Middle East Economic Survey

VOL. XLVII

No 37

13-September-2004

The Future Price Of Crude Oil

By Paul Stevens

The following article was written for MEES by Professor Paul Stevens, Centre for Energy, Petroleum and Mineral Law and Policy, University of Dundee, Scotland. Email p.j.stevens@dundee.co.uk.

At present, the attention of most observers of the international oil industry is firmly on the current price of oil and the prospects for an immediate price shock. There is much discussion as to the causes of the relatively high prices. These are clearly complex and controversial. There tend to be two schools of thought. One argues high prices are cyclical and arise from a coincidence of potentially reversible factors pushing in the same direction. Thus physical shortages as a result of booming demand and problems in Iraq and other producers combine with a bull run in the paper market. The other school argues that we are witnessing a fundamental structural change in the oil market reflecting insufficient investment over the last 10 years or so. The difference between the two schools is crucial. If current prices are cyclical in origin they will eventually go down, if structural they will stay high.

Forward Curves

Part of the argument from the “structuralist” school, most eloquently expressed by Paul Horsnell in the Oxford Energy Forum (August 2004), is that the evidence for a structural change lies in the futures curve for oil prices.  This curve generated by NYMEX gives future prices for WTI up to six years out. He argues that between 1986 and 2002 while the front end of the curve fluctuated anywhere between $10/B and $40/B, the back-end (four-to-six years out) remained stubbornly around the $18-21/B range. However, in the last 18 months, that back-end has increased by over $10/B. Indeed, at the time of writing, to buy a barrel of oil in December 2010 will cost $34.70/B. It is argued that this signifies a fundamental change in view by the industry towards impending shortages of crude compared to the views of ample sufficiency which dominated the 1990s. This argument is worth further analysis.

The first obvious questions are: who buys oil that far into the future and on what basis? There are two explanations, both of which have relevance. The first, which underlies the “structuralist” school, is that such purchases are done by those interested in wet barrels: ie, the sellers of crude and the refiners. They wish to lock in prices to hedge price risk. Given these players and motives, trading so far into the future tends to be a fairly thin market with limited liquidity. The result is that the brokers – who make most of their profits playing with these forward curves – are the ones who often strongly influence the back-end price. In theory, this explanation means the back-end price should bear some relationship to expectations of the long-run marginal cost of producing the commodity. In reality for oil, it is more a refection of expected prices. There has always been a strong disconnect between costs of producing oil and the price of oil. This disconnect arises from differences in geology and the presence of market controllers – since the 1970’s OPEC. Thus the recent rise in back-end prices might reflect the industry’s views that oil supplies in the future will be significantly less plentiful than in the past because of too little investment and hence prices will be higher. This is the structural shift argument.

Spread Trading

A second explanation for the rise in back-end prices concerns the practice of spread trading on the futures markets. Hedging price risk by users was the original function of commodity markets, the first probably developing for rice in 17th Century Osaka. However, inevitably such markets attracted speculators. To describe them as leaches, gorging themselves on this “eminently sensible body” is perhaps a little unkind; but on reflection perhaps not. Spread trading is effectively betting on the differential between a near price and a price some time in the future.  The basis is as follows. If it is felt that the spread between the near and future price is too wide, ie the near price is artificially high, it pays to sell paper oil a couple of months ahead at the near price and then buy paper oil several years ahead at the future price.  As the near price comes down, the trade is reversed and money is made. Spread trading is most popular simply because it reduces exposure to price changes and risk-averse speculators tend to avoid betting simply on changes to near term or future prices unless they are feeling extremely lucky.

A numerical example illustrates. Given the price pattern in the table below, the speculator today perceives the $10 differential between prompt and distant prices to be too great.

Note:  At the time of writing the actual spread is $10.10.  Two-to-three years ago the spread was some $5.00.

The speculator therefore sells (say) 1,000 paper barrels for two months time at $40/B and buys 1,000 paper barrels for three years time at $30/B. Buying three years out as well means they limit exposure to near-term price risk. In one month, the “unnaturally” high near-term price comes down to $30/B for one month ahead and with it the back-end price but not by as much. It falls to only $26/B. At this point the speculator reverses the trade. They buy 1,000 barrels at $30/B to meet their sell obligation making $10/B profit. They sell 1,000 barrels at $26/B incurring a $4/B loss. They sell at a loss simply to remove exposure to the futures price risk. The net gain is a profit of $6/B. By betting on the spread rather than changes to the near term and futures prices individually, they significantly reduce exposure to risk.

The example given probably overstates likely events, although there have been equivalent price movements in recent years. However, providing the futures price falls less than the near term one, a profit is inevitable. Clearly, if there is a view that the near-term prices are artificially high for whatever reason, there is a strong incentive to buy future barrels. Given the relative thinness of the market much further out, this invariably will push up the back-end price on the curve. Given it is widely believed that current high prices are the result of geo-political threats which do have some form of sell-by date, it seems a fairly easy way to make money. Thus the rising of the back-end prices cannot entirely be explained by perceptions of future shortage as suggested by the “structuralist” school. It does contain a significant speculative element.

Corporate Financial Strategies And Impending Shortages

However, if part of the explanation of the rise in back-end prices is a growing belief in impending shortages, it is worth speculating on why there has been this apparent change of view. One possible explanation for the change is that the “depletionists” have finally found an audience who believe their view of the future. The “depletionists”, who have been around for a long time, have been arguing that the world is running out of oil as reserves are depleted. In particular, using Hubbert Curve analysis, they point to non-OPEC reaching a peak in the “near” future although it should be pointed out they have been peddling this view for over 20 years and we still await the peak. 

Their argument, based upon the constraints of reserves, is seriously flawed for three reasons. First, it assumes a fixed stock of “conventional” oil reserves. This ignores the role of investment and while I will argue below this is a key issue, it has no part in the “depletionists” battery of arguments. An even more egregious error is that it ignores the potential from “unconventional” oil reserves. Second, it assumes future oil demand will grow without limitation along the lines suggested by the IEA. Again, there are a great many arguments which can be deployed as to why various drivers will eventually slow such growth. These range from environmental and security of supply concerns together with consumer governments in developing and transition countries using sales taxes on oil products to raise revenue, to name but a few. Finally, it ignores the feedback loops provided by markets. Growing shortage would increase prices which would in turn reduce the quantity demanded and increase the quantity supplied.

However, while the argument based upon reserve constraints can be dismissed, there is a real danger that their prediction of crude shortage may come to pass, albeit for very different reasons from the ones they deploy. It would be a delicious irony if, after all this time, they were eventually proved right but for entirely the wrong reasons. The key issue is investment by oil companies in exploration and production. Although this argument could be extended to other stages in the oil industry value chain, this short paper will focus only on the upstream. 

It is generally agreed that a great deal of money needs to be invested in exploration, development and production to sustain an increase in crude oil supplies for the next five-to-ten years at least. The IEA estimated earlier this year that some $2,188bn would be needed to be invested in exploration and development between now and 2030 if expected oil demands were to be supplied. This is an average of some $81bn per year. Leaving aside issues of exaggeration in the forecast, the problem is that there must be serious doubts that enough of the needed funds will be forthcoming from the major oil companies. This is not because their cash flow is insufficient. A $1 rise in oil prices increases the earnings of the majors by some 6%. The high prices enjoyed over the last two years mean that companies are experiencing record years in financial terms. In the past, high oil prices would have encouraged ever greater investments in exploration and production, thereby creating a self-adjusting mechanism. High prices increase investments which increase quantity supplied which reduce price. However, in recent years this has failed to materialize and indeed in this decade, according to Deutsche Bank, the major companies have cut their exploration budgets by 27%. 

The explanation for the potential lack of investment lies in the dominance of value-based management theories as the driving force of financial strategy in the major oil companies. This view of corporate finance began to gain credence in the 1990s. Its basis is simple, although the logic is based upon quite complex concepts such as the capital asset pricing model and later variations. If the company cannot provide a rate of return at least equal to the general stock market and to its appropriate sector, it should return funds to the shareholders rather than investing them itself. This is achieved either through higher dividends or share buy-backs pushing up the share price. 

As the companies in a mature industry such as oil struggle to maintain shareholder value, this is precisely what they are doing. Thus BP has announced that in the next three years, assuming prices remain strong, it will return some $18bn to its shareholders. This year it is expected to return over $6bn. To put this in perspective, in 2003, BP invested $9.7bn in exploration and production activities. In similar vein, ExxonMobil is expected to return some $6.4bn to its shareholders this year. In the second quarter of this year when the oil price (OPEC basket) averaged $34.43/B, ExxonMobil’s capital expenditure was $3.6bn; yet in the previous year’s second quarter when oil prices averaged $25.90/B, capital expenditure was actually $3.8bn.Thus in a period of strongly rising oil prices the company was actually cutting investment in the industry.

This problem of funds leaching out of the industry is compounded because returning funds to shareholders is becoming a key source of competition between the major oil companies to keep their shareholders happy.  Furthermore, it is only very recently that changes in Dutch law have given Shell the opportunity to follow a similar strategy. All the signs are that Shell will shortly engage in an effort to out “perform” the other majors in returning funds. This will cause an even greater outflow of investment funds.  The danger is that the very short term benefits to share price will be at the expense of future investment in maintaining and developing crude capacity. 

The next question concerns other possible sources of investment funds. In many cases, the national oil companies in the major producers are being starved of funds. Governments are increasingly suspicious of their behaviour and in any case have locked themselves into a high spending world where they need revenue for other things and investing in new capacity which may bring down prices makes less sense. The national oil companies may not be able to fill any gap arising from the major companies’ unwillingness to invest.

However, there is another source of funding which has interesting parallels with the experience of the minerals industry. For a long time, mineral prices were low as were mineral company profits. As a result, investment in new mines was restricted; shortages began to emerge as the demand for minerals increased sharply from the rapidly expanding economies, especially China and India. As prices and profits rose, the companies decided they rather preferred this higher priced world and decided not to invest too much in new capacity for fear of reverting to over-supply. However, faced with higher minerals prices, the increasingly angry consuming countries began to look to invest themselves in an effort to secure cheaper supplies. It is feasible that the growing consumers of oil, especially in Asia, will seek to put funds to develop new sources. They may also gain attractive terms since they are much less constrained by ethical concerns when investing in certain countries.  Thus there is less competition on the fiscal terms. Whether this sort of investment will be sufficient to maintain and increase crude producing capacity, given the sorts of numbers being bandied around by the IEA remains a moot point. It also raises fascinating issues to do with the geo-political consequences of such moves.

Simple economics argue that high prices produce a supply response creating a self correcting mechanism.  However, this tends to neglect the lead times involved. In upstream oil, the lead times for new capacity can be between five-to-eight years. Thus the crude shortages resulting from the current outflow of potential investment funds could be around for quite some time, together with their resultant high oil prices. Furthermore, this lack of investment will impact on all stages of the industry including refining, transportation, marketing and distribution. In this sense, those arguing for the existence of a major structural change in the industry may well have it right. There is a serious danger that short-termism driven by the demands of the stock market, something so long denied by many theoretical economists, may prove to be seriously damaging to oil consumers.