Many news articles in the past few months have tried to pinpoint one exact reason for oil’s price climb. Unfortunately, one reason does not fully explain the problem. There are several causes, many of which have been working in unison, that have led to the stark increase in oil prices. Investigating several catalysts for oil’s increase provides a more educated understanding of (1) what has caused such a monumental ascent and (2) what situations could bring about price fluctuations in the future. Understanding the inherent factors influencing price adjustments in oil has enabled and will continue to enable THOR’s investment committee to make prudent and timely decisions in managing client portfolios. This paper will examine the topics of: supply/demand imbalances, speculation and the U.S. dollar – which we believe are the most pertinent issues regarding oil these days.

SUPPLY/DEMAND IMBALANCES

“Fundamentals,” as that term relates to oil prices, are supply and demand imbalances. Supply and demand determines prices for any goods; the commodity of oil is no different. For example, consider ten people that want to buy one apple. If there are twenty apples in the market, prices will drop in order for sellers to be competitive to unload their apples. On the other hand, if there are ten apples and twenty people that want to buy one apple, sellers can raise their prices to exploit the fact that there are ten buyers that will not end up with an apple; those buyers that are willing to spend the most money will get an apple.

In the global oil market today, quantities of oil supplied and demanded are very complex, but adhere to the same basic principles. In the past two decades, fundamentals have been changing in favor of suppliers because global demand has eclipsed global supply. One of the most popular explanations for the increase in global demand for oil has been the growth of emerging economies such as China and India. As more jobs move to these countries, more money is spent on infrastructure projects, motor vehicles, etc. This increase in wealth and building leads to greater demand for oil as oil is necessary to operate infrastructure building and transportation machinery, among other oil consuming products.

One major reason for the decrease in the quantity of oil is the cost to extract oil from aging oil fields. Some analysts believe the world has passed “peak oil,” which means we have already extracted more oil than the perceived supply that remains in the ground. Trying to extract more oil from aging fields or searching for new fields in more remote destinations requires intense amounts of capital. For example, in the past year, the cost for major oil companies to contract an oil rig for one day has increased from approximately $400,000 to approximately $600,000 because there is more demand for rigs than supply. In instances where geographical limitations require additional time and capital to extract oil, there is very little incentive for oil companies to drill for more barrels because leaving it in the ground (and keeping global supplies lower than global demand) will cause the value of their existing reserves to increase. This decrease in global oil production is illustrated in figure 1:

Figure 2 illustrates some other examples of global events that could have an upward/downward impact on oil prices based on supply and demand.

Figure 2:

To illustrate further the global supply/demand imbalances, THOR has created three charts based on data from the Energy Information Administration of the United States. Figure 3 below breaks down oil consumption into two eight year periods beginning in 1991. For most countries, consumption (demand) has been increasing, but at a decreasing rate as indicated in the 1999 – 2006 period. This statistic is relevant because most media publications discuss an overall increase in oil consumption, especially among emerging economies such as China and India, but they fail to reveal this increase’s breadth over time. Interestingly, as opposed to China and India, the majority of countries that have increased their consumption at an increasing rate during the two periods are some of the major oil producing countries – Saudi Arabia, Iran, Venezuela, United Arab Emirates, Nigeria, Algeria, Libya, Qatar, and Angola. Especially as it relates to Middle Eastern countries, the increased profits from oil prices are being reinvested in infrastructure projects. China and India get most of the media attention regarding expected oil demand because their population base is significantly higher than that of the Middle East, but as the oil producing countries of the Middle East expand their building projects, more and more foreigners visit and, therefore, increase the region’s demand for oil. As these oil producing countries generate more wealth, they use more oil for their own interests. This means less oil is exported which in turn strains global supplies. Figure 5 outlines oil reserves held by various countries. The more barrels held for (future) internal purposes strains global supplies. The combination of increasing global demand and decreasing global supply creates upward pressure on oil prices.

Figure 3:

*Energy Information Administration

As you can see, most of these figures are from either 2006 or 2007. The actual supply and demand figures have changed somewhat since then, but the trends identified in the previous charts are the same. It is important to take a step back, however, and understand why these older figures are relevant to today’s crisis. Some figures being released to the public, especially those regarding breaking news, are often unverifiable. For example, Brazil announced earlier this year that it had discovered an offshore oilfield that could yield 33 billion barrels of oil. It came out later and announced that those numbers were inflated.

Both announcements caused a change in the price of oil on the day of each announcement. Figure 2 indicates the types of daily announcements that affect the expected future supply and demand of oil. Examples include rebel destruction of Nigerian oilfields, Iranian supplies being held in tankers in the Persian Gulf, decreased American gasoline consumption because of higher prices, etc. Whether announcements are accurate or not, the mere indication of a swing in either supply or demand can cause a change in the price of oil.

Expectations of supply and demand usually cause short term changes in the price of oil. These short term changes can lead to a long-term trend. Sometimes, however, these fundamental expectations have the opposite effect in the long run when outside forces intervene. For example, expected future Chinese consumption has been a major reason investors believe there will be greater demand than supply for oil in the future. This expectation is one reason oil prices have gone up in the short term. Prices got so high, however, that China raised government-set domestic prices for fuel and electricity. One of the expectations which caused a price hike ended up causing a governmental reaction that actually reduced Chinese demand for oil. Not surprisingly, the price of oil dropped close to 3% the day of the announcement.

No matter the direction with which the oil trend is moving, these daily price fluctuations indicate the significance of the second factor driving oil prices – speculation.

SPECULATION

To understand the role speculators play in the oil market, one must first understand the history of trading and how its evolution has increased price volatility. In the early 1970’s, crude oil prices were primarily determined by the largest oil companies in the world, all of whom were given the nickname the “Seven Sisters.” In the latter half of the 70’s, many Middle Eastern oil fields became nationalized into what is now known as the Organization of the Petroleum Exporting Countries or OPEC (“OPEC”). From the mid 70’s to the mid 80’s, oil prices were controlled by OPEC until falling global demand and increased production by non-OPEC countries led to a market controlled pricing system. The market controlled pricing system can be broken out into three areas: Term Contracts, Crude Oil Spot or Cash Market, and Crude Oil Futures Markets.

Term contracts are two-party contracts which cover multiple transactions over a specified length of time. The contracts specify the volumes to be delivered for the duration of the contract as well as a fixed method for calculating the price of the oil. As term contracts are negotiated between the buyer and the seller, they are not susceptible to price manipulation and speculation because they are not traded over-the-counter or on exchanges.

In term contracts, the price of the oil is determined by using one of three “benchmark” oil qualities – West Texas Intermediary (“WTI”), Brent Crude or Dubai. The price calculations use the benchmark price at the time the oil is loaded for transportation to the buyer as a base price. An adjustment is then made based on the quality of the oil to be delivered relative to said benchmark. Figure 6 illustrates the pricing regions of the three benchmark oils.

The crude oil spot market is also known as the “cash” market. Like a term contract, the spot market is an informal network of buyers and sellers – it is not an exchange. This market is important because it provides a market to dispose of or buy an incremental supply of oil not covered by contractual agreements. Spot market purchases and sales reflect incremental increases and decreases in supply and demand for oil. Rising prices in the spot market indicate excess demand, falling prices in the spot market indicate excess supply. As the cash market is based on current supply and demand and is not traded over-the-counter or on an exchange, it is less susceptible to price manipulation and speculation.

Term contracts and spot market transactions are the leading mechanisms for arranging for the physical delivery of oil.

Unlike term contracts and spot market transactions, the crude oil futures market does not involve the delivery of oil. As the name implies, the futures market involves the purchase and sale of commodities at a specified place, price, and time in the future. Another difference between the futures market and term contracts and spot market transactions is that the contracts are standardized. THIS DIFFERENCE MAKES THE FUTURES MARKET PARTICULARLY VULNERABLE TO SPECULATION. Standardized contracts are only available in over-the-counter markets or exchanges and they are significant because only the price needs to be negotiated, not the quantity or date. Therefore, standardized commodity futures can be traded many times before the expiration date contained in the contract; each time at a new price determined by EXPECTED supply and demand. Another convenient aspect of trading commodities futures contracts on exchanges is the presence of a clearinghouse. The clearinghouse acts as a party to every transaction. This means that when a customer wants to buy or sell his or her contract, he or she simply conducts the transaction with the clearinghouse as opposed to trying to find a buyer or seller. In futures markets, the number of shares at any given time must balance between longs – a purchaser of a futures contract that provides for delivery of a commodity to the holder, and shorts – the holder of the contract that requires said holder to deliver the commodity at a future date. Speculators, then, can enter and exit the market whenever they please without affecting the physical supply of oil. Such activity though does have a significant affect on the price of oil.

Commodity speculation, as figure 7 suggests, is broken down into three categories: Commercial positions, Traditional speculators and Index investors. In the past decade speculators’ cash inflows have significantly increased, which has driven up the spot price index of all commodities:

Commercial positions are those taken by commercial producers and commercial consumers of commodities. Commercial users do not want price fluctuation, so they lock into futures contracts to reduce the risk of price volatility. For example, if oil refiners believe the price of oil is going to increase over the next year, they will enter into a futures contract to receive an amount of oil at a price they believe to be lower than that of their expectations.

Traditional speculators are those that have always existed in the market – they provide liquidity by buying and selling futures contracts in the market. Traditional speculators’ positions have grown since 2000, much like Commercial positions and Index speculators. Because this group looks to buy and sell futures contracts, their affect on commodity prices over time will be far different than the last group – index investors.

Index investors are the pension funds, hedge funds, investment banks and college endowment funds whose cash inflows are part of a portfolio allocation decision. These groups will come to the market with a set amount of money and purchase as many units as possible with no concern for the price per unit. As this money pours into the market, prices rise. As prices rise, expected returns drive further cash inflows and the process feeds on itself. To further magnify the problem, especially in the past decade as supply and demand imbalances have been expected to lead to long term commodity price increases, index investors buy futures contracts with the intention of continuously rolling them over as they come close to being due. The standardization of contracts and the presence of the clearinghouse allow these transactions to take place with no risk of receiving the physical commodity. The money is constantly buying more contracts at higher prices in the future, placing upward pressure on oil prices generally. Figure 9 illustrates this problem. Since the end of 2003, assets allocated to commodity indices has risen from $13 billion to $260 billion as of March 2008 due to commodities becoming a new “asset class” for investing. During that time, the prices of the 25 commodities that comprise the indices have risen 183% on average. According to Lehman Brothers, since the beginning of 2006 the approximate $70 billion in commodity indices rose to the $260 billion March estimate – but with only $90 billion of new cash. The remainder of the profit came from rolling over contracts.

In conclusion, all three groups have created upward pressure on the prices of commodities, especially oil, because of macroeconomic supply and demand expectations. However, without the fundamentals, the investment risk for traditional and index investors would be significantly higher and may have changed the velocity of the flow of funds going into commodities, keeping prices at more stable levels. Fundamentals are what have driven the trend of commodity prices up, but speculator cash flows are what have kept them moving in that direction at such a rapid pace.

Index investors have been able to profit off the expectations of supply and demand. They have also used commodities to hedge against our final topic – the falling value of the U.S. dollar. Some financial professionals believe that oil, and other commodities, have risen as a result of the weak dollar because its value is dollar denominated. Theoretically, it makes sense that if a good is priced in dollars, a weaker dollar will require more units of currency to purchase an equal quantity of that good. However, the fact that commodities have risen in every currency dispels the theory that the weak dollar’s tie to commodities is the sole reason for price increases.

U.S. DOLLAR

After rising during the 90’s, the value of the dollar has been steadily declining relative to other currencies since the beginning of 2000. As the United States economy struggled in the wake of the tech bubble burst in 2002, global competition became more intense. One of the reasons for oil’s increase in demand – the growth of emerging countries – also led to a precipitous decline in the value of the dollar. The introduction of the Euro in 2002, and its steady rise in value compared to the dollar, also had a large impact. More recently, the liquidity crisis of 2007 and 2008 forced the Federal Reserve to lower interest rates. As money tends to flow to countries with higher interest rates, the rate cuts further exacerbated the dollar’s decline. Figures 10, 11, and 12 compare the value of the dollar over the last five years to the British Pound, Euro and Chinese Yuan.

The Chinese Yuan has had a very steep yet smooth decline since 2005. On July 21, 2005, China ended its fixed dollar peg with the United States. This allowed China’s currency to gain in value as its economy strengthened and the United States lowered interest rates. In 2007 and 2008, some Middle Eastern countries also considered ending their peg to the U.S. dollar as their economies grew, triggering inflation in those countries. President Bush has considered a strong dollar policy, but its timing at this point would not be good given that we are still feeling the affects of the credit crunch. A strong dollar policy involves raising interest rates to strengthen the dollar and fight inflation. Doing so at this point, could be devastating to the credit markets and future GDP growth. In June 2008, rates for three month Treasury Bills, which are an indication of future short term interest rates, revealed that the market is expecting the Federal Reserve to raise rates as early as September 2008. In response, Federal Reserve Chairman Bernanke has indicated it will likely be longer before rates are raised. Around the same time, European Central Bank Chairman Jean-Claude Trichet announced it would not be lowering rates to battle slowing European growth and a possible housing bubble burst because of significant inflation concerns.

To hedge against the negative effects of a falling dollar, investors have been using oil. Modern portfolio theory suggests that the more uncorrelated two asset classes are, the greater the diversification benefits to the portfolio. When the fall of the dollar against the euro is compared to the increase in the spot price of one barrel of WTI crude oil over the past five years, the two show a strong negative correlation. Therefore, in their effort to decrease portfolio risk, investors have impacted the price of oil based on changes in currency – a metric that has nothing to do with the physical commodity of oil.

Some believe the current commodity price hike is a bubble that is ready to burst; others believe the fundamentals signify the bubble is here for the long-term. The environment contains traits of both scenarios and there is a possibility both might happen – a bubble burst in the short-term followed by a gradual price rebound over time. The classic characteristics of a bubble – large investment inflows, a quick surge in prices and bullishness among investors and analysts – have been present in the oil market for the past year. The difference between the tech bubble and a possible oil bubble is that oil is a non-renewable commodity. Evaluating overvalued stocks is easier than overvalued commodities because stocks have uniform financial metrics such as a price/earnings ratio. The futures market, ironically, is the metric that has been historically used for commodity price discovery. According to an estimate by Deutsche Bank, if oil were to reach $150 a barrel, it would bring the market capitalization of oil and gas equities in the S&P 500 to more than 25% of the index – more than the valuations of technology stocks at the peak of the tech bubble. Oil price estimates are inherently unreliable because many times the sources’ estimates align with what would make the source the most money. For example, Goldman Sachs has estimated that oil prices could reach $200 a barrel within two years, a price increase that would certainly benefit their hedge funds that are invested in oil. On the other hand, several of oil refiners have said they believe the price of oil will drop to between $60 and $90 a barrel, prices that would provide higher margins (and profitability) for their final products (gas, diesel, etc).

If we are in a bubble, there are several questions to answer. What would cause it to continue inflating, what would cause it to pop and how would those scenarios affect other investments?

Assuming overall market fundamentals stay the same, more inflows into the commodities markets would keep the price of oil rising. There are several items that have been discussed that could deflate the bubble and cause oil prices to come down.

First, the government could increase minimum margin requirements. “Margins” are the percent of one’s total investment that an exchange must hold in order for an investor to use that exchange. Presently, only exchanges – not OTC markets – require investors to deposit margins to cover daily paper losses caused by commodity price volatility. Because exchange accounts are marked to market value on a daily basis, margins insure the risk that the other party in the contract will not default if there was a liquidation. Increasing margins would not likely have a great impact on oil prices because investors could move their money to an OTC market.

Second, index investors could be forced to exit the futures market altogether. The loss of these huge amounts of “long only” capital would put significant downward pressure on oil prices. Examples of two proposals are the banning of pension funds and institutional investors with more than $500 million in assets and setting trading limits on fund inflows from all institutional investors. These actions would limit the volatility of the oil prices we have seen in the past decade and oil prices generally would fall.

Third, increase regulation of the OTC markets. In the recent past, the Commodity Futures Trading Commission (“CFTC”) has been under the scrutiny of Congress to increase transparency in the futures trading markets, especially the OTC markets. The announcement of increased regulation of exchanges has caused oil investors on the New York Mercantile Exchange, the world’s biggest oil futures market, to cut their positions to the lowest levels in the last ten months. The price of oil has remained elevated more than likely because the positions were added in the highly unregulated OTC markets. There is so little regulation in these markets that no data regarding the positions of investors is able to be obtained.

If any of these efforts reduced the price of oil, the stock market would likely respond favorably. It is impossible to predict with any certainty how far stock prices would rise, but the decreased stress of high oil prices on companies and consumers would be great for earnings. The aftermath of the credit crunch and housing bubble burst will still weigh on the economy, but not to the extent that it has with oil prices at an all-time high. A large price decrease could provide overwhelming support to a struggling United States economy. GDP growth would increase, unemployment rates would drop and support for a bottom in house prices would be in place. As soon as the Fed feels the credit crisis is no longer a more imminent threat than inflation, it will likely raise rates, exacerbating a rise in the value of the dollar. This, in turn, will create downward pressure on oil prices.

CONCLUSION

In summary, there are several reasons for the spike in oil prices. Since oil is non-renewable, legitimate supply and demand forces are present that support high long-term prices for oil. Even though long-term prices may be high, the abrupt increase since 2002 can be attributed to investment inflows in long only funds. Index investors and other institutional investors saw a diversification possibility in a highly attractive area supported by fundamentals and continuously rolled over contracts, causing upward pressure on prices. These same institutional investors also used commodities to hedge against a declining dollar. Without the influence of all of these factors together, the price spike would not have been as great. Rapid price increases, as well as large investment inflows, and bullish sentiment often signify a bubble.

Fundamental factors and lack of authentic price measures cast a small amount of skepticism on the bubble theory. Several measures are being considered that could pop the oil bubble and drive prices down. Such a decline would be very good for the overall economy generally and the stock market specifically. It is impossible to predict what is going to happen in the future, but thorough analysis and understanding of the causes and effects of the 2008 oil crisis will enable us to better serve you.