Article based on academic research by an oil/gas expert. Shows why prices rose in 2008, and why they won't peak so high in the near future.

1. SMU - Cox : Research Detail 10/7/09 4:17 PM
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Title: Oil Market No Mystery: Look to Fundamentals
Discipline: Finance
Date: 09/2009
Executive Summary:
In summer and spring of 2008, Goldman Sachs analysts, Boone Pickens, and
other prognosticators said oil prices would rise to $200 or more a barrel, and
forecasts for $300 oil still linger. These voices, some with self-serving motives,
hold little sway on the real price of oil current or future. Unlike the stock market
which moves according to incident, expectations, confidence, and manias, oil
markets moves on the fundamentals of the real asset, something more tangible
and elemental.
SMU Cox oil and gas financial economist James Smith shows in his research
that the oil price spikes of the summer 2008 will not necessarily be the trend in
the future. Based on supply and demand factors, an analysis of which is
missing in many of the high-end forecasts, Smith clearheadedly reveals the
causes behind the much-debated high trajectory of oil prices and how the cartel
OPEC had a lot to do with it. His research "World Oil: Market or Mayhem?"
published in August's Journal of Economic Perspectives, offers a message of
what's to come based on history and fundamentals.
The Backdrop
From their "breathtaking ascent that reached $145 per barrel by July 2008," oil
prices then dipped below $40 per barrel again before the end of 2008.
Previously, oil prices were stabilized around $30 during 2000-2004. As of this
writing, oil has hovered in the neighborhood of $70 per barrel. Government
leaders concerned with future spikes, particularly in France and the UK, have
suggested regulating oil markets in their respective countries. Smith says that
such types of regulation typically create shortages. The U.S. had that
experience in the late-1970s and early 1980s when it tried its hand at price
regulation.
Smith writes that a unique combination of economic circumstances surrounds
oil markets. A short list would include:
extremely high price volatility;
the prominent role and unusual longevity of a major cartel (OPEC);
the size and scope of the oil industry and its links to economic growth;
doubts of oil's sustainability;
its CO 2 emissions that pulls oil into the center of the climate change
debate;
plus, a host of geopolitical issues that reflect the uneven distribution of
oil deposits around the globe.
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2. SMU - Cox : Research Detail 10/7/09 4:17 PM
Of the short list and its relation to the highs experienced that summer of 2008,
OPEC ranks at the top of the contributors list, alongside a series of supply
shocks in the run-up to July 2008. Smith says, "OPEC ran out of capacity and
couldn't accommodate the unexpected surge in demand, which occurred from
2004 onward. The capacity issue goes back several years; if OPEC had made
investments to build up capacity, they would have intervened before July 2008
to keep prices below $100 a barrel." He continues, "They did start upstream
investment in 2004, adopting a five-year plan, but it was not soon enough.
Today, they are cutting back on quite a few individual projects, though a
number are moving forward. "
The Facts
Global demand for crude oil has increased by 80 percent overall since 1975,
whereas actual OPEC production and non-OPEC supply have each grown by
just 24 percent. During the 1980s, while global demand for oil was shrinking,
the supply of non-OPEC oil was expanding robustly, putting substantial
downward pressure on price; and OPEC producers responded by cutting output
nearly in half between 1979 and 1985. After the steep decline of the 1980s,
OPEC production was not fully restored until 2004. "OPEC's production
restraint represents a commercial choice, not a geological ultimatum or a
reflection of high marginal costs," Smith says.
For 30 years, until roughly 2003, non-OPEC producers were able to offset
depletion of known reserves via exploration and technological innovation, and
managed to increase supply in concert with demand. Also part of the decrease
in supply that occurred after 2003 resulted from rapidly escalating costs in
production (like cost of pipe and drilling rigs) rather than resource depletion.
Over the long haul, demand has outrun non-OPEC supply.
From the period 2004 to 2008, global demand increased by 33 percent, while
non-OPEC supply decreased by 23 percent. Although OPEC members
responded by increasing their production, they lacked sufficient capacity (after
years of restrained oil field investments) to bridge the growing gap between
global demand and non-OPEC supply. Prior research by Smith revealed that
OPEC's goal is to set the price, and members synchronize production levels in
pursuit of that goal.
OPEC's hand
Consumers have suffered from OPEC's failure as well as its success: failure to
manage installed capacity has increased price volatility, while success in
restricting capacity growth has driven up the average price level. OPEC's
production capacity - 34 million barrels per day -- is virtually unchanged from
1973; the volume of its proved reserves, deposits that could have been tapped
to expand capacity, doubled over that span. In comparison, non-OPEC
producers have expanded their production capacity by 69 percent since 1973.
OPEC accounted for only 10 percent of the petroleum industry's upstream
capital investment during the past decade, although it produced nearly half of
global output. By holding back, OPEC has effectively allowed secular growth in
demand to absorb and eliminate its excess capacity, ceding market share to
non-OPEC producers in the process.
OPEC recently initiated numerous projects to tap its underdeveloped reserves
and finally expand capacity, investments that would amount to some $40 billion
per year between 2008 and 2012. The five largest international oil companies
(the "super-majors"), who own just 3 percent of global oil reserves, spent about
$75 billion during 2007 to develop new production. OPEC, with 20 times the
reserves, spends about half as much.
According to Smith's calculations, not until the price surpassed $50 per barrel
around 2004 did OPEC finally begin to create incremental capacity. Below the
$50 mark, most OPEC members have little incentive to relieve supply
pressures.
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3. SMU - Cox : Research Detail 10/7/09 4:17 PM
Price spikes, shocks, and speculators
The year 2008 witnessed large price swings, but volatility in oil prices is par-for-
the-course. The annual volatility of crude oil prices is high: 31 percent when
calculated over the "modern" era (1974-2007). Whereas annual volatility
averaged only 20 percent during the "golden age" of oil from 1874-1973. These
annual volatilities are quite high because the underlying demand and supply
curves are so inelastic, ie., quantities don't change quickly in response to price
changes. Demand is inelastic due to long lead times for altering the stock of
fuel-consuming equipment; supply is inelastic in the short-run because it takes
time to expand the productive capacity of oil fields. This fact means that shocks
to demand or to supply can help to explain the high level of volatility in oil
prices.
Thus, some combination of demand growth from the likes of China, India and
others, with a reduction to oil supply from higher production costs can partly
explain a substantial rise in oil prices after about 2004. If oil prices had not
risen past $90-$100/barrel, as in January 2008, these explanations might have
sufficed. However, prices rose 50 percent more between January and July
2008. Smith says by early 2008, China's growth and higher supply costs should
have been priced-in. So what happened?
Smith points to short-run issues. Seemingly small shocks exert large effects in
oil markets. Taking 1 million barrels per day out of the world market is a loss
equal to roughly 1.25 percent of total 2008 output, creating excess demand of
1.25 percent. When demand and supply are both highly inelastic, they combine
to create a large multiplier effect - each physical shock should trigger a short-
run price adjustment about ten times as large.
When asked about whether reduced consumption in the developed world can
offset the growing demand from the developing world, Smith replied, "We can't
conserve enough to offset the growth in demand from China, India, and others.
They are too large and their growth rates too fast; conservation cannot hold
world demand in place -- world demand will grow." He concludes, "It will take
innovative investments in supply and higher prices to keep the balance. Prices
will inch up. They have doubled since I wrote this paper. They could even shoot
up if there's an outage." In the short run, $145 a barrel is not incomprehensible,
Smith calculates, but not really in the long run.
Shocks to supply in the spring 2008 had much to do with the dramatic spike in
oil prices. The disruptions were many: the Venezuela-Exxon battle in February;
multiple problems for Iraqi exports; multiple disruptions in Nigeria that impacted
supply; labor strikes in the UK; and the rapid decline of Mexico's Cantarell oil
field. In quick succession, these events contributed substantially to the rapid
price rise of oil. So, surging demand and falling supply reveal the most likely
source of the rise, not the traders or speculators targeted by regulators.
According to Smith's analysis, "the distinction between hedging and speculative
trading in the futures market is not important because neither one exerts any
significant effect on current oil prices."
OPEC does engage in price fixing, and oil prices would not have reached $145
per barrel if OPEC had not previously restricted investment in new capacity.
OPEC aside, there is no evidence of price fixing on the part of anyone else,
which includes both speculators and the "super-major" oil companies. "Relative
to the size of the world oil market, hedge funds and even the "super-major" oil
companies are small fry," Smith states.
Here and now
During the second half of 2008, the collapse in demand for oil around the world
was due to economic decline. Despite global consumption (and consequent
depletion) of almost 700 billion barrels of crude oil during the past quarter-
century, the stock of remaining proved reserves has doubled from 700 billion
barrels in 1980 to an all-time high of 1,400 billion barrels. "Consider the impact
of horizontal drilling in oil and gas, Smith explains. "Huge resources that were
previously uneconomic can now be developed because of that technological
advance-an example being the Williston basin, the largest undeveloped oil
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4. SMU - Cox : Research Detail 10/7/09 4:17 PM
resource in the U.S." He adds that advances in the processing of seismic data
beneath the ocean floor revealed large oil deposits in the Gulf Of Mexico and
Brazil, previously hidden beneath layers of salt. "We peeled back another layer
that we previously didn't know how to penetrate. New technology can have a
big impact on the resource base and price."
Smith acknowledges that we cannot prevent the supply of conventional oil from
ever declining. But in the longer-term, he believes ample supplies of
unconventional petroleum resources and other substitutes for crude oil should
prevent oil prices from surpassing the mid-2008 peak on any sustained basis.
Regarding the high-end forecasts tossed about by various analysts and
executives, Smith questions, "Where's the global economic expansion coming
from to sustain consumption at those high prices? "Look at the demand curve.
There's a big focus on supply and the depletion story, but demand is sensitive to
price."
Based on James Smith's Journal of Economic Perspectives (August 2009)
article "World Oil: Market or Mayhem? "
Written by Jennifer Warren.
Thank You For Visiting !
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