Olle Östensson

1. The energy crisis: Background and outlookShort courses for Permanent Missions in GenevaAdapting to the new energy realities: trade and development perspectives31 October 2008 Olle Östensson

2. Outline • A short history of the oil price boom • Why did oil prices rise and why did they rise by so much? • How high is high? The argument for continued (relatively) high oil prices

3. In the general commodity boom, energy prices stood out

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

5. Price increases for coal and natural gas were more modest

6. 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?

7. Global oil demand, change on previous year, % Forecast September 2008 Source: International Energy Agency, Oil Market Report, various issues

8. 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

9. Developed countries still dominate total demand

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

11. China was expected to follow “the Korean path”

12. 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

13. 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

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

15. 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

16. 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 • 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

17. 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.

18. 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.

19. 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

20. Speculation? • Financial speculation involves the buying, holding, selling and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividends or interest. (Wikipedia) • Distinction between speculation and manipulation: speculators benefit from market variations, market manipulators attempt to influence variations

21. Speculation?Argument 1: Direct influence of futures markets • 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

22. 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

23. Who invested in oil futures and what was the effect? (1) • 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

24. Who invested in oil futures and what was the effect? (2) • During most of the period of price increases, the oil futures markets were in backwardation, that is, the prompt price was higher than the future price • The backwardation meant that the banks made a profit from their hedges • Other investors, who bought futures contracts directly, rather than as part of an index, also profited from the backwardation

25. 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 benefit from physical shortages

26. Who invested in oil futures and what was the effect? (4) Source: CFTC Fact Sheet – Speculative Trading in Crude Oil Market, June 23, 2008

27. Speculation?Argument 2: Indirect influence of futures markets • “Herd” behaviour • Holders of physical commodities observe that speculators are buying futures and conclude that prices are going to rise • They therefore hold onto their commodities or try to acquire more • The additional demand stimulates speculators to buy more futures and a price spiral results • Physical stocks are built up • The process continues as long as holders of physical commodities stand to gain from holding on to them, that is, as long as the market is in contango (future prices are higher than prompt prices), since otherwise they could earn more from selling • However, there was no sign of stock build up; in fact, stocks declined in 2008: and the market was in backwardation • The hypothesis that herd behaviour contributed to the price rise in a situation of physical shortage is consistent with the inventory data, although the hypothesis can not be supported by any positive evidence (this would require knowledge of the motives guiding the behaviour of holders of physical oil) • However, changes in speculative positions followed price movements • Moreover, since prices of commodities that are not traded on futures exchanges rose at least as much as those of commodities traded on exchanges, the hypothesis assumes two causes for the same effect, depending on whether a commodity is traded on a futures exchange

28. The “yield curve” for crude oil- the market was in backwardation except in early 2007

29. Where are oil prices going? • Demand • The rate of increase in oil demand has been modest compared to other commodities (only 2.2 %/year 2002-2007, the period of large price increases) and is unlikely to accelerate • Demand may be more sensitive to price increases than often thought • Developing Asia will account for most of the demand increase, but income elasticity is low (0.4 in China) and falling • The current oil price hike represents the strongest support programme that has ever existed to develop alternative energy sources and embark on a less carbon-emission-intensive economic development path • Governments may be prepared to commit to making high fossil energy prices permanent in order to stop climate change

30. Where are oil prices going? (cont’d) • Supply • Almost all energy production is extremely capital intensive and has low variable costs – this means that prices can vary dramatically in the short term, but in the long term all costs have to be covered • Increasing cost of non-OPEC conventional oil: low lifting costs, high finding and development costs • Non-conventional oil (heavy oil, bitumen, tar sands) has total costs of $70-90/bbl, high operating costs, environmental impacts are important and may constrain expansion • Non-oil alternatives (biofuels) have high costs – although Brazilian ethanol from sugar cane has production costs of $25-30/bbl - and capacity is constrained by availability of land and water, trade barriers and standards • OPEC oil can not be taken for granted

32. US Energy Information Administration: International Energy Outlook 2008 • Liquids production in reference case 112.5 Mb/day in 2030 (increase 1.2 %/year) • 9.7 Mb/day are projected to come from non-conventional sources, accounting for a quarter of the production increase • OPEC’s share of production increases very slightly (from 41 to 42%), the share of non-OPEC conventional oil falls Prices are assumed to remain relatively high

33. EIA forecast, Mb/day

34. OPEC production • OPEC is an intergovernmental organization operating on the basis of consensus, decisions are usually the result of compromises • Several OPEC producers are experiencing cost increases • Only a few have large enough reserves to be able to increase production significantly in the long term (Iran, Iraq, Kuwait, Sadi Arabia) • Iran and Iraq have large populations and could use additional income – but is such income better generated by increased market share or (continued) high prices? • Kuwait and Saudi Arabia have small populations and no need to increase their market share • Conclusion: OPEC can not be counted on to automatically make up the shortfall in world production, that is, act as swing producers

35. Conclusion: a realistic (?) assumption • The long term production cost of alternatives to conventional oil will set a floor for crude oil prices at US$ 60-80/bbl in today’s dollars • The price can and will fall below this floor, but only for limited periods

36. Thank you!