Oil Price Forecast - Fundamental Analysis.

Balance of Supply and Demand:

In the most generic economic explanation, crude oil being a globally traded commodity, is subjected to the basic price mechanism of supply and demand. Two major activity centres: downstream and upstream largely dictates the fluctuation in both supply and in demand. Demand for crude oil has a tendency to become more distributive as oil consuming countries increasingly trying to establish their own refining capacity in order to minimize on foreign import dependencies as well as to capture the economic value added during the refining process. A key trend in recent years, with new technology developments such as hydraulic fracturing which allows oil trapped in tight rocks to be exacted economically, the United States has become more are more self-dependent and hence, reducing pressures on international supply of crude oil.

On the supply side, there are two main players: OPEC countries and non-OPEC countries. Having rather contrasting policies with regards to pricing crude oil, these two groups can at times, cancelling out each other’s effort to maintain selling price. Canada for example, while gradually becoming a major exporter of crude oil, for years did not align their pricing policies with OPEC’s due to their strong belief on an open global market economy.

A key concept used in the industry is price-elasticity of demand for crude oil. This measures the sensitivity or responsiveness of oil demand to changes in price. According to the US Federal Energy Office’s estimation, the long run price elasticity of demand for oil consuming countries ranges from -0.2 to -0.6 with the US remains around -0.5. One could expect the short run price elasticity to remains in an even lower range considering the time lag it takes for adjustments. As such, it is visibly clear that the demand for crude oil remains very steady despite any potential price increases.

Gross Domestic Product Growth

Crude oil price is in correlation with Real GDP growth since growth in general requires crude oil to fuel economic activities. The world economy has been expanding at about 5% annually since 2004 until 2008 and averaged out at nearly 3.5% afterwards. In essence, the emergence of BRICS countries is largely responsible for such robust growth observed and while the world GDP growth has not necessarily been consistently high, growth nevertheless, places crude oil price into upward pressure. At this point, the emerging economies are still consuming crude oil at a relatively low rate on per capita basis so it is expected that the upward pressure on oil price will continue as their GDPs keep on catching up with richer countries.

Apart from the price shock experienced due to the global financial crisis in 2009, patterns of crude oil price movement and world real GDP growth have been markedly similar. Hamilton (2009) demonstrated that strong growth in world income was the main cause of oil price surge in 2007-08 and equally the dramatic collapse of oil price in 2009 was related to the financial crisis in the same year.

REAL WORLD GDP GROWTH AND BRENT CRUDE OIL PRICE

Crude Oil Production and Inventories

Despite a period of stagnation from 2004 to 2008, global production has been increasing steadily ever since. Large contributors to the overall production traditionally are OPEC and Russia. In recent years, Canada and the U.S. are sharply improving their production and becoming more and more influential in the market. However, the production level has been strictly close to consumption level on daily basis without taking into account the demand to accumulate inventories. Consequently, supply and demand will not balance once the net production capacity is compared with the real demand in consumption and inventories accumulation. This imbalance of oil supply and demand and more importantly, the persistent expectation that this imbalance will hold for a foreseeable future have contributed to the general upwards trend of crude oil price.

Crude oil inventory level is carefully watched by traders as it has a very strong influence on Market Expectation. Low crude oil inventories may cause uncertainty about the ability of the market to meet demand, which supports higher prices. Conversely, high crude oil inventory levels support lower oil prices. In recent years, on a “days of supply” basis, crude oil inventories have been on the declining trend due to continuous growth in demand. Demand for crude oil to accumulate inventories is significant and putting additional pressure on prices. As an example, in an effort to quarantine the threat of supply disruptions, the US in particular has been steadily increasing their Strategic Petroleum Reserve, the largest government-controlled inventory in the world. Despite this growing accumulation, the U.S. inventories alone do not reverse the global declining trend and in the long term prospects, traders expect demand for inventories will further putting upwards pressure on prices.

Data source: EIA – Independent Statistics & Analysis – U.S. Energy Information Administration

Production Spare Capacity

It terms of spare capacity, much of this capacity is possessed by OPEC with Saudi Arabia holding the majority. Therefore, the industry has long viewed spare capacity outside Saudi Arabia as an important indicator of supply tightness. It can be seen from the chart below that spare capacity is staggeringly low compare to the steady increase of the demand curve. Without a significant spare capacity, market participants cannot mitigate price shocks and supply disruptions effectively via pure supply and demand balancing. The total combination of these factors should in general put an upward pressure on crude oil price.

Analysts in general consider Production Spare Capacity a contributor to market expectation and hence, contribute to the price setting mechanism via market expectation. A report of high spare capacity within OPEC generally give market a comfort of knowing that supply is in a plentiful state whereas, a negative report of spare capacity could fuel fears of supply disruptions and price shocks. Noting a persistent global demand growth, spare capacity is still rather stagnating, it is common sense to consider that this trend is also putting crude oil price in an upwards pressure.

Market Expectation:

Apart from the level of supply and demand for the physical crude oil, market expectation has frequently been cited as an important element contributing to price movement. In October 2014, Goldman Sachs forecasts that despite OPEC’s latest price reducing efforts in order to maintain market share, oil price will still be further reduced due to the U.S. increased capacity via non-traditional oil exploration route. In essence, Goldman Sachs believes that the U.S. shale oil deposit and its latest extraction technology have enabled it to become the new first mover swing producer instead of OPEC, and hence, oil price could continue to decline. Upon the release of this forecast, crude oil price fell further, hitting a 28-month low of $79.44 per barrel mainly due to market expectation and sentiments. Market expectation while intangible, can create volatility in the market as demonstrated above. Many scholars believe that market expectation is strongly reflected in the futures contracts market by corresponding activities of trading participants. Hence, they consider that by analyzing movements in the futures contract market, traders can visualize the current and future market expectation regarding the price movement patterns.

Crude Oil Futures Market

A futures contract is an agreement to buy and sell a specified amount of crude oil at an agreed upon future date, at an agreed upon price and location. Unless offset, the parties are obligated to complete the agreed transaction at the expiration date. Market expectation therefore is reflected in the futures market where buyers and sellers fix future prices corresponding to the delivery times. Apart from providing much needed liquidity, large international futures markets also serve as price-signalling centres to worldwide traders as a whole. Due to their standardized format, futures may not a very efficient instrument to allocate the trading of the physical commodity. While less than 3% of futures contracts result in the delivery of crude oil, futures still remain a good indicative benchmark of market expectation.

On the other hand, whether price expectations reflected in futures contracts really contribute to the price setting mechanism is still a highly controversial issue. Business analysts in general are skeptical against correlating these two variables. Participants in the futures market in general are hedgers (commercial) and speculators (non-commercial) who we can distinguish by their exposures to the physical crude oil traded in the futures contracts. Some academic scholars also share similar views with business analysts. Bahattin, Jeffery, Buyuksahin and Harris (2009), using linear Granger tests, fail to find causality from traders’ positions to prices. On a behavioural aspect, most traders alter their positions following a price change which suggests that their activities in the market do not systematically affect the price but rather, traders are responding to new information reflected in price changes due to the market efficiency.

Geo-political, economics and natural disasters

Historically, crude oil price has a strong tendency to react to geo-political and economic events including weather related developments. In the current landscape, there is a high degree of uncertainty of future oil supply adequacy and market participants are continuously trying to assess the size and duration of possible disruptions. As discussed above, demand tends to be very “inelastic” to price change in the short term. At the same time, while supply is concentrated (within some countries with healthy crude oil deposits), demand is very distributive as other countries need crude oil and its products to drive their economic activities, any projection of future supply disruptions should result in a large price hike in order to balance the physical demand and supply.

Weather can also play a significant role in creating high price volatility. Hurricanes, earthquakes have been shutting down major economic activities on both sides of crude oil supply and demand. Severe cold weather is also an upwards price driver as suppliers struggle to meet demand for crude oil. In summer, gasoline use increases during the travel season, increasing demand for oil, leading to an increase in prices.

OPEC Intervention

OPEC is an international organization consisting some of the major oil exporting countries in the world. Currently OPEC has 14 members with Saudi Arabia being the largest producer. On average OPEC contributes some 40% of the total global crude oil production and its export represents about 60% of the total crude oil traded globally. Having such behemoth supply power, OPEC frequently use this position to place upwards pressure on crude oil price by continuously adjusting the production capacity and inventory. Apart from the global financial crisis in 2009, the world has hardly seen any other significant discrepancy between OPEC output and crude oil price.

At the time of writing, crude oil price is continuing on a declining trend, much at the irritation of OPEC. For almost 40 years, OPEC was a major force that can influence crude oil price at the level that could benefits member countries. In recent years, with Canada and especially the US, increasing on production capacity, OPEC can no longer assert its authority as before. Canada is one of a few develop countries that maintain a net export of petroleum products, whereas huge deposit of shale oil means that the U.S. is gradually approaching the point where they can become a net exporter. The political landscape of crude oil is further reformed as the U.S. and the European Community implementing heavy sanction on Russia which put the oil extraction industry in Russia under heavy obstacles to find buyers in the U.S and in Europe. Hence, sanctions on Russia further increase excess production capacity in non OPEC countries. Experts are predicting that OPEC may have to take action in order to reverse this declining trend. Some OPEC nations are producing crude oil at breakeven point well below the current trading price. However, the large majority of OPEC members are producing crude oil at breakeven points close to well above the current trading price meaning that they cannot sustain this trend for long. According to Citi group, Venezuela is producing crude oil at breakeven of $161 and Libya at $185. Kuwait and Qatar respectively require $44 and $71 to break even. These staggering differences again highlight the potential volatility of crude oil production cost from within OPEC and in the short term, it is prudent to consider that OPEC’s influence on price is waning.

Crude Oil Price and OPEC Petroleum Production

Interest rate

Interest rate traditionally is viewed by many scholars as having a negative correlation with crude oil price. In many cases, a decline in interest rate signals a new boost in terms of economic activities and hence, increases the demand for crude oil to fuel these activities. The effect of busy economic activities is further consolidated by the higher incentive to accumulate inventories and hence, increases demand for inventories. This influential theory was published by Frankel in 2008 which shows that the declining interest rate is a decrease in opportunity cost of holding on crude oil inventories, and hence, bolsters the demand for crude oil used to accumulate inventories.

Exchange rate

Crude oil trading is denominated in US dollar and hence, any fluctuation in the dollar exchange value theoretically can have an effect on the dollar selling price of crude oil. Oil producing countries place a great interest in monitoring the price movement of the dollar value. The dollar value directly impacts their oil revenue, and hence, international purchasing power. Oil consuming countries which represent the majority of the world demand are, on the other hand, sensitive to any fluctuation in the US dollar exchange rate due to the change in net expenses used to purchase oil for consumption and inventories. Fillip Novotny (2012) proved that the global demand for crude oil is negatively correlated with the US dollar exchange rate. This phenomenon is explained as oil consuming countries would import more in the event of a depreciating US dollar exchange and would refrain from importing in the event that the US dollar exchange appreciates. As the general demand changes, so too does crude oil price in a negative correlation and hence, it was concluded that crude oil price and US dollar exchange hold an inverse relationship and numerically a 1% depreciation of US dollar exchange rate would induce an increase of 2.1% in crude oil price.

Test of Correlation and Causality

Further to theories described above, a multiple linear regression is conducted in order to examine the true extent of correlation and causality between oil prices and several other fundamental factors. The data are obtained on a 73 months basis available at the U.S Energy Information Agency which collect various date on crude oil consumptions as well as macroeconomics data.

- WTI Spot: refers to spot price of WTI traded in the U.S (New York Mercantile Exchange). WTI Spot is used as a dependent variable in order to test causality of other fundamentals.

- Real World GDP Growth: the annual real growth rate on a global scale.

- Total World Petroleum Consumption: represents total demand. This variable does not take into account demand for accumulating inventories. Inventories fluctuation is reflected by another variable which is Net Inventories Withdrawals.

- Total World Petroleum Production: represents the total supply in the analysis.

- Real U.S Dollar Exchange Rate: reflects the real value of U.S. dollar in the exchange market. The time series data shows fluctuations which corresponds to fluctuation in the value of the U.S dollar.

- Net Inventories Withdrawals: represents withdrawals from global inventories including the U.S Strategic Petroleum Reserve.

- U.S Prime Lending Rate: is the bank prime lending rate in the U.S. This rate in the U.S was chosen to reflect the WTI Spot price in analysis is the spot price traded in the U.S.

- OPEC Production: OPEC’s means to control the price by varying the production, and hence, vary the supply side of crude oil. Hence, OPEC production can be considered as OPEC’s authority on influencing the price.

The non-hierarchical multiple regression (stepwise) was used to check the statistically significant contribution to the variability in crude oil price. Durbin-Watson residual is also chosen as the data in analysis has time-series characteristics. The regression shows that based on available data, despite all independent variables have strong correlations with WTI Spot prices, only Real World GDP Growth is statistically significant in contributing to the variability of WTI Spot prices. Since the data set consists of only 73 month data, it is suspected that power of this regression is not enough to reflect a strong causality as well as correlation as in reality.

Descriptive Statistics
	Mean	Std. Deviation	N
WTI Spot	92.84	8.653	73
Real World GDP Growth	3.340	.8682	73
Total World Petroleum Consumption	89.8892	2.25444	73
Total World Petroleum Production	89.8711	2.11484	73
Real U.S. Dollar Exchange Rate	104.3527	4.59357	73
Net Inventory Withdrawals Total World	.0185	1.01412	73
U.S. Prime Lending Rate	3.2897	.14355	73
OPEC Production	29.8796	.64372	73

Variables Entered/Removed^a
Model	Variables Entered	Variables Removed	Method
1	Real World GDP Growth	.	Stepwise (Criteria: Probability-of-F-to-enter <= .050, Probability-of-F-to-remove >= .100).
a. Dependent Variable: WTI Spot

Model Summary^b
Model	R	R Square	Adjusted R Square	Std. Error of the Estimate	Durbin-Watson
1	.587^a	.344	.335	7.056	.463
a. Predictors: (Constant), Real World GDP Growth
b. Dependent Variable: WTI Spot

ANOVA^a
Model		Sum of Squares	df	Mean Square	F	Sig.
1	Regression	1856.210	1	1856.210	37.278	.000^b
	Residual	3535.359	71	49.794
	Total	5391.568	72
a. Dependent Variable: WTI Spot
b. Predictors: (Constant), Real World GDP Growth

Collinearity Diagnostics^a
Model	Dimension	Eigenvalue	Condition Index	Variance Proportions
				(Constant)	Real World GDP Growth
1	1	1.968	1.000	.02	.02
	2	.032	7.873	.98	.98
a. Dependent Variable: WTI Spot

Residuals Statistics^a
	Minimum	Maximum	Mean	Std. Deviation	N
Predicted Value	81.38	99.51	92.84	5.077	73
Residual	-20.359	18.794	.000	7.007	73
Std. Predicted Value	-2.258	1.313	.000	1.000	73
Std. Residual	-2.885	2.663	.000	.993	73
a. Dependent Variable: WTI Spot

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Saturday, 11 July 2015

Crude Oil Price. Factors impacting Crude Oil Prices. A fundamental analysis.