What's Next for the Oil Risk Premium?

Crude prices soared after the situation in Libya escalated at the end of February. The sustained price increase since the conflict erupted is not justified by the amount of production displaced by the conflict. Libya exports 80% of its 1.6 mmbpd of production, so the supply shock is about ~1.3 mmbpd. OPEC has about ~5 mmbpd of spare capacity. When oil prices increased to $145 / bbl in the summer of 2008, Saudi Arabia boosted output to 9.6 mmbpd, well above the current output of 8.3 mmbpd. Notwithstanding capacity additions (which have been significant), Saud Arabia can cover the entire Libyan deficit by itself with spare capacity of 3 mmbpd. There is also significant refining spare capacity in Europe. Though heavy / light differentials will (and have) increased due to the quality difference between Libyan and Saudi oil, crude and product prices have gone higher than justifiable on a supply / demand basis.

Crude has moved further than justified by fundamentals due to the risk of further conflict. Nigerian elections are coming up this quarter and the severity of Syrian protests are growing. But the key driver is undoubtedly the tail risk of conflict escalating in Saudi Arabia itself.

Assuming a fair value crude price (Brent) of $90 / bbl implies a risk premium of around $30 (with Brent around $120-125). The uncertainty of what future conflict might look like makes it difficult to evaluation the value of the risk premium, but the relationship should look as follows:

It's difficult to take a strong stance on whether this risk premium is justified (my gut reaction given the implied probabilities is that the risk premium is overstated). I think a better question is how long does oil deserve this premium? It's hard to see a reason why the premium will disappear as long as we have headline grabbing news from the Middle East. The problem is that there are so many conflicts - Libya being merely the most conspicuous - that a risk premium may be warranted for an extended period. So while the value of the risk premium may be overstated, the premium may endure for longer than those focused on the progress in Libya might expect.

Commodity Exposure vs. Speculation

A new report from Rice University's Baker Institute by Kenneth Madlock and Amy Jaffe argues the Commodities Futures Modernization Act of 2000 is one of the main reason for high oil prices. A 2007 GAO study concluded the CFMA made it easier for financial players to obviate speculative limits and made it more difficult for the CFTC to regulate oil futures markets. The CFMA allowed oil to be used for risk management products that artificially drove demand. The report states that before the CFMA 20% of oil trading was from "noncommercial participants" (speculators) while today 50% of trading is from these participants. The graphs speak for themselves:

As you can see, the price of oil corresponds with the amount of speculators in the market. When oil peaked at $145, the percentage of non-commercial traders in the market was at its highest.

It is astounding how much opposition there has been to the idea that commodity prices are heavily influenced by speculators. It seems common sense that money flooding into a market will inflate prices, especially if the new entrants are net long. Commodity markets are simply fundamentally different than capital markets because they are intended to serve a completely different purpose. Commodity markets are meant to match supply with demand while capital markets are meant to efficiently allocate capital. When NYMEX oil futures trading is 10 times more than daily consumption, a market is no longer matching supply with demand (very few contracts actually end up in delivery). Peak oil, as it is commonly perceived, is a myth. Prince Turk Al-Faisal underscored this recently in an article in Foreign Policy. If peak oil is a reality and oil is a desparately scarce resource, why does Saudi Arabia have 4.5million bpd excess capacity?

I attribute much of the interest in commodities to trends in popular investment theory. The rising popularity of "absolute returns" and the success of funds who invested in alternative assets (great example is the Yale endowment managed by David Swenson) led to the conviction that all portfolios should have at least a 10% exposure to commodities, since this asset class is historically not coorrelated to traditional assets, thereby reducing risk. This wisdom was spread by consultants and has now become a firm staple of retail investing.

One place where this has been evident recently has been natural gas. After the turmoil of last fall, when commodity prices dropped across the board, investors piled back into commodities. Since retail investors can't buy futures, they bought many shares of commodity ETFs, especially USO and UNG, expecting prices to re-inflate. All commodities, that is, except natural gas. Natural gas actually fell and continued falling. Merril Lynch recently forecast it to go as low as $2/mmbtu. So while institutional investors shunned natural gas, retail investors literally could not get enough of UNG. UNG went from a $447m fund to a $4.5bn fund in three months. The fact that the fund is trading at a 19% premium to NAV underscores the retail demand.

There is nothing wrong with investors seeking exposure to un-correlated assets or hedging their risks with commodities, but these markets were clearly not designed for this level of activity. One good change would be position limits. A market that can be as easily manipulated as commodity markets needs many small players to be efficient, and not distorting elements like the UNG and USO.

(Interestingly, every recession since 1973 can be associated with some sort of oil shock: 1973 and the Yom Kippur War, early 80s and 1979 Iran Hostage Crisis, early 90s and Persian Gulf War, 9/11 and the early 2000s recession, and finally the 2008 oil shock and the "Great Recession." Obviously correlation does not imply causation...but why take the chance and leave these markets to undue influence?)

More on Oil Prices

I want to elaborate a little on why I am bullish on oil. I am not bullish because of industry fundamentals—i.e. I do not think there is more demand than supply. The reason oil is a good buy right now is a question of macroeconomics. As long as our economy is in a downturn and our financial system besieged, the Fed will keep interest rates at 0. This is reflected in the implied fed funds rate (from Cleveland Fed):

Also, the Fed will continue quantitative easing and keep treasury yields low. Third, investor’s risk appetite will return, as we’ve already seen in equity markets. Therefore, investors will start leaving safe US dollar assets like treasuries at greater rates. Because of low interest rates, the US dollar has little support. As the dollar falls, the price of oil will become greater because more dollars will be needed as payment. It’s that simple. (It also doesn’t hurt that the memory of $145/barrel oil is still fresh on speculators' minds.)

CAFE Standards and Oil Prices

What Greenspan called the “solid edifice” of free markets may have been discredited, but its power has not. The power of markets is the seamless aggregation of incentives; therefore, to unleash the full power of the free market, incentives must be properly aligned. Obama’s push for tighter emissions standards is an example of a misaligned incentive that will further disrupt the natural pricing of oil.

As many have pointed out, Obama’s toughening of the Corporate Average Fuel Economy (CAFE) standards is inefficient compared to a fuel tax. CAFE’s problem is it creates artificial incentives for certain vehicle types. Because of CAFE, light trucks and SUVs have gone from 10% of car sales to 50% in thirty years. By making these cars cheaper and smaller cars more expensive, CAFE is indirectly encouraging fuel consumption. Also, it makes new, more efficient cars more expensive in relation to old, inefficient cars.

A fuel tax is a much cleaner incentive because it acts directly on the factor the Government is trying to manipulate—fuel consumption. For example, the CBO estimates a $.46/gallon increase in fuel taxes will lead to a 10% decrease in consumption. This incentive is effective because it acts directly on the price elasticity of demand. The higher CAFE standards on the other hand can expect to reach this goal at six times the cost. This inefficiency comes from the distance between the incentive and the target.

Determining the fair value of oil has always been difficult because of the role speculation plays in the process. It is even more difficult when one takes into account the diverse tax and subsidy policies. (For example, India subsidizes and taxes fuel.) Take a look at this graphic for more information on the extent of fuel subsidies. Fuel subsidizing countries have experienced massive growth the last few years, and, since their domestic demand isn't priced according to the global market, oil demand has grown in correlation with GDP. Morgan Stanley estimated in 2008 25% of oil is subsidized when it reaches the ultimate consumer.

Analysts said the recent oil price increase from $50 to $60 a barrel was not based on “fundamentals,” referring to large inventories. It is hard to see when oil prices have ever been based on fundamentals over the last year. First there was “peak oil exuberance.” Then, after September 2008, oil prices have been closely aligned with the stock market. The reason for this correlation is that many expect oil prices to recover when the economy recovers. People seem to forget oil didn’t comfortably reach $60 until 2006, in the midst of a “forward Minsky journey” asset price inflation.

Nevertheless, the truth is simply there will continually be upward pressure on oil prices. If there are more signs of green shoots, prices will rise or linger above $60. Now that states are in fiscally different positions it will be interesting to see how government policies change—naturally we should expect less subsidies and more taxes. But this will not occur until prices start to cause the same damage they caused last summer. The CAFE standards mean that once prices get high again, it will take longer for the US to adapt, because the economic incentives are indirectly tied to their target. It will take countries with high subsidies, like Indonesia, even longer. CAFE standards and subsidies both decrease the price elasticity of demand. As long as governments enact policies such as these, oil is a safe bet.