Management Development & Productivity Institute & Goodwill International Group

Outline The Role of Stock Exchanges in the Oil Market The Role of Banks in Oil Markets Changes in Oil Prices Commodity Prices & Exchange Rates Current Assessments & Future Expectations Definitions of Volatility Determinants of Changes in Oil Price Elasticity of Demand & Supply (Price & Income) Peak Oil Speculation Portfolio Theory Structure of Modern Financial Markets Trading Expected Returns & Standard Deviation Hedging

The Role of Stock Exchanges Stock Exchanges such as GSE act as primary and secondary markets for capital; More specifically Stock exchanges help listed firms to/in; Raise capital for businesses Mobilise savings for investment Facilitate company growth Profit sharing Corporate governance Create investment opportunities for small businesses Serves as a measure of the economy’s performance source of funding foe government projects

The Role of Banks in Oil Markets Many energy companies do not have high credit ratings, resulting in greater borrowing costs to access the capital markets Business models are capital intensive with significant investment required for projects such as exploration, production, transportation etc. Balance sheets of many energy producers are constrained and do not offer excess free liquidity Energy companies face constrained operating cash flows which inhibit flexibility to make investments and effectively hedge risks Some energy markets are illiquid (especially for bespoke products) and require hedging to protect capital investment Banks with their liquid assets are therefore uniquely positioned to play a crucial role in commodity markets, offering various liquidity and capital solutions Banks play a crucial role providing liquidity and capital

Other Financial Intermediaries in the Oil Markets • Insurance Companies • Hedge Funds • Venture Capital Consumption Distribution Storage Refining

World Energy Trends According to EIA 2011, world overall oil consumption is forecast to grow at 1.2%per year over the next 25 years • OECD world oil demand is forecast to grow at 0.3%per year over the same period while non-OECD world oil demand is forecast to grow at 2.2%per year • The fastest growing market will be China (+3.4%per year over the next 5 years) • World oil production capacity is forecast to grow at 1.4%per year over the next 25 years • Large oil producers are forecast to meet the increase in demand over the same period: - OPEC: +1.3%per year - Caspian area: +3.6%per year • Large oil consumers will see their local production lag behind: • North America: +0.7% per year over the next 25 years

Global Energy Demand Vs Production by Region

Oil and Crude Trade

What Is Volatility? Chemistry:Evaporating readily. Economics:Percent change in price over a given period. Trading:Historical Volatility is the annualized standard deviation of percentage changes in futures prices over a given period. Politics: The price going in a direction you don't like …usually reserved for UP rather than DOWN. “Oil and energy price volatility is poorly defined with no accepted conceptual framework for analyzing or interpreting it... …not to mention designing policies and policy instruments to mitigate or reduce its effects.”

Positive Aspects of Higher Oil Prices Higher prices may simply be providing the right signals to the market: More non-OPEC oil & gas supply Better economics of renewable and alternative fuels Demand efficiency

A Primer On Oil Prices A bidirectional system of causality • Product prices determine crude oil prices and crude oil prices determine product prices. • Here are the things that really matter: • Volume and characteristics of alternative crude oil types offered for sale • Capability and capacity of the world refining industry to process these crudes • Government-mandated specifications for oil products marketed by refiners • Characteristics and volume of global petroleum demand • Available storage capacity for crude oil and petroleum products • Flexibility of the world transportation system for getting petroleum from the point of production to the point of sale • Source: Philip Verleger, PKVerleger LLC, “A Primer on Oil Prices”, 2009

Oil Prices Relate To Many Uncertain Factors Volatility in oil prices is often attributed to events and uncertainties in the markets Inventories Non-OPEC supply growth OPEC production decisions Global economic growth Global Oil Prices Spare production capacity Speculation, hedging, investment Geo-political risks Exchange rates and Inflation Weather

Product Yields of Different Crudes • The light and sweat crude production (Brent and WTI) is declining • Middle East has the largest growth potential, though the crude is sour • S. America (e.g. Venezuela) has large heavy oil reserve • West and North Africa has potential in producing light and sweat crude

Current Assessments and Future Expectations Price formation in the oil sector is complicated by future expectations • Current Assessments • Supply • Demand • Inventory Levels • Capacity Utilization • Value After Refining • Current Market Level • Recent Market Direction • Future Expectations • Weather • Geopolitics • Demand Growth • Supply Growth • Capacity Growth • Logistics Availability • Financial Markets • Interest Rates, Foreign • Exchange, Asset Markets

Demand & Supply Fundamentally the factors that determine price Oil in the international market remain the forces of demand and supply, ceteris paribus. The percentage change in Price relative to percentage change in quantity demanded/ supplied is referred to as elasticity of demand or supply respectively

Elasticity of Demand & Supply Price Price D P1 D1 P2 D2 Qe Quantity Quantity Peak Oil (Inelastic Demand) A perfectly inelastic demand curve (e.g. China)

High Volatility Due to Inelastic demand and supply curves Demand is inelastic due to long lead times for altering the stock of fuel-consuming equipment; supply is inelastic in the short-run because it takes time to augment the productive capacity of oil fields. Price volatility provides incentives to hold inventories, but since inventories are costly, they are not sufficient to fully offset the rigidity of demand and supply. This fact means that shocks to demand or to supply can help to explain the high level of volatility in oil prices.

Relatively Inelastic Price of a gallon of gasoline $1.5 $1.00 D 26 25 Gallons of gasoline Figure 4.2 The Demand curve for gasoline

Relative Elasticity of Demand Figure 4.2 follows with a relatively inelastic demand curve for gasoline. There are few substitutes for purchasing gasoline, especially in the short-run. In this case the price of a gallon of gas rises from $1 a gallon to $1.50, a 10% increase. The quantity demand falls very little - from 26 gallons to 25, a 4% decrease. The resulting elasticity calculation is 0.4 (% change in quantity demanded / % change in price = 5%/10%, in absolute terms). With a price elasticity of 0.4, for every 10% increase (decrease) in the price of gasoline, the quantity demanded of gasoline decreases (increases) by approximately one-half as much.

Income Elasticity of Demand is Strong Canada USA South Korea Taiwan Australia Japan Oil Consumption per Capita (gallons per day) Germany France Sweden Mexico 1 Italy Venezuela Russia UK Thailand 0.5 Brazil Indonesia China India GDP Per Capita (‘000USD) Twenty five years ago, South Korea and Taiwan were where China and India are now. One third of the world’s population is just entering the middle class and want the oil-consuming lifestyle that goes with it.

The Oil Under-Investment Cycle Part of the volatility in oil prices is explained by the investment cycles As governments (producer and consumer) take more control of oil & gas, supply is constrained and the under-investment cycle is exacerbated.

The Oil Under-investment Cycle Most Oil & Gas Reserves remain in the hands of Governments/NOCs NOCs under-invest by giving equal importance to other public spending, subsidising local oil price, and increasing taxes on Oil & Gas E&P activities As Oil prices increase, supply fails to react Prices move higher to the point of demand destruction-incentivising governments to move away from Oil Under-investment reduces local supply and squeezes growth into higher supply provinces Companies under-invest because of volatility Consumer governments act against Oil & Gas NOCs lack capacity to respond to rapid price increases Price volatility forces companies to plan conservatively Prices shoot up from price point of (private) marginal supply to point of demand destruction, an incentive for consumer governments to move away from Oil As NOCs fail to react to price increases price increases until demand reacts

Investment • INVESTMENT: Placing funds with a conservative expectation of earning a return through dividends more than appreciation. • PORTFOLIO THEORY AS A SUBFIELD OF FINANCE • The field of Finance contains at least the following various themes; • Public Finance • International Finance • Corporate Finance • Derivatives • Risk Management • Portfolio Theory • Asset Pricing

Portfolio Theory Portfolio theory is both a descriptive and normative theory. On the one hand it studies how people should combine assets (normative view). The leading idea can be summarized as the maxim “Do not put all eggs in one basket”, which is known as the principle of diversification. On the other hand portfolio theory describes how investors do combine assets (descriptive view). This second aspect has important implications for asset pricing, because if one knows how investors form their portfolios then one can determine how assets are priced. This is because prices are determined by the demand and supply generated by the investors` portfolios decisions.

The Structure of Modern Financial Markets Modern financial markets are populated by various investors with different wealth, objectives and heterogeneous beliefs. There are private investors with pension, housing and insurance concerns, firms implementing investment and risk management strategies, investment advisors providing financial services, investment funds managing pension or private capital and the government financing the public deficit. The investment decisions are ultimately implemented by brokers, traders and market makers.

What Does a Trading Company Do?

Participants in International Energy Markets

Evolution of Oil Trading • Crude oil and all major refined petroleum products trade on international markets • Liquid and transparent futures markets allow participants to ‘hedge’ their spot and term supply contracts prices in the forward months • Appropriate financial instruments enable industry participants to manage their price risk exposure and offer additional profit opportunities • The main price indexes known to the general public today are futures – WTI: traded on the NYMEX – Brent: traded on the ICE in London

Oil Market Evolution

Paper Money Influence Over Oil Prices

Paper Money Influence Over Oil Prices Cont. • Non commercial players (hedge funds, investors and entities with no direct involvement in oil) drive the market prices according to their global investment Positions • When building up long net positions oil prices rise… …Conversely when those long positions are unwound or when they initiate short positions first oil prices decline as traded paper barrels outnumber physical barrels (about: x10 times) • Oil producers have limited leverage to drive prices

New Oil Market Participants

Trading Thus, intraday price movements reflect how the average investor perceives incoming events. In the very long run price movements are determined by trends in fundamental data like earnings, dividend growth and cash flows. How the short run aspects get washed out in the long run, i.e. how aggregation of fluctuations over time can be modelled is rather unclear.

The Game Structure of Financial Markets The concept of reflexivity is described by Soros (1998) in the following way: Financial markets attempt to predict a future that is contingent on the decisions people make in the present. Instead of just passively reflecting reality, financial markets are actively creating the reality that they, in turn, reflect. Moreover, Soros writes: “Each market participant is faced with the task of putting a present value on a future course of events, but that course is contingent on the present values that all market participants taken together attribute to it”.

Expected Return & Standard Deviation for Shares NYEP Plc: A share costs 100GHp to purchase now and the estimates of returns for the next three years are as follows:

Frequency Function A frequency function or probability distribution for shares in NYEP Plc is depicted in the figure above. If the Economy booms over the next year then the return will be 20% If normal growth occurs, the returns will be 5%. A recession will produce a negative return, losing an investor 10% of the original investment

Expected Return The example above only has three possibilities: A more sophisticated approach to probability distribution is where the distribution is assumed to be normal, symmetrical, and bell shaped. We could add to the three possibilities; slow growth, bad recession, moderate recession, etc thereby resulting in a different representation of probability of eventualities We are better off representing the possible outcomes in two summary statistics; the expected return and standard deviation

Expected Return NYEP Plc

Standard Deviation n i=1 Standard Deviation gives a measure of the extent to which outcomes vary around the expected return, as set out in the following formula: Ơ = Ʃ (Ri – Ř)²Pi

Standard Deviation NYEP Plc

Expected Return, Discovery Plc If we contrast the expected return and standard deviation of NYEP with that for a share in a second company, Discovery, then using the mean-variance rule we could establish a preference for NYEP The expected return = (-15x0.2) + (5x0.6) + (25x0.2) = 5%

Hedging • A financial strategy designed to reduce risk from price changes by taking a position in a futures market opposite to a position held in the cash market. • Trading futures contracts with the objective of reducing price risk is called hedging. • Not all risks faced by a business can be hedged via a futures market—i.e., quantity risk.

Forms of Hedging • A Short (or selling) Hedge: Occurs when a firm holds a long cash position and then sellsfutures contracts for protection against downward price exposure in the cash market. • A Long (or buying) Hedge: Occurs when a firm holds a short cash position and then buysfutures contracts for protection against upward price exposure in the cash market. Also known as an anticipatory hedge. • A Cross Hedge:Occurs when the asset underlying the futures contract differs from the product in the cash position • Firms can hold long and short hedges simultaneously (but for different price risks).

Speculation Speculation is placing funds with the understanding that the deal entails high risk. Speculators generally take a position in financial instruments with a view to making profit from changes in their value. Spread is the difference between the price to buy and the price to sell a financial security.

Types of Speculators The four main types: Speculators that hold Physical Inventory based on a desire to control the market. Speculators that participate in the financial market to manipulate the market. Speculators that hold Physical Inventory based on the expectation of higher prices in the future. Speculators that participate in the financial market to gain exposure to commodity price risk.

Speculation Is NOT Manipulation Discussion of commodity prices often leads to discourse about speculation. The term speculation is a broad label that gets applied to several different kinds of traders with very different motivations. To begin a productive discussion, it is useful to define terms.

What’s the Difference between Gambling and Manipulation Gambling is risking money on an outcome that depends mostly on chance. So what then is the difference between Speculation and Gambling? Manipulationis deliberately misleading other investors to artificially inflate or deflate market prices.

So Where do the speculators fit in? “It is still rather generally believed that futures markets are primarily speculative markets. They appear so on superficial observation, as the earth appears, from such observation, to be flat.” Holbrook Working, Stanford University,1960

Expert Opinion Can Change Rapidly and Significantly

Did Speculators Drive Oil to $147/bbl in 2008? Main Street blames Wall Street But We have all ignored the factors below? Extraordinarily strong (unsustainable?) global economic growth from 2002-2007. Constrained oil supply from key producers like Russia, Venezuela, Nigeria, Iran, Iraq and others. Lack of OPEC spare production capacity and untimely cutbacks by OPEC at the end of 2006 that were not reversed until late 2007.

Management Development & Productivity Institute & Goodwill International Group