Saturday, February 14, 2009

"Understand Crude Oil Price"

I finally finished reading Prof Hamilton's paper on crude oil prices. A must read.

Key Take-aways:

(1) The real price of oil appears to follow a random walk with no drift.
(2) The current spot price is most likely the best forecast one can make. It is however unlikely to be a good one as the standard deviation of quarterly log price changes is high at 15%. Prof Hamiltion makes the following example: at the end of Q1'08 the price of oil was 115USD, four years from then one should not be surprised to see the oil price within a range of 34USD to 391USD.
(3) Speculation does not explain the oil price behaviour well. A point made by EDHEC in a recent position paper as well (see "The true role of speculation")
(4) Demand: Price elasticity are hard to estimate. Short run elasticities for gasoline demand are low and have been declining (from -0.25 -0.34 over 1975-80 to -0.034 -0.077 over 2001-2006). The author provides an intermediate-run price elasticity for crude of -0.26 based on 1980's data.
(5) Income elasticity: numerous studies at ca 1. But it has been declining as well over time and the poorer the country the higher the income elasticity.
(6) China: demand increased by 7.2% annually between 91 and 2006. Extrapolate the trend and China will consume as much oil as the US in 2020. In 2006 it consumed 2 barrels of oil per person vs. 6.6 for Mexico and 25 for the US. Ie China's oil consumption could triple and it would still be less per person than in Mexico today.
(7) Supply: the largest private producer Exxon has a 3.1% share of daily production and the five biggest private companies have a 12% share. This is close to Saudi Arabia's share of 12.1%. OPEC-10 had a 37% share of world liquid production in 2007. Overall global production has stagneted over the past three years.
(8) Effectiveness of cartel behaviour of OPEC is hard to prove empirically. Alternative hypothesis is of Saudi Arabia using its monopoly power to influence price while others operate on a more competitive basis.
(9) Very long lead time between discovery of a new oil reservoir and actual delivery of oil to a refinery imply very low short term price elasticity of supply.
(10) Ballpark estimates of the "average" or "typical" decline rate to apply to global production is ca 4% per year. Many large fields are now in decline (Texas, Prudhoe Bay, North Sea, Mexico’s Cantarell, and China’s Daqing) and Saudi Arabian production appears stable in spite of the large increase in rigs.

The author concludes: "...if demand growth resumes in China and other countries at its previous rate, the date at which the scarcity rent will start to make an important contribution to the price, if not here already, cannot be far away".

No comments: