (real 2009 dollars) 6 135 Forecast 4 90 2 45 0 0 -2 -45 OECD consumption (left axis) -4 -90 WTI crude oil (right axis) -6 -135 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Sources: EIA.

despite high economic growth percent change (year-on-year) price per barrel (real 2009 dollars) 6 135 Forecast 5 4 90 3 2 45 1 0 0 -1 World oil consumption (left axis) World GDP (left axis) WTI crude oil (right axis) -2 -3 -45 -4 -90 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Sources: EIA.Rising oil prices held down global oil consumption growth from 2005-2008. 2011 15 . Thomson Reuters Richard Newell. May 5.

Oil supply Richard Newell. May 5. 2011 16 .

almost no near-term price-driven variation in production levels – even with rising prices.Oil supply and production: What matters? • OPEC – actively sets production quotas for members (compliance varies) – can influence prices with announced price targets and quotas – maintenance of spare capacity by Saudi Arabia gives it the option to pursue price objectives – in times of low spare capacity. there was almost no net annual production increase during 2005-2008 Richard Newell. OPEC’s ability to respond to supply shocks or rising demand is reduced – this reduced ability coincided with 2004-2008 oil price increases • Non-OPEC – production is typically at or close to full capacity – unlike OPEC producers. 2011 17 . May 5.

Thomson Reuters Richard Newell. May 5. 2011 18 .OPEC production often acts to balance the oil market. OPEC quota cuts tend to lead to price increases million barrels per day change (year-on-year) percent change (year-on-year) 5 100 4 80 3 60 2 40 1 20 0 0 -1 -20 -2 -40 -3 -60 OPEC quotas (left axis) WTI crude oil (right axis) -4 -80 -5 -100 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Sources: EIA .

Non-OPEC production saw strong growth in 2009-2010.5 35 0.0 -70 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Sources: EIA. EIA expects these increases to slow in 2011-2012 million barrels per day change (year-on-year) price per barrel (real 2009 dollars) 2. 2011 19 .5 105 1.0 140 Forecast 1.0 0 non-OPEC production (left axis) -0.5 -35 WTI crude oil (right axis) -1. Thomson Reuters Richard Newell.0 70 0. May 5.

Short Term Energy Outlook Richard Newell.0 Starting in January of each year.5 49.5 50. which tends to move toward the actual realized growth outcome as the year progresses. each line shows the expected forecast of non-OPEC supply growth for the specified calendar year. 2011 20 .Non-OPEC supply expectations were adjusted upward in 2009-2010 after production decreases during downturn million barrels per day (annual average expectations) 52.5 2007 2008 2009 2010 2011 Source: EIA.5 2008 2011 2009 51. May 5.0 50.0 48.0 2007 2010 51. 49.

limiting its ability to respond to demand and price increases spare capacity (million barrels) price per barrel (real 2009 dollars) 7 140 Forecast spare capacity < 2. May 5.5 million barrels 6 120 OPEC spare capacity (left axis) 5 100 WTI crude oil (right axis) 4 80 3 60 2 40 1 20 0 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: EIA. 2011 21 . Thomson Reuters Richard Newell. OPEC’s spare production levels were low.During 2003-2008.

May 5. Thomson Reuters Richard Newell. 2003-2008 saw periods of very strong economic and oil demand growth.5 million barrels Forecast 5 4 90 3 2 45 1 0 0 -1 World capacity* (left axis) -2 -45 World GDP (left axis) WTI crude oil (right axis) -3 * World capacity = OPEC capacity plus non-OPEC production -4 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 -90 2012 Sources: EIA. slow supply growth and tight spare capacity percent change (year-on-year) 6 price per barrel (real 2009 dollars) 135 spare capacity < 2. 2011 22 .In summary.

2011 23 .Inventories: The balancing point Richard Newell. May 5.

May 5.Inventory builds go hand-in-hand with increases in future oil prices relative to current prices (and vice versa) million barrels change (year-on-year) dollars per barrel change (year-on-year) 200 20 150 15 100 10 50 5 0 0 -50 -5 -100 -10 OECD inventory (left axis) -150 -15 WTI crude futures spread (12-month-ahead minus next-month's futures price. right axis) -200 -20 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Sources: EIA. Thomson Reuters Richard Newell. 2011 24 .

Financial market activity Richard Newell. 2011 25 . May 5.

and commodity index funds in oil derivatives trading – to date. as one indicator of changing linkages among markets – the relationship between changing information in the marketplace and changing expectations. building on our recent use of futures and options prices to measure the uncertainty surrounding future price expectations Richard Newell. 2011 26 . perhaps triggered by fundamental factors in the oil market and the global economy • Internal work is looking at several relationships – the relationship between levels of index investment. hedge funds. May 5.EIA is reviewing information that bears on several proposed linkages between physical and financial markets • Our academic partners are looking at the growth of swap dealers. and oil price changes – movement in the correlation of daily returns between energy and other assets. both for crude and commodities more generally. they have not identified any rigorous research that either proves or disproves that speculation caused or contributed to 2007-2008 oil price volatility – some evidence suggests that the price run-up and decline may have been exacerbated by the formation and collapse of an oil price bubble.

Commodity derivatives have multiple roles in the market • Successful futures and derivatives markets can help improve market efficiency – provide transparent price discovery – tools for managing and hedging price risk – serve as a vehicle for investors to diversify their portfolios • Derivative trading can also influence the degree of price fluctuations – moderation (arbitrage can reduce price discrepancies and smooth them over time) – amplification (if herding behavior and/or bubbles occur) • Prices could diverge from what physical factors alone may warrant. 2011 27 . particularly if current conditions and expectations about the future are uncertain – identifying the magnitude of such episodes is extremely challenging Richard Newell. May 5.

6% to 5.The attraction of commodity diversification brought increased institutional investment during the oil price rise • Crude oil and other commodities were an attractive investment – expectations for crude oil demand were high in 2007 and the first half of 2008 – crude oil price had historically been slightly negatively correlated or uncorrelated with other investments up until 2008 • There were increased risks to traditional asset classes. as evidenced by unfavorable trends in indicators linked to these assets over the period July 2007-July 2008 – equities: unemployment rose from 4.1% (Cleveland Federal Reserve Bank) – real estate: S&P/Case Shiller Home Price Index fell 14.8% (Bureau of Labor Statistics) – bonds: annual inflation expectations rose from 2. 2011 28 .6% to 3. May 5.9% Richard Newell.

800 1.600 1.000 800 600 400 200 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Bloomberg Richard Newell.Open interest in crude oil futures grew over the last decade as more participants entered the market average daily open interest in crude oil futures (thousands of contracts) 1. 2011 29 .400 1.200 1. May 5.

with a strong negative correlation in recent years • In contrast. but the relationship has recently weakened Richard Newell. crude oil and natural gas returns have been correlated over the past decade. 2011 30 .S. Treasury bonds • The correlation between crude oil and the dollar has varied over the past decade. April 21.Daily return correlations between oil prices and other asset classes have generally strengthened in recent years • The correlation between daily returns on crude oil and other globally-traded commodities has strengthened over the past few years • Crude oil also began showing stronger absolute correlations in 2008 with the S&P 500 and U.

25 to 0.65 > 0.4 -0.65 -0.4 0. May 5.25 to 0.25 -0.65 to -0.Correlations between daily price changes of crude oil and other commodities generally rose in recent years 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Energy Natural Gas Gold Metals Copper Silver Soybeans Agriculture Corn Wheat WTI crude oil price peak < -0.65 Negative correlation Positive correlation Note: Correlations computed quarterly Richard Newell.25 0. 2011 31 .4 to -0.4 to 0.

25 0. Treasury is based on the negative of the change in yield on 30-year U. Treasury WTI crude oil price peak < -0.25 to 0.4 to 0.S.S. the value of the index rises. dollar. Dollar Index (DXY).25 to 0.S.25 -0. ** U.Correlations (+ or -) between daily returns on crude oil and financial investments have also strengthened 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 S&P 500 U. 2011 32 .S. per U.4 to -0. Dollar U.65 to -0. Note: Correlations computed quarterly Richard Newell.4 -0.S.65 Negative correlation Positive correlation * U. bond prices fall. which is a weighted index of a basket of currencies.65 > 0.4 0.S.65 -0. As the dollar strengthens against other currencies. May 5. government bonds because as yields rise.

processors. end users and swap dealers. 2011 33 . Source: CFTC Commitment of Traders Richard Newell.Non-commercial participation in commodity derivative markets has been increasingly on the buy-side (net long) number of contracts (thousands) 250 Non-commercial net open interest 200 Commercial net open interest 150 100 50 0 -50 -100 -150 -200 -250 -300 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Note: Non-commercial consists of managed money and other market participants. merchants. Commercial consists of producers. May 5.

even if we limit attention to the postDecember 2007 period – preliminary evidence suggests that a broader commodity measure may have a different relationship to oil price movements than one that considers only the level of oil index investment Richard Newell. May 5. but it is only available postDecember 2007 – suggests that investment positions in oil futures and derivatives moved counter to oil prices during 2008 and early 2009 – the use of supplemental CFTC commitment-of-traders data to look back further for oil (by backing out other commodities) is methodologically difficult • We are also looking at other measures of index investment in all commodities – constructing a measure of index investment that aggregates across commodities is even more challenging.Did the level of commodity index investment move with or counter to movement in oil prices? More evidence is needed • CFTC “special call data” on commodity investment is an important source of information. 2011 34 .

6% Gold 10. CME Group Richard Newell.3% Soybeans 7.9% Sugar 3.Crude oil plays a major role in commodity investment 2011 Target Weights of the Dow Jones .8% Nickel Live Cattle Lean Hogs 2.2% Natural Gas 12% Copper 7.UBS Commodity Index Zinc 2.3% Aluminum 5.4% Cotton 2.0% Gasoline 3.9% Wheat 4.2% 3.4% Soybean Oil 2.0% Source: Dow Jones Indexes.4% 2.5% Heating Oil 3. May 5.6% Corn 7.0% Crude Oil 15% Silver 3.5% Coffee 2. 2011 35 .

then rose as prices fell 700 135 600 125 500 115 400 105 300 95 200 85 100 75 0 65 -100 55 -200 45 Long (left axis) -300 2007 Short (left axis) 2008 2009 WTI 1st nearby (right axis) 35 2010 Sources: CFTC Special Call Report. the size of CFTCreported index investor positions fell as prices rose. May 5. 2011 36 .Index investors' CFTC futures-equivalent positions may have actually run counter to movements in oil prices index investor future-equivalent positions (thousands of contracts) price per barrel (real 2009 dollars) from the end of 2007 through early 2009. Bloomberg Richard Newell.

2011 37 .4 1.2 Commodity index investment reported to CFTC under "special call" 0 2005 2006 2007 2008 2009 2010 2011 Source: CFTC.S. commodity funds) 0.6 0. commodity funds compared to CFTC’s total index notional investment asset value ratios relative to December 2007 (normalized dollars) 2.6 1.4 Assets under management (five largest public U.2 2 1.8 1. May 5.4 2.8 0.2 1 0. Bloomberg Richard Newell.Assets under management by largest U.S.

increased interest in oil as an asset class • Activity in markets for other commodities. bonds. May 5. however. and should be considered in analysis of oil price formation • Additional research is needed to better understand the linkages among these markets Richard Newell. 2011 38 . and foreign exchange has become more highly correlated with oil. equities.Oil price formation: both physical and financial markets matter • Supply and demand fundamentals remain a key underlying driver of oil prices – the low near-term responsiveness of both oil consumption and production to price changes is an essential factor underpinning oil price volatility • Financial market conditions in the past few years have.

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