Oil Market Volatility
December 10, 2007
Introduction
Oil prices went up as much as 40 percent in 2007, a change that rivals the historic price spikes of the 1970s oil embargo. Amid ongoing concerns about high oil prices, some analysts say the trend can no longer be explained simply by the increasing demand from countries like as China, India, and Russia. While supply and demand still form the foundations of the oil market, energy analysts also view oil investor behavior as a factor in the recent price spikes. The increasingly speculative behavior of a more diverse set of investors, including hedge funds, pension funds, and investment banks, has made oil-market trends harder to predict. Yet other analysts still believe that supply and demand are the main factors determining prices, and that the failure of industry analysts to adapt to new realities should not be blamed on investors. Many experts agree that the days when the Organization of the Petroleum Exporting Countries (OPEC) could virtually dictate prices are over. These days, analysts say, the oil market behaves more than ever like other commodities markets.
Supply and Demand
Supply and demand remain among the most influential components of oil-market behavior. However, unlike most other markets, drastic changes in price do not necessarily kindle changes in demand. “Prices can fall a long way without stimulating demand,” says Tim Evans, an energy analyst at Citigroup. While lessening demand does have an impact on price, the continuing increase in oil consumption by developing countries coupled with steady high demand from the United States, mean that demand is not likely to ease in the near future, analysts say.
Supply issues, on the other hand, can have a considerable impact on oil prices. Geopolitical events that threaten oil supplies, such as troubles between Venezuela and the United States or Turkey and Kurdish Iraq, can spook investors and lead to price volatility. But some analysts say recent price increases do not reflect major changes in supply. Unlike huge price leaps in the past, oil supplies have remained within a relatively healthy range. In May 2006, Royal Dutch Shell’s CEO Jeroen van der Veer told Fortune that oil tanks were full, there were no lines at gas stations, and there were no problems with fuel deliveries, yet prices remained at historic levels.
Oil markets do not entirely act like other commodities markets. Evans, who calls the market “a volatile beast,” says the OPEC cartel is a major reason the oil market is not truly competitive like other markets. Up until the mid-1980s, OPEC set crude oil prices. Now it simply influences the market by adjusting production levels for its members, which supply about 40 percent of the market. Such actions can have a significant impact on prices. OPEC supply cuts in 2003 and 2007 saw gradual but significant increases in prices in the following months. But when crude prices rose in 2007, OPEC officials often contended that the market had enough supply and blamed rising prices on oil-market investors.
Energy expert Philip Verleger argues market unpredictability is not the fault of investors. Instead, he says oil analysis has become “lazy” and has not adapted to the fact that the oil market now behaves more like other financial markets where supply and demand factors prevail. Evans agrees somewhat, but says increased “financially driven oil trading has given the price a greater independence to swing further away from a fair market or equilibrium price for a longer period of time.”
Oil Futures
As with other commodities markets, there are two sets of oil prices: a spot price, for oil delivered immediately, and a futures price, for oil delivered at some specified time in the future. When the spot price for oil is less than the futures price, this is called a “contango” market. When the futures price for oil is less than the spot price, this is called a “backwardation” market. Contango markets encourage the stockpiling of oil supplies; people will buy spot-price oil and hold it, waiting for the higher price in the future. In backwardation markets, there is an incentive for oil holders to sell their stocks in the short term, thus adding supplies to the market.
If a contango market implies that oil inventories currently are abundant, a backwardation market implies that oil inventories are currently tight. In a backwardation market, there is an incentive for investors to simply sell the near-term futures held at the higher prices and buy futures further out at the lower rate, thus making a profit on the difference. Verleger says “cash from investors adds liquidity to the market and liquidity is a good thing.” But Evans notes investors also increase volatility, which may not be so benign.
Large-supply holders such as OPEC have in the past played a big role in moving the spot price and futures markets to suit their aims. Experts say OPEC created a backwardation market by significantly curtailing production in the late 1990s to drive oil prices up from $10 per barrel. Backwardation can be self perpetuating. In such a case, investors sell in the short term because they believe the price will go down in the future, which keeps inventories low.
None of this moneymaking [in the oil markets] would be possible unless supplies were tight, but speculation on this scale magnifies price volatility. — Barry McKennitt, U.S. National Association of Petroleum Investment Analysts
Investors closely follow oil inventories to gauge supply and demand. But oil speculation as seen in the last few years, some analysts say, masks real supply and demand of present oil in favor of the supply and demand of oil futures. D. Barry McKennitt, executive director of the U.S. National Association of Petroleum Investment Analysts, says that none of this moneymaking would be possible unless supplies were tight, but speculation on this scale magnifies price volatility. One oil expert noted that while “there’s nothing criminal about betting on price, it is a problem when the bets themselves influence the price” (LAT).
Despite new investor behavior, contango markets remain more stable because of higher inventory but backwardation markets spur growth in the oil industry for infrastructure and exploration—considered very good for the industry. One reason oil supplies are tight is because a lack of investment in exploration and infrastructure in the 1990s, deterred by low oil prices. An analyst in the Middle East Economic Survey asserts OPEC’s current dilemma is whether to encourage a backwardation market, which spurs industry growth but is also more volatile, especially now with the increase in oil speculators. Giacomo Luciani, director of the Gulf Research Center Foundation, notes in Arab News that commodities investors tend to profit from volatility and argues that the way to reverse the ballooning of prices through speculation is for OPEC to reassume its role as “price maker.”
Other energy experts say OPEC is now in a delicate position for addressing market dynamics. While high oil prices can encourage much-needed investments in oil infrastructure and new exploration, some oil producers remain wary of spending their windfall due to worries that the market will return to the prices of the 1990s. But most analysts believe oil supplies will remain tight and prices high.
Crude Differences
Different qualities of crude oil supplies play a crucial role in market prices. Crude oil is classified by density and sulfur content. Refiners consider light and sweet crude (containing less than 0.5 percent sulfur) the best because it takes little refining to produce high quality products, such as gasoline. Sour crude contains 1 percent sulfur, a problem for refining since sulfur is both corrosive and toxic. The higher viscosity of heavy crude also requires extra efforts to refine. Since the world has limited refining capacity for sour and heavy crude, these varieties sell at prices less than sweet and light varieties, sometimes significantly so. Crudes can be blends of heavy sweet or light sour as well.
A considerable portion of OPEC production falls into the heavy-sour category. Many non-OPEC nations also have started to produce more heavy sour crude due to older oil wells. This in turn has created a tight supply of light sweet crude. Some analysts believe heavy-sour production is going to significantly exceed light-sweet production as time goes on, which could continue to help increase volatility on light-sweet crude prices until refining capacity catches up.
Platts, an energy news service, says of the two lower-grade types, sour or heavy, “it is the sour crude that is gradually assuming more importance” in pricing. However, a new factor has made sour crude less attractive. The United States and Europe both recently mandated greater use of low-sulfur diesel for air quality reasons. The International Energy Agency says the first option for refiners to meet low-sulfur targets is to use low-sulfur crudes. This has created higher demand for light sweet crude, leading to tighter supplies in the past year. Under such conditions, when major suppliers like Saudi Arabia seek to boost production to ease prices they sometimes have trouble finding buyers because their surplus production is mainly lower-quality crude. Light sweet crude prices jumped by $20 to $25 per barrel from August 2007 to November 2007, Verleger notes, while at the same time Saudi Arabia was cutting the price of its sour crude.
OPEC in November 2007 said the shift toward lighter oils and stricter fuel-quality standards will have “substantial consequences” on supply and demand. The organization stressed the need to upgrade refining (PDF) for desulphurization capacity by eighteen million barrels per day in the next fifteen years. Citigroup analyst Evans says refineries just need to spend the money to upgrade refineries. He says as long as poorer-grade crudes sell at a discount and light crude prices remain high there will be an incentive to invest in upgrades.
Some also wonder if light sweet crude going into the U.S. Strategic Petroleum Reserve (SPR) helps to drive up crude (PDF) prices. But others believe the amount of crude added to the reserve is too small to have a major impact on price. By the end of 2007, the U.S. Department of Energy was buying about one hundred thousand barrels a day to refill the reserve to its capacity of 730 million barrels.
New Market Players
Further complicating oil markets are new kinds of investors, says a 2007 analysis from JP Morgan (PDF). “Corporates, macro hedge funds, [commodity trading advisors], and institutional investors all trade commodities in very different ways,” says the bank’s global commodities research arm. Institutional investors such as pension funds and mutual funds are the newest entrants into the energy market and thus the least understood, the bank says. They hold a major stake in oil markets—one analyst told NPR in August 2006 that if the pension funds walked away from the market prices might drop as much as $20 per barrel. Other analysts say these investors may not understand the market’s complexity and thus do not behave in predictable ways, increasing volatility. Some institutional investors use the expertise of hedge funds or investment banks rather than attempting to maneuver the market alone.
Cash from investors adds liquidity to the market and liquidity is a good thing. — Philip Verleger, energy expert
Hedge funds come at the market from a “different direction” and “have become increasingly sophisticated,” JP Morgan’s researchers argue. McKennitt, of the U.S. National Association of Petroleum Investment Analysts, says these funds use sophisticated trading techniques but are not interested in “the fundamentals.” No one knows how much money has gone into the market from hedge funds, which account for most of oil speculative trading, he says, because they aren't subject to traditional reporting standards. Some hedge fund experts say this freedom from regulation is part of what makes hedge funds so successful.
Evans says a lot of money has been put into the market by investors in search of above-average returns, which has a price impact. “It’s a financial stampede,” he says, into a market where the physical supplies aren’t tight enough to warrant current volatility. Commodities markets, in general, and oil markets in particular are not transparent, McKennitt says. Although there is widely acknowledged growth in oil market investment, the magnitude of the influx is not clear. In December 2007, Japan commissioned the International Energy Agency to study fund impact (Platts) on the oil market. Citigroup’s Evans said recent data from the U.S. Commodities Futures Trading Commission shows that the number of open futures contracts rose 33 percent between 2006 and 2007.
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