The Petro Bubble

1. The Petro Bubble Philip K. Verleger, Jr. PKVerleger LLC April 2005

2. Crude Oil Spot Prices, January 1998 to April 2005 Source: Platts.

3. Theme • After ten years, commodities have finally become a suitable investment class for pension funds. • The billions pushed into funds have contributed to the 12-month rise in crude prices. • OPEC’s focus on market backwardation kept returns good. • Money continues to chase oil assets even as prices rise to unheard of levels. • The rise may culminate in a “Super Spike.” • Or Saudi Arabia may deflate the bubble.

4. This price rise is not about fundamentals. • The press and analysts attribute the price rise to supply and demand factors. • Extraordinary growth in China and India • Lagging investment in E&P • Inadequate and unsuitable refining capacity • Others attribute the price rise to a belief that global reserves have been exhausted.

5. These explanations do not fit the facts. • There is plenty of oil today. Tanks are full. • The world is awash in cash and investors seek outlets. Commodities are a new outlet. • High prices today are the best cure in the long run for expectations of high prices. • Ultimately, Saudi Arabia and/or the United States have the power to cure the current level of high prices.

6. Current oil supplies are more than adequate. • US crude stocks are well above normal levels. • Global oil stocks have increased. • Returns to storage – the market indicator of supply availability – are at record levels, suggesting a growing surplus. • Discounts of cash to futures confirm the surplus.

7. U.S. Commercial Crude Oil Inventories, 1982 to 2005 Normal Range Source: API.

8. Usable Commercial Stocks in OECD Countries Normal Range Source: EIG; PKVerleger LLC.

9. WTI Returns to Storage, 2004, 2005, and Normal Range Normal Range 2005 2004 Source: PKVerleger LLC.

10. Brent Returns to Storage, 2004, 2005, and Normal Range Normal Range 2005 2004 Source: PKVerleger LLC.

11. Natural Gas Returns to Storage, 2004, 2005, andNormal Range 2004 2005 Normal Range Source: PKVerleger LLC.

12. Heating Oil Returns to Storage, 2004, 2005, andNormal Range 2004 2005 Normal Range Source: PKVerleger LLC.

13. Gasoline Returns to Storage, 2004, 2005, and Normal Range 2005 2004 Normal Range Source: PKVerleger LLC.

14. March 2005 Crude Oil Price – Settlement Price of First Futures vs. Spot Crude at Cushing Source: NYMEX; Platts.

15. Commodities as an Asset Class - 1 • Investment banks have pushed commodities as an investment class for 14 years. • Academic research shows returns on collateralized commodities match or exceed equities and bonds while being negatively correlated with these assets. • Research was ignored until recently. • No more than $5 billion invested until end of 2003 • Now probably more than $75 billion invested

16. Commodities as an Asset Class - 2 • Research was ignored until recently. • No more than $5 billion invested until end of 2003 • More than $75 billion invested by end of 2004 • At least $40 billion more invested in oil in the first quarter • Research shows investment in commodities boosts portfolio returns. • Returns from investment in energy easily overwhelmed returns on other assets in the first quarter.

17. New Research by Gorton and Rouwenhorst • Returns to futures exceed returns to spot commodities. • Commodity investments “outpace” inflation. • Return on futures matches S&P 500. • Commodity returns are negatively correlated with equities and long-term bonds. • Commodity futures have opposite exposure to inflation compared to equities and bonds. • Commodity futures provide a diversification against systematic risk. • Commodity returns outperform “matching equities” three to one.

18. Goldman Sachs Initiative • Goldman Sachs led in developing the idea. • Created a diversified index in 1991 • Introduced idea of “roll” and “spot” returns • Did not go far until 2003 and 2004 • At the end of 2004, perhaps $40 billion invested, 90 percent from pension funds.

19. Many Funds follow the Goldman Sachs Commodity Index Formula. *Percent of total allocation to commodities. Source: PKVerleger LLC.

20. Required Futures Contract Purchases to Match a $50 BillionInvestment Increase in Collateralized Futures*

21. Stock, Bond, and Individual Commodity Future Performance over the Business Cycle – July 1959 to March 2004 (Average Monthly Annualized Returns, Percent)

22. First-Quarter 2005 Returns toVarious Investments

23. Open Interest in All Petroleum Futures Source: NYMEX.

24. OPEC and Oil Industry Offer Investors a One-Way Option through their Inventory Policy. • One-way option: a guarantee to investors that they will not lose money • Term originated in currency markets during fixed-exchange regimes. • Investors short currency of country with serious international imbalance. • Country can either raise interest rates or lower exchange rates. • Investors do not lose if interest rates raised but do profit with lower exchange rates. • OPEC creates the one-way option by managing inventories.

25. OPEC Policy to Keep Inventories Low • Policy originated in March 1999. • Goal is to keep stocks low and markets in backwardation. • Companies have supported the effort by cutting stocks. • Result is backwardation.

26. Theoretical Supply of Storage — Relationship between Inventories and Price Spreads Source: Jeffrey C. Williams, The Economic Function of FuturesMarkets (Cambridge, England:Cambridge University Press, 1986.)

27. Mid-continent U.S. Inventories vs. Cash/Futures Price Spread, 1990 to 2004 Source: PKVerleger LLC.

28. Oil Industry Assists OPEC by not Selling Production Forward. • Producers increasingly prefer options to swaps or futures. • Some purchase puts. • Other firms enter collar arrangements. • The trend to options reduces the supply of oil offered to investors. • The cut in supply at a time of increased demand results in higher prices.

29. The Impact of OPEC’s One-Way Option • OPEC keeps inventories low – causing backwardation. • Cash flows into commodities – lifting forward prices. • Low inventories cause cash prices to rise relative to forward prices. • More cash flows in, causing prices to rise. • In theory, the cycle is never ending. • The result is a bubble.

30. Bubbles Can Last a Long Time. • Greenspan warning of “irrational exuberance” was made in December 1996. • Market collapse did not come until March 2000. • Some bubbles deflate slowly – or are superseded by later events. • A market disruption could prolong the oil bubble and lead to a super spike.

31. Governments Can Intervene to Break Bubbles. • The Federal Reserve Board broke the silver bubble in 1980. • Governments may be forced to break the current energy bubble if prices rise to excessive levels. However, tools are limited. • Swaps of strategic reserves • Recession induced by higher interest rates • Imposition of regulation on hedge funds • Central banks will act if oil prices are seen to boost inflationary expectations.

32. Saudi Arabia could also break the bubble. • Key officals worry that current high prices will destroy too much future demand. • Saudi Arabia has ended the one-way option. • Saudis have tools to break bubble. • Enter swaps with U.S. Strategic Reserves • Increase production • Remove destination limits on Saudi oil • Enter financial swaps to offer funds what they want

33. The Key Question is Will the Intervention be Smooth. • Almost any type of market intervention carries the risk of causing a collapse. • Buyers from pension funds will withdraw. Hedge funds may short the market. • Other producers may rush to sell. • Firms that have written puts to producers would have to sell to remain delta neutral. • The copper collapse carries a hint of things to come.

34. Spot Copper Price, January to December 1996 Source: Norman’s Historical Data.

35. NASDAQ 1000 Closing vs. Two-Year-Forward Price for WTI WTI NASDAQ Note: WTI price shifted back 66 months. Source: NASDAQ; NYMEX; PKVerleger LLC.