Why Have Oil Prices Risen?

Jacob Wellendorph Ejsing, John Hydeskov and Palle Bach Mindested, Market Operations

INTRODUCTION AND SUMMARY

Oil prices have risen sharply during the last two years and are monitored closely, also by financial-market participants and monetary-policy
authorities. Both equity and bond markets have in some periods reacted to fluctuations in oil prices, and the European Central Bank, ECB, has mentioned oil prices in every one of its last 24 " introductory statements" ^[1]. This reflects how fluctuating oil prices have had a substantial impact on both inflation and economic growth.

Since the beginning of 2004, the price of oil has more than doubled from just over 30 dollars per barrel to more than 70 dollars per barrel, thereby reaching an all-time high in nominal terms. In real terms, the oil price is still below its highest ever level in 1981, cf. Chart 1, but in absolute terms the most recent increase in the real oil price matches each of the two oil-price shocks in the 1970s.^[2] Whereas those were genuine shocks, the development since 2004 has been more gradual.

The main explanation for the higher prices is the growth in global demand for oil, driven primarily by China and the USA. Overall, the development in the USA has been in line with the expectations of international organisations, investment banks, etc., while the demand in China has been surprisingly high.

Global production has been increased to a degree, and this has prevented the oil market from adjusting solely via higher prices. Further growth in production from the current level would require substantial investments, however, since the capacity limit has almost been reached. Hence the price hikes reflect sluggishness in the expansion of the extraction capacity rather than an actual shortage of oil in underground deposits.

PROSPECTS OF SUSTAINED HIGH OIL PRICES

Previously, temporary factors such as deteriorating weather conditions or wars have exerted considerable upward pressure on oil prices. In most cases, however, this has affected the spot price, while the relative impact on the prices of oil futures for delivery several years ahead has been negligible. In the current situation, on the other hand, the long-term oil price has risen even more than the spot price, indicating that the market participants expect oil prices to remain at the present level, cf. Box 1.

INTERPRETATION OF FLUCTUATIONS IN THE FUTURES CURVE FOR CRUDE OIL	Box 1
Trade in oil for future delivery (futures) takes place at specialised exchanges in e.g. New York and London. The contracts are standardised and traded with delivery horizons of up to around 7 years, even though the largest trading volume is seen in contracts maturing within one year. Chart 2 (left) shows the futures curve for the US reference crude oil, West Texas Intermediate. The Chart shows the relation between the strike price and the maturity in months. Since the beginning of 2004, the futures curve has shifted significantly upwards for all delivery horizons. Chart 2 (right) shows some correlation between the estimated change in the oil price one month ahead (defined as the difference between the price of the second-shortest and the shortest futures contracts) and the actual realised price changes. The Chart is based on 195 monthly observations from February 1990 up to and including April 2006. The slope of the regression line is significantly different from zero, but not significantly different from 1. This entails that estimates of short-term (one month) future price changes derived from the futures curve have on average proved to be correct. However, the Chart also illustrates the considerable uncertainty of the estimate.
DEVELOPMENT AND INFORMATION CONTENT OF THE FUTURES CURVE	Chart 2
Note: Prices for WTI Light Sweet Crude traded at NYMEX. Right-hand Chart: t-statistic for the slope of the regression line (robust to heteroscedasticity) is 2.5. Source: Bloomberg and own calculations.
Even though the number of outstanding futures contracts is modest in relation to both the value of total oil production and turnover in the non-standardised OTC market, the futures curve is the best real-time indicator of developments in the oil market. The curve contains information on e.g. investor expectations of future oil prices. Changes in the futures curve can therefore be used to assess whether a given price development is temporary or permanent. If the oil market is affected by temporary shocks, such as unusually cold winter weather, the spot price reacts more violently than the price of oil for delivery several years into the future. The main reason is that the demand for crude oil is very inelastic in the short term since enterprises and consumers will still require oil, even in periods when prices are set to fall. Chart 3 shows two examples of temporary impacts on the futures curve. The left Chart illustrates the impact of Hurricane Katrina, which devastated the area around the Mexican Gulf in the late summer of 2005. A substantial increase was seen at the short end of the curve, while the price of oil for delivery in two years was not affected. The right-hand Chart shows the fluctuations in the futures curve in connection with the war in Iraq in 2003. Fluctuations in the curve were even greater in this case, since the short end rose by 50 per cent up to the onset of the military operations. Again, the price of oil for delivery two years ahead was almost unaffected. The market participants' assessment that the price increase would not last proved to be true, and by the end of the invasion on 1 May 2003 the futures curve had fallen back to the pre-war level.
CHANGES IN THE FUTURES CURVE FOR CRUDE OIL IN CONNECTION WITH HURRICANE KATRINA IN 2005 AND THE WAR IN IRAQ IN 2003	Chart 3
Note: Prices for WTI Light Sweet Crude traded at NYMEX. In the right-hand Chart, 8 November 2002 is the day when the UN Security Council adopted Resolution 1441 on Iraq, 12 March 2003 is the day when the oil price peaked (one week before the operations in Iraq began), and 1 May 2003 is the day when George W. Bush declared that the open combat in Iraq had ended. Source: U.S. Department of State, CNN, Bloomberg.
In the event of shocks that are expected to be permanent, the entire futures curve shifts. Such shocks might e.g. be technological innovations or a permanent shift in demand. The price hikes in recent years, which include all delivery horizons, are examples of this, cf. Chart 2 (left).
1 In the OTC (Over-the-Counter) market, contracts are concluded on individual terms, typically with large investment banks as intermediaries. The outstanding volume in the standardised markets (the futures market) in New York and London is substantially lower than in the OTC market and constitutes approximately 4 per cent of the value of global oil production. See Campbell, Orskaug and Williams (2006) for further discussion.

MARKET EXPECTATIONS OF FUTURE OIL PRICES

The current course of the futures curve points to sustained high oil prices, cf. Box 1, Chart 2. However, futures prices are affected not only by the market participants' expectations of the future price of oil, but also by a risk premium, cf. Box 2. Consequently, there is often a considerable gap between the futures price and the expectations of experts and market participants.^[3] In April 2006 oil futures for delivery in 2010 exceeded Reuters' oil price survey by more than 20 dollars per barrel. This indicates that currently futures prices contain a substantial risk premium, even though this by no means explains the entire difference.

Expectations of future oil prices are subject to considerable uncertainty, and the ECB (2006b) thus states that with a probability of 90 per cent the oil price will be in the interval of 40-90 dollars per barrel at the end of 2006.^[4]

DEMAND

The most significant factor behind the rise in oil prices in recent years has been increased global demand for oil, reflecting high global growth. The global economy grew by 5.3 per cent in 2004 and by 4.8 per cent in 2005.^[5] US growth in 2004 and 2005 was, respectively, 4.2 and 3.5 per cent, while growth rates in the euro area were more moderate at 2.1 and 1.3 per cent, respectively. The Chinese economy continued to expand very strongly, growing by 10.1 per cent in 2004 and 9.9 per cent in 2005.

In the period from 1970 to 2004, global oil consumption rose from approximately 45 million to more than 80 million barrels a day. The USA and Europe are the largest consumers of oil, accounting for, respectively, approximately 20 and approximately 15 million barrels a day, while China takes up approximately 7 million barrels a day.^[6] Viewed over the last 10 years, US consumption has risen moderately and European consumption only slightly, while China's oil consumption has more than doubled, cf. Chart 4. Even though China accounts for the strongest relative increase in oil consumption, the increase in absolute terms has been just as high in the USA.

The development in the USA and Europe has generally corresponded to market expectations, while demand from China has been surprisingly high.^[7]

SUPPLY

Oil production
For a long period, OPEC has sought to regulate prices via production agreements among its members. In the last few years the price has often exceeded the official OPEC target.

OPEC's share of global production has been increasing moderately in recent years and is currently approximately 40 per cent. Today, Saudi Arabia, Russia and the USA are the world's largest oil producers, cf. Table 1, but owing to the distribution of oil reserves, cf. below, US production is very likely to be diminishing in the coming years. Even though the USA is one of the largest producers, it is also the largest net importer of oil.

Production capacity
Spare production capacity is chiefly found in the OPEC countries.^[8] However, excess capacity has been reduced substantially in recent years, cf. Chart 5, due to rising global demand. Supply must be said to be tight, and even small and temporary disruptions to oil production have a
significant impact on prices. Recent oil-price hikes have thus been triggered by e.g. hurricanes, strikes and minor conflicts.

Production capacity in the OPEC countries has increased slightly in recent years, indicating that the price increases in the last couple of years have primarily been driven by changes in demand. Chart 6 shows the relationship between high capacity utilisation in OPEC countries and oil prices.

In its efforts to curb oil prices, OPEC has stepped up production in recent years. In spite of this, prices have not fallen, which indicates that OPEC's power to dampen prices has been reduced.^[9]

Oil reserves
Most of the demonstrated global reserves are found in the OPEC countries, cf. Chart 7. Approximately 75 per cent of the global oil reserves are thus held by OPEC countries, notably Saudi Arabia with approximately 22 per cent. Overall, these reserves can last for around 40 years at the current consumption rate.

The demonstrated global oil reserves have approximately doubled over the last 35 years, but the figures are subject to considerable uncertainty. The reserves are an indication of the quantity of oil that, in all probability, can be extracted, and not the total quantity in the underground deposits.^[10] Thus the figures do not include e.g. oil deposits as tar sand, although it would already be worthwhile to exploit some of these at the current level of oil prices. If tar sand, which is primarily found in Canada, is included, the total reserves increase by more than 10 per cent. Improved extraction technologies can also boost global reserves, e.g. if the extraction ratio for an oil field is increased from the current average of 35 per cent to 40 per cent.^[11]

Investments
The current price rises are not attributable to an acute shortage of oil, but to strong growth in demand, combined with a sustained period of low investments in oil extraction. This has reduced the spare production capacity. There is broad consensus among international institutions and market participants that large annual investments in oil extraction are required in order to meet future demand without massive price hikes. The low investment rate can be ascribed to several factors, including that the investments are of a very long-term nature, giving considerable uncertainty as to future oil prices. This price uncertainty is difficult to hedge in the derivatives market, partly because there are no contracts with maturities exceeding approximately 7 years, while at the same time liquidity is low in these long contracts, cf. Campbell et al. (2006). Moreover, many oil companies have presumably learned a lesson from their investments in the early 1980s when oil prices subsequently dived, leading to losses on the investments.

Finally, many of the demonstrated oil reserves are not accessible on market terms since many OPEC countries have only given the international oil companies very limited access. Some of the oil reserves are also found in politically unstable countries. Therefore the surge in demand in recent years has to a large extent been reflected in oil prices, rather than in a substantially higher supply.

CONCLUDING REMARKS

Looking forward, two key questions are apparent.

Firstly, will the strong growth in global oil demand continue? Curbing demand growth in the USA and China would require either a slowdown in economic growth, the implementation of energy-saving measures, or restructuring in favour of alternative energy sources.

Secondly, will the OPEC countries be able to boost investments in production capacity? Investing in new extraction capacity entails not only financial risk, but also other significant risks related to the continued geopolitical tensions in the Middle East, where most of the world's demonstrated oil reserves are found.

Both futures prices and explicit expectations among market participants point to sustained high oil prices in the years to come. Since global production is close to its capacity limit, the estimates are, however, subject to much uncertainty and disruptions caused by e.g. natural disasters or military conflicts could potentially have drastic price implications in the coming years.

LITERATURE

BP Statistical Review of Global Energy, various editions.

BP's website: http://www.bp.com.

Campbell, P., B. Orskaug and R. Williams (2006), The forward market for oil, Bank of England Quarterly Review, spring.

ECB (2006a), Factors accounting for the rise in oil prices, Monthly
Bulletin, January.

ECB (2006b), Monthly Bulletin, March 2006, p. 16.

Danish Energy Authority (2005), Analysis of oil and natural gas reserves (in Danish), May 2005.

Energy Information Administration, U.S. Department of Energy (2006), Short-Term Energy Outlook, March.

IMF (2006), World Economic Outlook, April.

IMF (2005), Oil Market Developments and Issues, March.

IEA (2006a), Key Energy Market Statistics 2005.

IEA (2006b) Oil and Gas Technologies for the Energy Markets of the
Future speech at the Oil and Gas Innovation in the Fossil Fuel Future conference, 22 February 2006.

IEA (2006c), Oil Market Report, various editions from 2005 and 2006.

OPEC's website: http://www.opec.org.