Understanding Oil and Mineral Prices in the Financial Crisis

1. Oil and Mineral Commodities, and the Financial Crisis30 March 2009 Olle Östensson

2. Outline • A short history of the commodites price boom • Why did oil and mineral prices rise and why did they rise by so much? • The downturn: How much was due to the financial crisis? • The recession: • How deep and how long? • Will things go back to « normal »?

3. The commodity price boom

4. Crude oil prices 1960 to mid-2008, US$/barrel Source: UNCTAD Commodity Price Bulletin

5. Reasons for the price increase • Demand • Two years – 2003 and 2004 – with above trend increases • Geographical differences • Expectations • Supply • Slow capacity expansion • Low spare capacity, concentrated in one place • Inventories • Supply-demand imbalances and price spikes in commodity markets • Other factors • US$ depreciation • Mismatch of refinery capacity • Speculation?

6. Global oil demand, change on previous year, % Source: International Energy Agency, Oil Market Report, various issues

7. Shares of increase in global oil demand 2001-2007, % Large share for China, Middle East and Other Asia – but also for North America Source: International Energy Agency, Oil Market Report

8. Energy intensity, metric tons oil equivalent per thousand US$ in nominal and PPP 2000 exchange rates Source: International Energy Agency

9. China was expected to follow “the Korean path”, but didn’t

10. Reasons for price spikes in commodity markets • Very low short term price elasticity of demand because of lack of substitutes and because use cannot be postponed • Very low short term elasticity of supply because of fixed capacity and high capacity utilization (a logical consequence of product standardization) • When prices are perceived to be rising, target inventory levels are raised because buyers want to avoid paying higher prices • If there is a perceived risk of shortage, target inventory levels are raised to avoid having to default on deliveries • Precautionary stocking is insensitive to price increases and will continue long after prices have exceeded “reasonable” levels

11. Supply side factors: Capacity developments • Slow capacity increase • Low oil prices in the 1990s reduced the incentive to add to capacity • There was no spare capacity among non-OPEC producers • OPEC spare capacity • In the 1990s, OPEC had cut back production • As late as 2001, OPEC spare capacity was 5.6 million barrels/day • In June 2008, it was 1.5 million barrels/day (less than a week’s world consumption), all in Saudi Arabia

12. Supply side factors: Production costs • Production costs rose rapidly after 2000, both reducing incentives to invest and creating expectations about future price increases • The “peak oil” theory made arguments based on rising costs of production more credible

13. Production costs, conventional oil Source: US Energy Information Administration

14. Supply side factors: Inventories • The history of inventory changes is ambiguous – total OECD stocks were actually higher than normal in the first half of 2007 • OECD stocks fell in early 2008, particularly in Asia, creating an imbalance • Official stock build ups took place throughout the period of price increases and rumours of massive increases in Chinese stocks abounded • Very little information was available about stocks in producing countries • It is likely that a general atmosphere of uncertainty contributed to precautionary stocking behaviour

15. A source of uncertainty: Estimates of non-OPEC supply growth have been too optimistic in recent years Estimate 1 year ahead Estimate end of current year Sources: December editions of IEA’s Oil Market Report.

16. Summary of factors Sources: WTI: Reuters; OECD Days Supply: International Energy Agency and U.S. Energy Information Administration estimates; World Excess Production Capacity: U.S. Energy Information Administration estimates.

17. Other factors • US$ depreciation • Demand rose particularly fast in the transportation sector • Refineries produce products in fixed proportions, composition of crude oil is crucial • A shortage of light crude oil may have further fuelled the price increases

18. Speculation?The argument • Low returns on stocks and other assets led hedge funds and other investors to invest in commodity markets, particularly oil • The volume of investment was very large and, it is argued, drove up prices

19. How do futures markets for commodities work? • Futures markets trade contracts for future delivery of a certain quantity of a commodity • The contracts are almost always cashed in and very seldom do buyers actually take delivery in commodities • The attraction to investors or speculators compared to dealing in the physical commodity is (1) you avoid storage and handing costs and (2) you only have to pay a small part, usually 10 per cent, of the total price in advance; therefore the potential for profits is very large

20. Who invested in oil futures and what was the effect? • Banks and others sold “commodity index funds”, that is, financial instruments that were intended to replicate the price movements of commodities • Oil is usually a large component in the indices, since it is an important commodity in world trade • Since the sellers of commodity indices wanted to avoid losses, they hedged by buying contracts on commodity exchanges that corresponded to the indices that they sold – thus they would be able to pay off the investors; this activity was responsible for the vast majority of futures market investment • The sellers rolled over their hedges, that is, they sold the contracts for cash before the due date and bought new ones for more distant dates • Accordingly, no oil ever changed hands and the price of physical oil was not affected • The process can be compared to betting on the outcome of a tennis tournament – the bettors do not decide who wins the Wimbledon

21. Who invested in oil futures and what was the effect? (3) • No correlation between the amount invested in futures contracts and the price level • Changes in positions did not precede price changes, but followed them (US Commodity Futures Trading Commission) • Backwardation is the classical indication of a physical shortage, speculators exploit physical shortages

23. Mineral commodities • Above trend growth in usage • Under investment in the 1980s and 1990s because of low prices – therefore, capacity became a constraint • Inventories were gradually depleted • Price spikes resulted from precautionary buying – all buyers tried to ensure that they would be able to meet their needs

24. Average annual growth rates of usage of minerals, % per year

25. The main factor: China

26. Surplus or deficit (-) of global production over usage for lead and zinc, 1996-2007, per cent of production

27. Average quarterly prices and end of quarter inventories (LME) of lead and zinc, % of 4th quarter 2003 prices and end 2003 inventories

28. Iron ore prices, US$/ton Sources: UNCTAD Iron Ore Trust Fund, TEX Report, Metal Bulletin

29. Freight rates reflected the overall boomExample: Iron ore freight rates, 1999-2008, US$/ton Brazil-China Australia-China Sources: Drewry, SSY

30. The downturn • Did not happen at the same time for all commodities • The recession in the US began in the 4th quarter of 2007 – well before the collapse of Lehman Brothers in September 2008 • It started as a “typical” recession brought on by a commodity price boom • High commodity prices lead to higher general inflation, deterring investment and constraining production • Tightened monetary policies reinforce the trend, causing an end to the boom • But it became a financial crisis: “when the tide goes out, you can see who’s been swimming naked” (Warren Buffett) • As a result, worst recession since the Great Depression

31. Characteristics of the recession for commodities • Widespread downturn led to falls in demand • Note: Mineral commodities are used in construction, capital equipment and durable household goods, first sectors to be hit in the crisis • Lack of credit led to: • No trade finance • No working capital finance • No finance for investment • As a result, world trade was strangled and commodity demand fell precipitously

32. Monthly world crude steel production, % change year-on-year

33. Implications, oil and mineral exporters • Real exchange rate appreciation during boom • Undiversified exports and economic structure, low productivity growth • Subsidized fuel consumption, leading to allocation errors and inefficiencies • Widening income differences • Eventually, slow growth • But, the scenario takes place against a background of high incomes

34. Implications, oil importers • High energy costs act as a tax on development, reducing real income • For commodity exporters, effect is offset – at least to some extent - by high prices for export products, and prices of most commodites have fallen less than oil prices • Exporters of manufactures experience income losses

35. Terms of trade, developing countries and countries in transition Source: UNCTAD, Trade and Development Report, 2008

36. What happens now? • How long and how much will commodity prices be depressed? • Short to medium term • Long term

37. Short to medium term:Prices have fallen by less than generally thoughtAverage 2008 and December 2008 (2000=100)

38. Short to medium term, cont’d • Demand for food commodities has held up relatively well – people have to eat, even in a recession • Minerals and metals producers have cut production drastically, reducing the impact on prices • Oil producers (OPEC) have instituted cutbacks, but quota limits are not observed

39. Short to medium term, cont’d • The impact on investment has been severe, but has mainly hit projects that are in the midst of the project cycle • Projects that were almost finished are going ahead but may not enter into production • Long term projects are continuing, but at lower spending rates • Prices have probably bottomed out and will start rising slowly towards the end of 2009

40. The long term1. The new oil economy • The lesson learned from the oil crisis is that energy diversification is a necessity • This is reinforced by the need to slow climate change • Accordingly, oil demand will grow more slowly than otherwise • A “floor” to prices will be set by production costs for alternatives – US$ 50/barrel? • A ceiling will be set by moderate demand growth – US$ 80/barrel? • OPEC discipline will hold up if prices fall too far • Unknown factor: risk for new supply shortages due to under investment in exploration and development • What is the future for oil economies?

41. The long term2. Minerals and metals • Chinese transformation from export orientation to push for domestic demand – effect on minerals demand? • In spite of this, minerals demand is likely to grow fast in emerging economies because of rising incomes and need to improve infrastructure • Because of cuts in investment, bottlenecks may emerge quickly and prices could rise to new heights • Reinforcement of existing pattern of production, Africa may have lost its opportunity…and Russia?

42. Thank you!