OIL AS A FINANCIAL ASSET
(formulation of the question)
The dynamics of the oil price has always been at the center of attention for modern economists, politicians and other actors. Today we find multiple reports that try to discuss the reasons behind the frequent fluctuations in oil prices. The most common factors in relation with the negative vector for oil prices are: - reduction in demand due to the economic plight in key oil consuming regions and countries, - changes in the structure of demand due to the increase in energy efficiency and introduction of new fuels, - innovative technological advancements, such as the “shale revolution” in the United States, - presence\absence of spare capacity in extracting and refining oil, - military conflicts (or the threat of the occurrence) in oil-rich areas or areas used for oil transportation, - sanctions against oil producing countries (for example, Venezuela, Iraq, Russia), - competition between oil producers seeking to maintain their market share, or the place on the market itself, - processes related to the global distribution of property in the world. Of course, each of these reasons require a very careful analysis, and, most likely, the answer to all the questions are contained in a comprehensive approach to all the known factors. However, no matter how convincing they might seem at first, we will take the courage upon ourselves to say that contradictions within them occur too often. Without the task, nor the opportunity to examine this in great detail, I will confine myself to two examples. It is alleged that the reason for the drop in the oil price in 2009, was the fall in demand due to the incipient financial crisis of 2008. However, this could very well have happened before. Therefore, to be more convincing, I compared the Oil price and oil production for the last 21 years.
Figure 1
Figure 2
You can see by the first graph that there were periods of significant rises in price (for example in, - 1978, 1993, 2003, 2007). From the perspective of the supporters of the parsed position at this time, there was either a reduction in supply or an increase in demand. And in 1985, 1998 and 2009, when the price fell, there was a fall in demand or an increment in production. But from figure 2 it is clear that the production always followed consumption. Large scale of over-production, falling demand, incline or decline of production in the stated years was not observed. Furthermore, in 2008-2009, when the price of oil fell drastically, there was still no change in the balance of supply and demand.
Developing the point of view about the influence of supply and demand on the price of oil, many analysts attribute the fall of oil prices (almost to half the original price) in 2013-2014 with an increase in oil production in the US, which is said had violated the global balance. In 2013, USA increased its Oil production by 15% and in 2014 by 17%1. Let’s look at the graph of the growth of oil consumption in China. Figure 3
source: United States Energy Information Administration
From the graph we can see that the growth of consumption exceeded the volume of production that was added by the United States. However, consumption in other Asian countries also increased Figure 4
source: United States Energy Information Administration
1
source: U.S. Energy Information Administration
Figure 5
Moreover, if we look at the dynamics of oil consumption, by country, from 1985 to 2014 (by BP data in million tones per year), it is easy to notice the link between the declining oil consumption in Russia after 1991, with the growing oil consumption in the United States. Likewise, we see the relationship of decreasing oil consumption in USA and Japan with rapid growth in the corresponding oil consumption in China. Perhaps, from these graphs, we can draw a conclusion: at a time of global economic growth, there is already a deficit of tangible oil. How does this affect the price? Well, it doesn’t.
Meanwhile, USA is already revealing signals of falling oil reserves. According to the “Short term outlook” from 7th July 2015 by Energy Information Administration, there will be no decline in US oil production. In May the production fell by 50 thousand barrels per day and the decline will continue. By Marketwatch: “Oil production from seven major U.S. shale
plays is expected to fall by 91,000 barrels a day in August from July”2
However, this level of production is only possible to maintain under extraordinary efforts. According to Statistics from the North Dakota Government, (which has one of the largest structures of Bakken shale oil occurrences) from January until June 2015, the number of operating wells increased by 966 (in March there was only 253). Thus, if in December 2014, the production amounted to 1164 thousand barrels per day, by June 2015, it was 12 thousand barrels less per day. I.e. volume of drilling unprecedentedly increased, while extraction decreased.
2
http://www.marketwatch.com/story/eia-oil-output-from-majorshale-plays-to-fall-91000-barrels-a-day-in-august-2015-07-13
Any geologist or petroleum engineer would say that these are the first signs of exhaustion of oil supply in the area. Yet the price of oil falls, and the majority of forecasts predict further decline. Lets consider the second example. Chart of The Day published a graph with the price of WTI crude oil, adjusted to the inflation, for the period of 19702012. From the graph you can see that its analysts compare the periods of sharp rise in oil prices with periods of tensions and wars in the Middle East. Everything seems to be very reasonable. Figure 6
However, we note that in 1977 there was no conflict in the Middle East, and the oil prices rose. From 1980 until 1988, there was war between Iraq and Iran; in 1982 we have the conflict between Israel and the PLO in Lebanon; the Palestinian intifada began in 1987, and in each of these conflicts, the oil price was falling. Interestingly, from March 2003 onwards, there was war in Iraq; in 2009, the Arab Spring commenced, which resulted in dramatic revolutions, armed conflicts, and the war in Libya. Yet, during all this time of Middle Eastern and North African unrest, the price of oil showed a completely different dynamic: it was a continuous rise and fall - in 2004, 2009, 2011.
It is noteworthy that the collapse of the Council for Mutual Economic Assistance, the Warsaw Pact and the Soviet Union, which could have ended Figure 7 up anywhere, even in an armed conflict between previously socialist countries, previous republics of USSR, between parts of Russia (and this was the prerequisite not only in Chechnya, but also other oil regions in Russia – Tatarstan and Bashkortostan), American and world markets, as the graphs show… noticed nothing at all. 30 – 40% (if not more) of world economics was source: British Petroleum affected, yet the prices of oil did not react with a clear downward tendency. Even during World War 2, there was almost no change in price. Can we explain or predict the direction of the dynamics of the oil price from these results? Of course, it would be wrong to argue that the oil demand, political and military plight in oil producing countries, circumstances related to production, processing, transportation of oil, and so on, do not affect its price. Most certainly they do, but between them there exists a more complex, non-rectilinear correlation, than usually expected. However, clarification of the extent and structure of this correlation is a topic for another study. As I’ve mentioned before, the analysis of existing positions is not an objective for this work.
Analyzing the price of Oil from 1970 to 1984, when the stock exchange of oil and futures had not yet been introduced, oil was sold as a physical commodity. I compared it with the price charts of other raw materials, and what I found was astonishing. The periods of rises in prices for other, non-oil, commodities, often coincided with the price of oil.
Judge for yourself, Here are the price charts of Copper, Nickel and Zinc, Figure 8
COPPER $/mt
Figure 9
Figure 10
NICKEL $/mt
ZINC $cents/kg
source: World Bank Global Economic Monitor (GEM) Commodities
Here is an Oil price chart. Figure 11
Crude Oil $/bbl
Please note that the allocated periods of rise in price are: 1974-75; 1980-81. In all the previous examples, prices began to decline after 1981. To ensure that this is not an accident, I compared the price charts of oil and gold in closer detail. Figure 12
GOLD $/toz
source: World Bank Global Economic Monitor (GEM) Commodities
Apart from the difference in the levels of volatility, it is easy to notice that the core areas of the dynamics of prices in that period coincided: 1973-1974 – we have growth; 1975 – we have oil price stability and a high value, as well as high volatility in gold around the price value, and a reduction in price; from 1977 increase in price of Oil and Gold; and since 1979 the price chart for oil and gold became very similarly.
To ensure that it is not a coincidence, or a statistical and technical regularity, I compared the prices of Oil and gold from 2006 to present day. Figure 13
Figure 14
And here I found that the price vectors are similar by time and direction; 2006-2008 growth; 2009 drop; 2009-2011 – growth; 2011-2013 – flat at high values and volatile; 2013 – gold falls and becomes flat with high volatility, and oil follows with exactly the same trend a year later. But what can force different category raw materials exhibit the same trends in the dynamics of their prices, when their geographical occurrence, processing, and areas of use have nothing in common? It seems like all these differences are insignificant. The first thing that comes to mind is finance.
The monetary system, the events taking place in it, from our point of view, had and have (similarly to the price of other tangible and intangible assets) decisive influence. Of course, we are not the first to come up with such a question. Giulio Cifarelli3 had outlined his vision in "Is Oil A Financial Asset? An Empirical Investigation Spanning the Last Fifteen Years"; Marek Kolodziej, Robert K.Kaufmann, Nalin Kulatilaka, David Bicchetti, and Nicolas Maystre in "Crude Oil: Commodity or Financial Asset" (published by Elsevier Ltd. 2014); Morgan Stanley Global emerging markets equity team в "The Straw That Broke Oil’s Back" (Morgan Stanley, February 24 2015) and a few others. They cover the topic of increasing the impact of financial speculators to trade oil futures in detail, since the start of the 2000s to present day. But from our point of view, the understanding of oil as a financial asset is not limited by the problem of financial speculators, nor the specified timeframe. There is evidence to suggest that since the mid-70s, oil started to act in a dual capacity - as a tangible asset and as a financial asset. We admit that when we talk about the price of oil, most of the time we do not think of oil as a commodity. What do we know about it? The stock exchange price of oil has been in the region of 50$/bar for a long time. But hardly 5-7% of exchange contracts end in real delivery. On the actual market many oil suppliers even today receive 90$/barrel through hedging contracts. There are also black market oil prices, rumors say that they are around 20-30$/barrel. But who knows for sure, and what is the volume of this market? What is the volume of the barter oil market, and how can we calculate the prices there? What is the volume and prices of programs such as “oil for food”, government procurement for defense purposes and so on? Under years of sanctions, Iran has expanded its oil trade outside dollars - for example in renminbi’s, rupees, rubles and other currencies of developing countries, for gold, for barter operations. But are they the only ones? Who has estimated the size of this market and the price of oil on it? It seems that not only the price but also the structure of the real trade of tangible oil for many, who talk about the oil market, comes with a high degree of uncertainty. Many aspects are simply not considered. When we speak about the price of oil, we talk about tangible oil, oil as a commodity and not, stock exchange oil price, contract, contingent, “paper” (similarly to how gold ended up). To be more precise, for long we have been calling oil prices as prices of financial derivatives - oil futures, and others. This has been happening at least since 1990, when the open positions on oil futures on NYMEX amounted to 1.5 the size of the world’s oil production (and if we consider that a significant amount of oil produced in the USSR did not even make it to the world market, then the size of the available global oil market is even more than 1.5). But there were also the stock options
3
[email protected]
with an oil base, and the Intercontinental Exchange (ICE) in London, other stock exchanges and OTC derivatives… from this point of view, 50% of global oil production, which were offered in the form of futures on the NYMEX in 1983 – was also quite significant. Such an approach is completely natural. In the middle 40s international financiers achieved a great victory, by signing the Bretton Woods agreement. After the war, this became the foundation of the world monetary system. Not only was it the emergence of a new world reserve currency, which by itself was a major professional achievement, but it also gave a new degree of freedom in relation to the volume of money and credit. It laid the groundwork for restructuring the world economy, from production economy to finance economy. The “petrodollar” system was not any worse. Developing what Bretton Woods system introduced, not only increased the demand of dollars and loans in them, but also placed the traditional commodity goods - oil and the financial instrument – dollar in an inextricable link. The dollar had gained new force as a "commodity currency", and the role of oil, at least in the processes related to the regulation of demand for the dollar and loans in it The volatility of inflation and the regulation of many other financial processes increased dramatically, thus making oil one of the elements of the global financial system. Consequently, the price of oil began to obey the rules and circumstances of not only the commodity market and developments in the real economy, but also the laws of the financial market. In this aspect, it seems correct to consider oil as a financial asset. That is why it’s not surprising that the price charts of oil and gold from 1979 match. Similarity between the graphs comes from the similarity of functions. Just as the one financial instrument was added to the other, “black gold” was added to gold (we do not believe, like many others that with the conduct of the “petrodollar” oil replaced gold. If we carefully analyze the charts since the early 70s you can see that gold continues to play its role for a long time). After all, gold is not only a raw material, it is also money. At least, it has been money for an endless amount of time, and its role as a mean of investment for gold still stands till today. But the functions of oil and gold become almost identical, so without oil money wouldn’t work. From this position we will look back to the first large increase in oil price in 1974. Many attribute this to the Arab-Israeli war, which incidentally lasted only 18 days. We have already noted that we do not believe that armed conflicts are the main reason for the change in oil price. Lets recall that during the Yom Kippur War: OPEC supply fell by 5 million barrels/day, which was only about 9% of the world’s consumption, and only lasted a few months. The prices rose 4 times from $ 3 to $ 12 /barrel, which then remained stable for a few years and then rose again. Another explanation for the rise in oil prices in 1974 is the "greed" of exporters, the fact that they tried to make up for their losses from the 1971-declining dollar. It would be interesting to know in relation to what did "greedy" exporters
count their losses, while the dollar was the base for all the prices of oil and the instrument for its payoff. Moreover, no other currency simply existed. Could it relatively be gold? In comparison to gold, the price of dollar fell, but not as much as the price of oil increased. Furthermore, in 1974-75, the price of dollar grew, but oil prices did not decrease. In addition, while gold was still considered as international money and the price of oil grew in respect to gold, the price of gold did not decline, sometimes it even increased along with oil. So all references to the "greed" of exporters seem unconvincing. However it may be, neither before nor after the change of oil prices in 1974, "greed" or "generosity" of exporters was not explained. From our point of view, the following happened. We will recall that in 1973 Nixon (negotiations led personally by Henry Kissinger) and Saudi Arabia managed to reach an important agreement. It included that Saudi Arabia would only sell oil in dollars, and in return the US would provide politico-military, diplomatic protection, supply of weapons and Saudi Arabia would have the opportunity to invest the income from oil sales into the US economy. During the next two years, more or less similar agreements with the United States were reached with all OPEC countries and some other countries with oil supplies. That’s how the “petrodollar” system was developed. Meanwhile, there was a change in the price of oil. If his aim was tangible oil, then the significant increase in its price should have been regarded as unduly risky, the dubious venture in terms of lack of cause and particularly immediately after the agreement was reached with the United States. But if the goal was the dollar, then everything is clear: its not the oil that has risen in price, it’s the dollar that has decreased in price in gold and oil. If the aim was to increase the demand for the dollar, then the "extended selling in the new season at special prices" – is a perfect beginning for the “petrodollar”. Therefore oil along with gold has proved itself as a financial instrument and asset. Soon after, oil quotes features typical for the stock markets such as high volatility, cyclicity, fractality, and others, started to occur very often. The price of oil began to correlate with a number of financial indicators such as the dollar, stocks, the yield of US Treasury bonds, etc. Of course, in the future the main demand for the dollar was provided by rapidly developing financial markets and not oil. Yet, in relation to our topic this means that the function of oil as a financial asset has only increased from year to year, and the price of oil has become even more dependent on events in the financial sector.
Remember how in the 80s stock exchanges, which had barely started to trade oil, suddenly, made a historic change and began trading natural raw materials in “conventional” oil in the form of futures and other instruments related to oil. It is believed Figure 15 that futures were designed to mitigate the financial and price risks of suppliers and buyers of oil in the 80s. From history we know that it increased the number of participants in the oil markets and a surprising number operations in it, decreased the importance of regular trade, increased the role of one-off transactions, in prices under which the set of unpredictable factors led to a sharp increase in participant’s risk in transactions.
This is of course true - but not entirely. Compare the price of oil before the 70s, when Oil was not sold on the stock exchange, and the price of the dollar was quoted in gold, with the price of oil after 1985.
Figure 16
There is no say in the reduction of risks of oil transactions for participants. All the stability and predictability of prices was left in 50s and 60s. However you can see on the exchange stocks that there is a new dependency of oil prices from prices of another financial instrument – Dollar, which has now become so familiar: dollar rises- oil falls, dollar falls- oil rises. Figure 17
Figure 18
It is evident, that if from 1970s to 1985, the coincidence of vectors of oil and dollar prices can be treated as unstable or even random. Then, somewhere from 1984-85, since the heyday of the oil futures markets, regularity started manifesting with stability: until 1985 dollar rises- oil fails; 1986 oil risesdollar falls; 1987 oil falls, dollar rises; 1989- oil falls, dollar rises and so on.
I am aware, that for profound, or at least an adequate judgment, on the found regularities, I don’t have the knowledge, nor the information or experience to deliver. Since the late 70s the central banks of the largest economies in the world (including the US and the Federal Reserve) obtained the opportunity to change the interest rates on the government's disposal, thus have an influence on inflation, price and economic activity in different (and after some time in all) sectors of the economy. They also gained influences to expand the area of application of the Figure 19 dollar and loans in it. In all economies in the world, it may as well be that the correlation we described in the value of oil and the dollar after 1985 has more meanings than just the technical patterns, which is characteristic for financial markets. Even if I am wrong with my conclusions, to present day the share of the financial sector has grown multiple times (for example, the share of the financial sector profits in the United States increased from the a value of less than 10% before World War II to more than 50% at the present stage). The structure of the world economy has changed so much that even the flagships of the production and technology sector began to receive the majority of their income from stock markets and the sale of product (primary source of all data Thomson Reuters DataStream).
Figure 20
Figure 21
Figure 22
Figure 23
It can be seen that the increase in market capitalization in leading markets counts trillions of dollars in the absence of any macroeconomic or corporate improvements. Moreover, capitalization growth often occurs at the most negative trends in business since 2008-2009.
Under these circumstances, talking about oil it would not be wrong to say that its function as a financial asset only increases with years. In addition, it does not require a lot of effort to track when it started. But it is also clear that under the growth of financial economy the importance of oil as part of the monetary system can be reduced, and reduced significantly. Lets look at another case. Lets take the graphs of European and US stock markets from 2008 until the middle of 2015.
US Stock Market
Figure 24
Figure 25
European Stock Market
source: S&P Dow Jones
Note that in the period of 2008-2009 there is almost a perfect match. Since 2009, despite the fact that the dynamics of the US market is higher, their simultaneous and parallel upward movement begins, in which even the corrections match. This continues until the mid 2015. How did that happen? After all, the structure of the US and Europe economies are very different. In Europe, they also have UK threatening to withdraw from the European Union, Greece that collapsed, problems in Portugal, Spain and Italy, incomprehensible Hungary, depopulated Baltic countries, poor Romania and Bulgaria, losses from sanctions against Russia, Ukraine, terrorist attacks, immigrants and refugees… On the other hand in US there is nothing, yet the graphs are the same. It may be that the data on fall or raise in a fraction of percent of US GDP plays a spectacular role for European investors. They not only prefer the stock markets of these countries, but also exert the same activity on all of them. If we return to figures 20,21,23, we can see that companies in Eurozone in 2015 in comparison with December 2014 recorded one of the largest increases of capitalization during absolutely failing accounting results. U.K. companies experienced an even worse failure. In US total income has not increased since 2011, however capitalization increased by 60%. From our point of view in a situation like this, such rapid growth of stock markets in Europe and the United States seems to be a highly professional and highly successful work of financial institutions - their ability to regulate a system much more capital intensive than the oil market. Lets now look at the price of dollars and euros. Figure 26
Figure 27
It seems as if, deliberately, they are in antiphase with each other, as per usual of oil and dollar. When we talk about money, it’s quite easy to imagine how much profit can be obtained by forcing investors to go in the dollar and then in the euro. But in this case, it would be appropriate to assume that the form of the correlation of oil and dollar prices, which has been developed since the mid 80's, among others, had the same goal. But lets pay attention to the way the graph ends. The dollar goes up following the stock market, demonstrating the stability and reliability of the US economy. While the European stock market rises (as it should for a strong economy) strives downwards (as it should for a weak economy). Could there be any sense behind this? There could be. By the time when the dollar begins its sharp upward movement, much of the global economy falls, or is already at the bottom: Asian markets, Markets of developing countries and their currencies, commodities and gold - and so the Euro follows. Figure 28
Figure 29
Asian Stock Market
Emerging BMI
Figure 30
Commodities Index
aource: S&P Dow Jones
Figure 31
I think that the priorities are marked clearly. Swiss franc and the British pound stand separately, however their volumes are insignificant. The Chinese Market grows and the Yuan is stable during that time, but their fate to us now is unknown.
But we are interested in oil. Lets compare the price charts of oil and dollar. Figure 32
From 2008 until 2012 the picture is as per usual: Dollar is on the top- Oil at the bottom, and vice versa. From 2012 until 2014 dollar and oil experience volatility but remain flat, but their prices are no longer in antiphase, they are now familiar. (In those days, people would say that oil pulled away from the dollar. That is doubtful). Finally in 2014: Dollar rises sharply, oil sharply falls. Lets try to understand this. To do this we need to combine the previously made observation of oil, the dollar, gold and S&P 500. So, we have assumed that the priorities lie in the dollar and the US stock market. QE1 starts at the end of 2008, the amount of money on the market increases, and oil experiences a phenomenal drop. Gold falls, S&P 500 falls. On the other hand the dollar rises. 2009 - turning point: dollar, oil, gold, S&P 500 rise, but before the end of QE1 Gold and oil slightly drop, while the dollar has a sharp fall. S&P 500 grows with the weak dollar. In august 2010 QE2 begins: Everything grows, dollar, S&P 500, oil, gold. But after the end of QE2 dollar once again has the most dramatic response. Oil, gold, S&P 500 have a small drop, while the dollar goes down sharply. What would I do if my aim were to maintain the growth of the US stock market? I would attack the gold and oil, trying to strengthen the dollar, so I could increase the faith in the stock market. In September 2013 QE3 begins: Dollar rises, S&P 500 Rises, oil drops, until 2014 rises up then falls, it seemed like gold would also rise, but it falls straight away and does not recover. Lets try to draw conclusions. It is said that in ancient Greece there was a long jump technique with stones. The jumper would make a run and push himself off the ground with stones in his hands, and when he
felt that the momentum was over, he would throw them down with strength, thereby increasing the length of the jump. Maybe we are seeing something similar? Of course despite the fact that the capitalization of the world stock market is estimated to be around 70-90 trillion dollars, and people such as Paul Krugman constantly remind us of redundancy of investment assets, the sources of money for US and China stock markets (which not long before its fall attracted approximately 15 trillion dollars), and for other markets seems to be enough. But money needs to demonstrate the right direction, especially when you need the gamble to overcome caution. During QE, easing in Europe and Japan started the system up, but inertia needs support. It is not excluded that at first it was the money from the market of precious metals that helped and only later on oil money. After all, at the end of QE 3 the US stock market has received approximately another 5 trillion dollars. You can estimate how much of that makes up oil money: the volume of legal purchases of commodity oil in the world in 2014 amounted to over 30 billion barrels - so we can talk about $ 1 - $ 1.5 trillion. It draws on the new QE. But, the main thing is the volume of oil derivatives. I don’t have any recent data, but at the end of May 2011, the NYMEX open positions in oil futures were in commodity equivalent to 365 billion barrels of crude oil, which is 12 times the size of oil production in the world for the whole of 2010. It is likely that someone might have needed money from here too. In any case, we have became a witness of yet another manifestation of the role of oil as a financial instrument when falling oil prices could contribute to the preservation of the global financial goals. Figure 33
If I'm right, as long as the dollar and the US stock market will rise, even in times of correction of the stock market and the dollar, the price of oil, (as with the price of any other tangible assets), will fall. Only assets that will remain stable and show growth are the ones that will either help or not interfere with the growth of the US stock market. Of course, the growth of the dollar and the US stock market is not the only and ultimate goal of global financial institutions. Somewhere behind questions arise about overindebtedness, treasury bonds, debt market, etc., but the main thing is the stability of the system, and the retention of the achieved. But all this is too far beyond my competence. Yet the question still remains: can such a sharp decline in oil prices caused almost exclusively by financial motives, cause irreparable damage to the petrodollar system, that has been ever so successful since the 70s? It is hard for me to judge and assess casual relationships. But from the graphs shown above, it is easy to understand that the time for decrease in oil prices was chosen very well - when the demand for the dollar in the petrodollar system was reduced to a minimum. CONCLUSION I do not know how long oil will remain in between its two hypostases. Perhaps, development of financial economics will lead us to virtual money and instruments, for which oil will no longer be needed. Maybe we will suffer a total crisis. But until that happens, it is important to understand the laws that reflect upon oil prices. I suppose that oil has two forms of existence in the modern economy: financial commodity and conventional contract type: two functions – industrial raw material and a financial asset; two prices – price of crude oil and the conventional oil price, oil as a financial asset. There are different groups of factors that directly or indirectly affect either only one (only marketable or only conditional) or at times even both types. The price of conventional oil, serves as a financial asset in the modern monetary system, and has dominant influential factors that are specific to the financial field. For the last 40 years or more, the development priority is the financial sector rather than production, the price of conventional oil has a greater impact on the price of crude oil than vice versa. So the factors affecting the prices of conventional oil turn out to be preferential compared to the factors of affecting the prices of crude oil. I plan to devote my further studies to confirm or refute this position.
