Politics, Geopolitics And Financial Flows In A ‘low’ Oil Price Environment

Transcript

SPECIAL REPORT January 23, 2009 Politics, geopolitics and financial flows in a ‘low’ oil price environment DURING THE PAST FIVE YEARS THE INTERNATIONAL OIL SECTOR B E C A M E a vital laboratory for those of us intrigued by the interaction of domestic policies Ed Morse Managing Director Chief Economist +1 212 651 3196 [email protected] Edward Kott Senior Associate +1 212 651 3176 [email protected] and international politics, of oil and money, and of the uses of oil as an instrument of foreign policy in the service of other political goals by governments of resource rich countries. Then, as now, there were the usual debates between those in the analytical community whose views are well-entrenched and those who believe that history doesn’t exactly repeat itself and are eager to find something new. The former camp includes what has been until recently a growing consensus that peak oil is here as well as economists whose views of the market are based on static theory. The latter camp includes those who have seen in the unprecedented rise of financial flows – speculative as well as passive, technically- as well as fundamentallybased – something fresh, providing new interactions between Saudi Arabia and OPEC on the one hand and “systemic” markets on the other; it also includes those who were not surprised by oil prices, which have always reflected a cyclical industry, falling precipitously last year. Commodity markets in general and oil markets in particular have enjoyed a history of sudden turning points. Some of these, as in 1971-72, when the elements of a dramatic and unprecedented rise in prices were put in place, have foreshadowed a long-term period during which oil importers feared the consequences of supply disruptions and oil-rich exporters obsessed over finding ways to prolong the sector’s expansionary phase. Other periods, as in 1982-85, saw importers grow complacent about the operations of the energy market and exporters find ways to act in concert to shift the burden of adjustment to lower prices onto the markets on whose growth the producers depended. It is premature to conclude that the sharp fall in prices that began in July 2008 presages a new basic turning point in oil markets. But it’s safe to project that markets will remain softer for the next two to three years than they were in the last five. If this is the case, what can we conclude will likely characterize the interplay of domestic politics, international geopolitics and financial flows in the oil sector in the near to medium term? LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Please see important analyst disclaimers on the last page SPECIAL REPORT A more feckless oil weapon THE LAST FIVE YEARS SAW THE REBIRTH OF THE USE OF OIL AS A C R I T I C A L I N S T R U M E N T of foreign policy by key resource countries – Iran, Russia and Venezuela in particular. The underlying geopolitics of the oil market is defined by the world’s dependence on oil as an energy source, particularly but not only in the transportation sector, and by the concentration of oil resources – both assets and flows—in a handful of countries. As energy prices were rising, these countries rapidly earned increased respect from other governments and investors, which propelled them to rely increasingly on oil and natural gas as instruments of foreign policy. The degree to which the Chavez example reverberated in Latin America is one reflection of this, just as Moscow’s assertive attitude has brought more heavy-handed Russian diplomacy to neighboring states, from Ukraine through Transcaucasia to Central Asia, than at any time since the collapse of the USSR. With lower prices, the power of the oil weapon is waning rapidly With oil and natural gas prices having collapsed, the power of their weapons has been waning rapidly, turning creditor into debtor nations and depriving them of the revenues required to fulfill their international goals. This too is problematical internationally for this reduction in their power has been swift and the governments involved find it difficult to believe that the authority they earned in a period of high oil prices has withered. Two dangers loom on the horizon, each with global consequences. First, lower revenues are creating domestic political problems, as the populations of key energy-producing countries have grown accustomed to much higher per capita incomes as energy prices soared. Financial problems are likely to emerge as companies and some governments inevitably default on their international obligations. Second, with their power weakened, other countries may be tempted to try to weaken the resource players further, unleashing unpredictable forces. In thinking about how the oil instrument or weapon might evolve within this environment during the coming years, it is useful to reexamine the context of oil’s use as an instrument of foreign policy, especially if the oil market is about to undergo a sustained period of weak demand and low prices. This context is related to the division of the world as a whole into three broadly different sets of countries. Within the OECD oil has been relinquished as an instrument of policy F I R S T , T H E US, C A N A D A , T H E C O U N T R I E S O F W E S T E R N E U R O P E A N D OE C D A S I A have basically relinquished the use of oil as an instrument of policy in their relationships with one another. Although aspects of their own xenophobic pasts come to light from time to time, by and large these countries have given up impeding flows of energy or flows of capital into energy in the relations with one another. They have dismantled the state – at least so far – when it comes to energy regulations, and both the flow of goods and the flow of capital among them is guaranteed and unimpeded. When it comes to relations with the outside world – with OPEC countries, Russia or other emerging markets – their positions are more nuanced and frequently embody the direct and unabashed use of oil as an instrument of policy, as had been the case of US and European relations with Libya until recently and with Iran over most of the past decade and a half. For a second group of countries, for whom earnings from oil and gas are critical sources of government revenues and critical factors in their economies, the sector traditionally remains a core instrument of foreign policy. What differentiates how oil or gas may be used as a weapon is the state of hydrocarbon markets and of oil and gas prices. In a relatively benign For some oil producers the ‘oil weapon’ is ever present LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Page - 2 SPECIAL REPORT environment, resource rich countries are as dependent on their markets as their markets are on them, and from time to time even more so. This means that they do not have freedom to take advantage of their customers in a zero-sum manner, in which one’s gain comes at another’s loss. Rather the world is more ambiguous and at best a seller or a buyer must think in terms of relative gains or losses – both gain together but one more than the other; or both lose together, but one more than the other. In tight markets, however, the naked, unadulterated oil weapon comes into its own. It can take on the brutal face of Russian gas diplomacy – withholding supply to blackmail others, either for money or for political reasons. Or it can take on the more subtle face of Iranian and Venezuelan diplomacy, where oil revenue is critical because of the geopolitical uses to which that revenue is put. For the ‘BRICs’ the oil weapon is a frequent temptation The third group of countries includes much of the emerging market world. Among the socalled BRICs, the darlings of emerging market investments in the middle part of this decade, Russia clearly falls in the second category of countries, but Brazil, India and China, like most emerging market governments, are in a position of ambiguous status. India and China are oil importers and while state firms play a large role in the energy sector, so do market mechanisms. Indeed in their relations with other countries, especially with the OECD countries, Brazil, India and China have clearly opted far more for market solutions that limit the role of energy as an instrument of policy. It is likely the case that if low oil prices persist for several years, these emerging market countries will find that subsidizing energy objectives will become increasingly too expensive and will move increasingly into the “first world” camp. The implication is that Chinese policy will increasingly look like India’s – the state will decreasingly favor national flag companies and nationally-owned companies will focus on their commercial objectives and shun circumstances in which governments use them for larger non-energy foreign policy purposes. And Brazil, as a major emerging longterm exporter will likely evolve to look far more like the UK or even Norway, with its national champion company forced to confront competition in its home market to keep it honest and competitive. Figure 1. Real per capita net oil export revenue of selected OPEC countries (2000$) $20,000 $18,000 $16,000 $14,000 $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 1994 1996 1998 2000 2002 2004 2006 2008 OPEC UAE Saudi Arabia Venezuela Iran Nigeria Figure 2. Nominal OPEC oil export revenues billion usd 1,200 1,000 800 600 400 200 0 1996 Libya Venezuela Nigeria Kuw ait Iran UAE Saudi Arabia Other OPEC 1998 2000 2002 2004 2006 2008 Source: EIA. Source: EIA. LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Page - 3 SPECIAL REPORT THE ABRUPT DECLINE IN OIL PRICES IS HAVING AN IMMEDIATE AND Russia has lost the power of the oil weapon, but still thinks it commands its former authority C O R R O S I V E I M P A C T on resource producers, especially those highly dependent on oil revenues both for uses at home and internationally. For Russia, revenues from oil and gas resources, whether from domestic sales and taxes or foreign sales and export taxes are critical to the legitimacy of the state and its hopes of pursuing assertive policies abroad. The former superpower has, especially during the Putin years, which have coincided with higher and higher oil prices, grown critically dependent on its oil and gas revenues and on the oil and gas weapon for exerting influence abroad. While pegging a government budget’s breakeven oil or natural gas price is difficult, it is clear that hopes and plans that emerged in a world of $140 oil are challenged at $90 and are pretty close to impossible to meet at $40. And at $40 the country needs to confront fundamental choices between capital expenditures at home and spending at home and abroad. Recent years abound with examples of the use of oil and natural gas as instruments of foreign policy by Russia. These include, especially, efforts to rein in the near abroad former USSR independent states of south central Asia, Ukraine and the Balkans, efforts that use pipeline connections through Russian-controlled territory that provide access to third-party markets in the Mediterranean, Northern Europe and East Asia. But since August, the problems imposed on Russia by lower oil and gas prices abound. Note: • The difficulty in using the power of denial in negotiations over supply. This past winter’s cutoff of natural gas to and through Ukraine to European markets is particularly instructive. Russia’s bargaining position has, from the beginning, been undermined by two factors. On the one hand, West European governments have grown wary of Russian “guaranteed” supplies to the point of frightening populations enough to provide bite to EU policy proposals limiting vulnerability to Russian supplies. On the other hand, Russia’s critical need for revenue from natural gas exports has from the outset limited the credibility of Russia’s denial of supply. While prices were rising, Russian firms used their unfettered access to Western credit markets to borrow for capital and other programs with no strings attached. This has been particularly the case for Gazprom, which has borrowed many billions of dollars in Western markets since 2004 – its debt swelled 41% in 2007 alone – without requirements to reinvest in new supplies, indeed without much of anything in the way of strings or conditionality. As a result, Gazprom used the capital to buy assets abroad within the very countries originating the credit and without any monitoring of the many uses to which the capital might have been put. With cash flow now reduced to a fraction of earlier expectations, and international credit having vanished, Gazprom and other Russian firms’ last credit resort is the state, whose own revenue base has been slashed and whose rapidly-depreciating currency is making debt repayment even more difficult. Russia has aggressively used oil and gas as an instrument of policy in recent years • Venezuela may have to confront its new weakness sooner Venezuela, already overspending when oil was at $147 per barrel, is confronting extraordinarily harsh realities, which we will discuss below, impacting the legitimacy of the Chavez regime and causing it to face unhappy choices. Other Andean oil and gas producers are confronting similar realities directly affecting the ability of governments in Argentina, Bolivia, Ecuador, Peru and to some extent Colombia, to meet commitments at home, let alone abroad. For Iran, while the pain might be more muted than in Venezuela, the government budget is increasingly challenged and if prices remain at current levels for long – LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Page - 4 SPECIAL REPORT or even rise toward $70 – the government will be unable to support the array of international activities that it has engaged in recent years. In particular, it will be strained to continue to support various groups throughout the Middle East in pursuit of the government’s international policies. In today’s softer markets importing countries may again find oil sanctions attractive The flip side of the erosion of the use of oil or natural gas as an instrument of foreign policy is the potentially wider attraction to its use by oil importing countries. From a global perspective, the most widespread use of oil as an instrument of policy by an oil importer has been the United States, through its perennial political attraction for sanctions against oil producers to deprive them of revenue. Newly-elected President Obama is himself on the record as favoring a more entrenched gasoline embargo of Iran, for example. It remains to be seen how his Administration’s attitude toward what might be perceived as renegade oil producers will evolve. But the history of US administrations using oil sanctions, especially in periods of low oil prices, suggests that regardless of arguments that might be made that these sanctions are in the long run likely to be ineffective and counterproductive, the new Administration is likely to be tempted to follow the path of its predecessors. The taming of resource nationalism HUGO CHAVEZ CAME TO POWER IN VENEZUELA IN AN ELECTORAL Resource nationalism will, however, be a “sticky” phenomenon L A N D S L I D E at the lowest point that oil prices reached in 1998, ushering in a decade of increased resource nationalism, with its many faces. The Venezuelan case was particularly poignant insofar as this phenomenon is normally associated with the increased role of the state in the management of national resources and of the energy sector as part of the enhancement of state power. In Venezuela, rather ironically, Chavez found in the state company PDVSA less a source of power than an impediment to government control. Dismantling the state firm turned out to be a pre-requisite to the new resource nationalism. That’s because in many ways the independent state firm had latched onto the logic of globalization and became the supporter not only of the pursuit of commercial rather than political objectives, but in the process the main supporter of two trends that epitomized globalization: investment abroad, especially in the main markets to which PDVSA sold crude oil and mostly in the form of refining assets, and foreign investment at home, bringing in additional capital to exploit marginal fields on the one hand and fields where their local firm had lacked technical expertise. But another aspect of the Chavez revolution resonated internationally, a fundamental change that manifested as oil markets tightened after 2003. One of the conditions of tightening markets is that they facilitate a process whereby governments – the main holders of acreage being made available to investors to exploit resources – increase the cost of acreage acquisition and resource exploitation as the balance of power weighs more heavily on their side than on that of companies. In short, those with capital, technology and human capacities to exploit resources must cater in tight markets to those (the governments) with acreage and seeking capital technology and management skills. Taxes go up as the market for exploration rights tightens and the price and fiscal take associated with exploration rights also increases. During the past five years as the world underwent an exploration boom, the costs of exploration and production – finding and development costs – have increased at a phenomenal rate, by 350% or more between 2004 and 2008. Part of the increase was in the Resource nationalism is basically a reflection of tightening market conditions LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Page - 5 SPECIAL REPORT form of taxes or rents from exploration and production imposed by governments. One of the most interesting features of this element of costs is that they are sticky even as competitive conditions emerge, For example, during the past nine months, the costs of tubular steel, day rights for shallow water rigs and vertical land rigs, the price of engineering services and an array of other costs have fallen. The cost deflation partly reflects overcapacities that have recently emerged, as in steel costs or in shallow water exploration, where rig availability has increased due to recent capital expenditure programs. Yet measures of exploration and development costs have not experienced the same 30-50% reduction seen in these core costs. That’s because critical contracts are longer term in nature; deepwater rig day rates are set in term contracts lasting 5 or 10 years and rig owners holding of these contracts are reluctant to renegotiate their terms. In today’s softer market companies with capital to spend are gaining bargaining clout One of the features in the landscape of the upstream sector today is a bargaining ritual unfolding between companies with capital to expend and contractors whose services are required for exploration and development programs. The same ritual dance is unfolding in the relationship between governments and their issuance of exploration licenses and firms in their quest. Undoubtedly, in the short run all of the costs are sticky. Just as drilling contractors are reluctant reduce rates, so too are governments reluctant to start competing with one another to attract capital to invest in exploration and production activities. Some analysts have argued that the government tax regimes in place are so sticky that there is little hope that governments will change policy rapidly or any time soon to attract capital for investment in natural resources. One major international oil consultancy has recently concluded after conducting a rapidly put together survey that a reversal in resource nationalism is unlikely to take place in the near term, concluding that government policy in this area takes a long time to reverse. This conclusion might well be overly hasty. It is based on conditions of the 1970s which are far different from those of today in critical respects. The new turn toward resource nationalism, for example, follows a period in which it was neither fashionable nor cost effective, as opposed to what unfolded in the 1970s when most of the energy resources of the world were nationalized. The superficial survey also ignores the rather rapidly responsive fiscal changes that took place in the UK, Norway and Canada, where governments, having tightened terms for foreign investors, loosened them rapidly and considerably when confronted with highly competitive conditions for attracting capital. It just might be the case that the rapid collapse in oil prices over the past nine months might also be accelerated by reversal of resource nationalism. The sharp fall in prices appears to be accelerating the decline of resource nationalism In some resource rich countries, the need for capital to boost production in order to boost revenue is becoming critical. Over the past few weeks one of the governments leading the movement to attract capital is the same one that led the resource nationalism charge in a rising price environment, namely Caracas. Hugo Chavez’s new attempt to attract capital for the Orinoco belt this summer may well not attract the capital required because of low prices and because of the recent history in dealing with foreign ownership and the well-know counter actions of Exxon especially and also of ConocoPhillips to those moves. But other companies have remained in Venezuela and are bullish on their ability to exploit heavy oil resources. Penetrating their bargaining postures at this stage is a bit premature. A prolonged period of low prices brings with it the potential for significantly lower costs, both for development and for operations. LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Page - 6 SPECIAL REPORT Venezuela is not alone in confronting the dilemma that without external capital, technology and project management skills, its resource base might erode too rapidly. Among major oil producing countries, Russia, Iran and Iraq are in a similar position and even Brazil might find that spreading the risks of exploration and development with foreign capital might be highly attractive in a lower price environment. In Russia, production in 2008 was already lower than in 2007 and the consensus is for a slide of 5% in the production base this year. Both Gazprom in the natural gas sector and the companies seeking to exploit resource-rich offshore waters increasingly recognize that it cannot develop the resource potential on their own. It seems far more likely to expect a more rapid relaxation of terms in these major resource countries than the skeptics now expect. And if Caracas and Moscow move in this direction, it is likely to Baghdad, Brasilia, La Paz, Quito and Tehran will not be far behind. Saudi Arabia and surplus capacities The return of surplus capacities appears likely to last several years capping prices… As in all tight markets, governments in consumer or importing countries have been obsessed by fear of supply disruptions in the oil sector during the past five years. In recent years, similar fears have entered the West European political landscape when it comes to disruption of natural gas supplies from Russia. “Fear” has also, as always, been twinned with “greed” on the part of exporters, creating an interplay between the two in a dance that become quite complex. There is little doubt that the decline in surplus oil production capacity to virtually zero in the middle of this decade jolted markets. The lost cushion of surplus capacity, which had once seemed a permanent fixture of oil markets before the price collapse of 1985, surprised all market participants, not the least of which was Saudi Arabia, whose ability to supply markets Figure 3. OPEC crude production and spare capacity (1973-2009) kb/d 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 Jan-73 Jan-77 Jan-81 Jan-85 Jan-89 Jan-93 Jan-97 Jan-01 Jan-05 Jan-09 OPEC production Spare capacity …as a mirror reflection of how lower capacities accelerated the price rise Source: EIG, LCMC estimates LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Page - 7 SPECIAL REPORT lies at the heart of its political clout both globally and within OPEC. That Saudi Arabia and other key OPEC countries were caught off guard by the evaporation of surplus capacity exposed the complacency about their upstream investments. Energy Intelligence Group pegged surplus production capacity at around 12 mb/d at its peak in 1985 and was eliminated when Iraq invaded Kuwait and the UN embargoed their oil, yet was still over 5 mb/d as recently as mid 2002 (Fig. 3). It then virtually disappeared, not as a result of oil capacity peaking but rather as a result of above-ground politics: the Venezuelan strike in 2002-03, growing upheaval in Nigeria, Iran’s failure to put in place an acceptable regime for attracting capital, and the US’ ousting of Saddam. And it was only then that resource nationalism in Russia and elsewhere reduced the pace of non-OPEC oil production growth. Lost capacity, especially in OPEC countries, caught governments and industry by surprise By 2003-04, Riyadh became concerned about this lost capacity. To be sure the kingdom responded by raising production (including from the Neutral Zone), which PIW pegs at 7.5 mb/d in mid 2002, growing to 9.2 mb/d (2003), and after falling in 2004, reaching close to 11.0 mb/d in 2008. But by boosting production, Saudi Arabia ate up is spare capacity and that cushion for the global market dwindled further. In the meantime, Saudi Arabia engaged in an urgent and massive campaign to increase its production capacity after 2008, and there is little doubt that campaign is succeeding despite the doubts of peak oilers. PIW estimates that Saudi capacity rose from 9.5 mb/d in 2002 to 11.8 mb/d today and will climb another 1 mb/d by 2010, not including rapidly growing gas liquids potential. OPEC’s total production capacity appears to be heading to well above 37 mb/d by 2010, 5 mb/d above 2002 levels (before the Venezuelan strike) and a record historical level. In retrospect the disappearance of OPEC/Saudi spare capacity was the most critical element in propelling prices from 2003-08, and the reemergence of that capacity should be the most critical element for at least the next three years, longer if global demand fails to rebound to its earlier 1.5- 1.8% annual growth level. Here is a short list of the reasons: • Saudi Arabia will likely wield surplus capacity for its own political ends – keeping prices moderate to spur economic growth and curry influence internationally as well as to withhold export earnings from countries whose use of oil revenue is deemed inimical to the kingdom’s international objectives (e.g. Iran, Venezuela and Russia). High spare capacity also carries the threat of higher production to ensure discipline within OPEC’s membership. The very existence of surplus capacity overhanging the market will reduce speculative flows designed to take advantage of a price spike. To the degree that the kingdom again defines a price band within which it hopes to maintain prices, speculative flows will be reluctant to test those limits. At the moment, Saudi policy appears directed to maintaining a price band of $40-$75. And incentivized Riyadh to accelerate upstream growth • • Tamer financial flows Financial outflows from commodities is now pressuring price It now appears that the enormous financial flows that began entering commodities markets in 2003-04, propelling prices upward after that and downward after mid-2008, are going to play a much more neutral and benign role going forward than they had in recent years. There are several ways in which financial flows impacted markets over the past five years, mostly through growing investor activity in financial instruments which provided direct exposure to LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Page - 8 SPECIAL REPORT energy (and other commodities) prices, but also through equities and other investments that provided indirect exposure to the underlying values of commodities. Both exchange traded and off-market open interest is now falling Evidence of this abounds. Open interest in futures and options on crude oil on the two major exchanges on which the two are traded – NYMEX and ICE – grew phenomenally from 2004 into 2008, providing the most objective measure of these flows. As 2004 opened there were some 628,000 futures contracts in open interest on the NYMEX, representing 628 million barrels of oil. By September the total open interest grew to 1.54 million contracts, representing over 1.5 billion barrels of oil and the number hovered in a range of 1.35-1.5 million contracts from then until late June/early July 2008, after which open interest entered a period of time of steady decline well into December of last year, falling back to just over 1.1 million contracts. Adding in open interest in ICE crude oil contracts emphasizes these trends, as combined NYMEX and ICE open interest grew from 950,000 contracts (representing nearly 1 billion barrels of crude) in early 2004 to 2.7 million contracts (2.7 billion barrels). As deleveraging took place from mid-2008 to the end of the year about 1 billion barrels (more than one third of total open interest in crude oil) had been liquidated. The flows into and out of oil, like those into and out of other commodities, were actually much greater. Adding the flow into and out of options to outstanding flows into crude oil contracts brings total exposure closer to 7 billion barrels at its peak in 2008. But more interesting and less easy to track are flows into and out of crude oil via over the counter contracts, which by our judgment grew from being a fraction of exchange traded crude in 2004 (perhaps some 80% of exchange-traded open interest) to a multiple of exchange-traded crude by 2008 (probably more than 120%). And the deleveraging that has taken place during the selloff in the commodities world and other asset classes since mid-2008) was paralleled in OTC interest, which we estimate to again be a fraction of exchange-traded volumes. The liquidation of passive investments helped lead the market down in Q3 Part of the rise and fall of exchange-traded and OTC crude oil tracks closely total investment flows into passive investments (index funds, like the S&P/GSCI or the DJ/AIG). These investments were undertaken largely by pension funds, endowments and some sovereign wealth funds. While the initial motivation for these investments was asset diversification, these investments became increasingly attractive in the context of 2004-08, with tightening markets due largely to higher demand growth in the US, China and elsewhere; surplus capacity dwindled, further increasing financial flows and pushing prices upward, which only attracted more investments. It is our judgment that assets under management in these passive index funds rose phenomenally, especially from 2006 to midsummer 2008, growing from around $75 billion to $280 billion before falling back by year end to the same level as early 2006. While some of this outflow is associated with reduced asset values, a great deal of it is the result of massive liquidation of positions in passive investments, as seen in the figures below. What was true of passive investments has LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Page - 9 SPECIAL REPORT also in my judgment been true of speculative flows affecting the “back end” of the market, or deferred prices, as well as investments in commodity funds that, unlike index funds, are not simply long-only but trade long-short largely on the basis of technical factors. It seems to be the case that somewhere between 15 and 20% of capital flows into commodities came from passive investors, while another 10-15% came from technical commodity traders. The rise and decline of commodities prices reflects and is partially caused by the demand for paper commodities. A regression analysis applied to these flows shows strong causality between inflow of new capital into these funds and higher prices, as well as outflow and lower prices. But the market liquidation appears now to be over As is clear in the figure above, it now appears that the liquidations which drove markets through the latter part of 2008 have now been curtailed and that investor flows are likely to have a far less dramatic impact on prices than was the case during the period 2004-8. Indeed, the view that prices are likely to fluctuate within a narrower band of $40-75 per barrel reinforces the conclusion that financial flows into commodity index funds going forward for much of the next two to three years will be benign. A similar conclusion relates to speculative flows. The deleveraging that has taken place over the past six to nine months affected not only passive investors, but also speculators. Among the many factors at work, two in particular loom large and also reinforce that view that financial flows will have a significantly reduced impact on prices. First, there is simply less capital available in hedge funds and from individual investors to impact the market in a way similar to what happened over the past few years and in particular over the period September 2007 through June 2008. During this period a sort of investor frenzy took place, close to a “mass hysteria” among investors, in which high oil prices were considered to have no impact on the global economy and to be the inevitable result of higher demand in emerging markets and peak oil. Only much higher prices, it was thought, could play the dual role of killing demand and encouraging new investments in supply. Attention was focused on buying deferred oil, which rose from $70 per barrel in September 2007 to $135 in May 2008. In the four weeks after April 1 alone, it rose from $95 to $130. That money exited rapidly after July, as prices started to fall. Speculative flows have diminished as well LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Page - 10 SPECIAL REPORT In softer markets the risk/reward from speculation is shifted Second, there were other, even more speculative short term investments, which came in spurts, including September-October 2007 and late spring 2008. These speculative investments saw little risk in putting money into deferred oil and significant upside potential in case of a disruption to supplies. The disruption scenario was fueled by the view that spare capacities were a factor of the past and that Saudi Arabia’s upstream expenditures could do little more than keep pace with alleged accelerating depletion of its giant fields, especially the supergiant Ghawar field. Without spare capacities to replace lost disrupted oil, whenever perceptions increased of a potential major disruption from a political event – especially one focused on Iran and its quest for nuclear potential – speculative flows increased. As spare capacities now are large and growing and expected to remain a major feature of the market for the next two years, speculative flows designed to generate super earnings with a disruption will look increasingly like poor bets. A final financial factor that grew to have an important impact on both passive investor flows into commodities and on speculative flows relates to the dollar, a currency under increasing duress as the credit crisis erupted and spread, fueling expectations beginning in September 2007 in particular of rate cuts by the US Federal Reserve Bank prompting higher commodity prices and precipitating a de-linking of the currencies of Saudi Arabia and other Middle East producers from the dollar. There was a direct causal link between rising commodity prices and speculative flows going long the Euro, short the dollar, and long commodities. Here too there are reasons to believe that over the next few years the impact of the dollar and of speculative flows will be significantly less pronounced. History bears this out – before 2007, when it became fashionable in financial circles to believe there was an inverse relationship between the US Dollar/Euro rate and the dollar price of commodities, there was in fact no discernible correlation between the two. And now, even if there were, the likelihood is that the US Federal Reserve’s cut to virtually zero is being matched by similar cuts by other central banks, and that loose fiscal policy in the US will be matched by loose fiscal policies elsewhere. In short, the factors that for the past five years exacerbated price volatility and helped push prices up will no longer be as effectively at work. The decline of the dollar also spurred speculative flows into oil… …and this too is a feature of the past The result: a more benign oil market? The oil market looks superficially more benign It is tempting to conclude that for the next three years or even longer the oil market will be less tumultuous than it was for most of this decade. That is both a possibility but also in the end a false hope. Certainly it is likely that the oil market will see far more limited financial flows exacerbating price trends than it has in the past half decade and longer. Certainly it is likely that a tamer market for exploration and production could increase global production capacity, mirroring the past half decade when resource nationalism constrained the growth in supply. And certainly it is possible that there will be more opportunities for OECD-type governance freeing up markets for trade and capital flows will again diminish the temptation by oil producers to use oil as an instrument of policy. Even so, darker clouds remain on the horizon. One of these clouds has to do with the unintended consequences of some of what now see unfolding. Right after the Iran-Iraq war concluded, in the winter of 1988-89, Saudi Arabia (and Kuwait) started to increase production to erode prices and deprive both Baghdad and Tehran of oil revenues because of But darker clouds are on the horizon LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Page - 11 SPECIAL REPORT suspicions about how each country might use the increased revenue associated with higher production after the war. One consequence of that was Iraq’s taking of Kuwait in the summer of 1990 and its physical threats to the Arab Gulf oil producers. That should serve as a cogent reminder that resource wars have not been waged in a high price environment, but they certainly have in a low price environment. Similarly, lower prices in the late 1990s, again engineered by Riyadh, aimed to punish Venezuela for eroding Saudi Arabia’s position in the US market. The result was the election of Hugo Chavez as President of Venezuela. These historical examples should remind us that the impacts of unintended consequences can be rather severe. Softer markets don’t necessarily limit chances of political disruptions Additionally, softer markets do not necessarily mean that the chances of political disruption are more limited. The threat of terrorist attacks in Saudi Arabia might actually increase as factions in other countries conclude that the kingdom is responsible for lower prices by not curtailing production enough to push prices back over $100 per barrel. Nor can one rule out an Israeli attack on Iran’s nuclear facilities, leading to a shutting in of Iranian output in retaliation, or an Iranian effort to block passage of tankers through the Strait of Hormuz in the Arabian Gulf. And it remains possible enough for civil strife in Nigeria, Venezuela and perhaps one other large producer to result in a simultaneous disruption from those three countries. What’s more, even though the probability of a price spike remains more remote than it did a year ago, there is no reason to expect that oil price volatility has come to an end. There are many factors that have impacted the growing volatility of oil prices. Among these are current global economic conditions, which have seen the volatility of exchange rates increasing and impacting the volatility of all oil prices; and even within oil, physical market conditions themselves, including bottlenecks around the Cushing, Oklahoma pricing hub for WTI have had a role in enhancing volatility. Any list of geopolitical risks lurking over oil markets must include a set of factors related to the Middle East, and it’s hard to prioritize them. Even so, the inevitable departure of the US from Iraq could unleash political forces that impact oil flows in multiple unexpected ways, especially if one result is open civil war within the country and its division into successor states, aping what happened in the Balkans with the breakup of Yugoslavia, with perhaps an even more bloody result. Nor can one keep from the list a multiplicity of factors related to Iran – the elections this year, the country’s nuclear ambitions and the reactions of neighbors and international powers (including the US) to them. The financial crises confronting a range of resource rich countries provide another long list of potential nightmares. The list includes Russia and Ukraine, with a question of who defaults first and with what consequence; it includes Venezuela, Ecuador and Bolivia in Latin America, the heartland of resource nationalism. Indonesia, Nigeria, Egypt and the other North African countries are not far behind. While the future remains uncertain, one trend remains clear: the way the interaction of politics, geopolitics, and financial flows impacted oil prices between 2003 and 2008, is unlikely to persist during the next two years and beyond. But even in an atmosphere of lower prices, these dynamics are well worth watching; the fabric of the last five years may have Price spikes are more unlikely, but price volatility has not necessarily ended The Middle East still presents a host of geopolitical risks The financial crisis creates an additional layer of risk LCM Research - Louis Capital Markets/ LCM Commodities 500 Fifth Avenue – 20th Floor – New York – NY 10110 – +1 212 398 3600 Page - 12 SPECIAL REPORT unraveled, but the threads are just now beginning to form a fresh pattern. A new world of geopolitics is emerging and it is still too early to determine when circumstances will warrant a revaluation of this new world. NEW YORK Pierre Houri +1 212 398 3650 [email protected] Pierre Lacaze +1 212 398 1230 [email protected] LONDON Ben Kelly +44 207 726 4084 [email protected] HONG KONG Alex Colin Jones +852 3793 1101 [email protected] • Certification The views expressed in this report accurately reflect the personal views of Edward Kott and Edward Morse, the primary individuals responsible for this report, about the subject referred to herein, and no part of such compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein.. • Disclaimer The material herein has been prepared and/ or issued by LCM, member SIPC, and/or of its affiliates. LCM accepts responsibility for the content of this material in connection with its distribution in the United States. 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