Additional specifications and requirements

Market and Behavior Analysis in the Oil Industry

According to a Council on Foreign Relations report published December 10, 2007, 'Oil prices went up as much as 40% in 2007, a change that rivals the historic price spikes of the 1970s oil embargo." (Johnson, 2007) Analysts are responding to the growing concerns about the high prices of oil which "rivals the historic price spikes of the 1970s oil embargo" and states that the "trend can no longer be explained simply by the increasing demand from countries like as China, India, and Russia." (Johnson, 2007) Johnson relates in the Council on Foreign Relations report that increasing speculation on the part of investors which are more diverse than traditionally combined with hedge funds, pension funds, and investment banks has resulted in the oil-market trends becoming even more difficult to predict. Other analysts claim that the primary factors that determine prices are supply and demand. It is generally a consensus among the experts that the times of OPEC dictating oil prices has ended causing today's oil market to behave like other commodities markets more than the oil market has been historically known to behave.

I. SUPPLY and DEMAND ANALYSIS

Johnson (2007) relates that supply and demand are traditionally and "remain among the most influential components of oil-market behavior. However, unlike most other markets drastic changes in price do not necessarily kindle changes in demand." Tim Evans, energy analyst at Citigroup is noted as having stated: "Prices can fall a long way without stimulating demand..." (Johnson, 2007) in contrast, considerably affecting oil prices is the factor of the supply of oil. The increase in oil consumption most particularly in developing countries combined with the U.S. And its' steady high demand for oil makes it likely that there will be no respite from the demand for oil in the near future. Factors that create price volatility include geopolitical events threatening the supply of oil and for example the conflicts of the United States and Venezuela which once having scared investors results in volatile prices in the oil market. However, it is argued by some analysts that price increases recently are not a reflection of supply of a major nature. The truth is that supplies are relatively stable and have remained in this range for some time. It was announced by Royal Dutch Shell's CEO Jeroen van der Veer in May 2007 in an interview with Fortune Magazine that: "...the oil tanks were full, there were no lines at gas stations, and there were no problems with fuel deliveries, yet prices remained at historic levels." (Johnson, 2007) the oil markets may be differentiated from the commodities markets in their behavioral characteristics. The oil markets have been called of Evans to be a "volatile beast" and attributes the breakdown in true competition of the oil market to be the fault of the "OPEN cartel..." who set crude oil prices until the middle of the decade of the 1980s. In the present tense OPEC adjusts its members production levels and thus influences the market just as effectively as if it were still crude oil 'price-setting' since its' members comprise 40% of the supply for the oil market. These actions have a great potential to impact the price of oil. According to Philip Verleger, an energy expert, the unpredictability of the market should not be blamed on investors but instead, should be focused in the direction of analysis which has previously been "lazy" lacking the adaptability integrate the fact that the oil market has become more like other commodity markets than historically noted in that supply and demand factors now prevail in the oil market as in any other commodity market. While Evans does not disagree with this view he relates the belief that it is the oil trading which has been greatly "financially driven" and which has "given the price a greater independence to swing further away from a fair market or equilibrium price for a longer period of time." (Johnson, 2007)

II. PRICE SYSTEM

There are two sets of oil prices in the market, just as in other commodity markets which are: (1) a spot price (oil to be delivered immediately); and (2) a futures price referred to as a 'contango' market. (Johnson, 2007) the implications in a contango market in which supply is very abundant results are that the market experiences 'backwardation' with inventories currently pressured by demand. There becomes an incentive for investors in this type of market to "sell the near-term futures held and higher prices and buy futures further out at the lower rate, thus making a profit on the difference." (Johnson, 2007) While the investor's cash creates more liquidity in the oil market, which is in itself a positive factor the volatility of the market is also created by investors, which according to Evans "may not be so benign." (Johnson, 2007) Historically OPEC and other large holders of oil supply have held a primary role in "moving the spot price and futures markets" and it is related by experts that a backwardation market was created by OPEC in the latter part of the 1990s decade "by significantly curtailing production...to drive oil prices up from $10 per barrel. Backwardation can be self perpetuating..." with investors "selling in the short-term because they believe the price will go down in the future, which keeps inventories low." (Johnson, 2007) Inventories of oil are followed closely by oil investors who desire to."gauge the supply and demand..." (Johnson, 2007) However, over the past few years, a real supply and demand of present oil has been masked "in favor of the supply and demand of oil futures." (Johnson, 2007) ID. Barry McKenneth, U.S. National Association of Petroleum Investment Analysts states that this profit in oil would not be possible "unless supplies were kept tight, but speculation on this scale magnifies price volatility..." And as noted by one expert in the field and reported in the work of Johnson (2003) "there's nothing criminal about betting on price, it is a problem when the bets themselves influence the price." (Johnson, 2001) the stated components of residential natural gas prices include: (1) Local distribution; (2) Processing, transmission and storage; and (3) Commodity. (Levin and Coleman, 2007) the following figure lists the commodity costs of natural gas accounts for approximately half of a residential natural gas bill as published in the EIA, Natural Gas Monthly March (2007).

Components of Residential Natural Gas Prices

Source: Levin and Coleman (2007)

The following figure shows the Natural Gas Production in the United States from 1990 through 2006.

U.S. Annual Natural Gas Production

Levin and Coleman (2007)

It is additionally related that the decline in natural gas production added to the increasing demand and limited storage capacity."..has contributed to the rise in natural gas prices over the past several years." (Levin and Coleman, 2007) Other factors have also driven up prices including the rising prices of crude oil enabling substitute fuel prices to rise with no creation of economic incentives for motivation of fuel-switching. In addition, affecting volatility and price increases are extreme weather conditions, which has as well resulted in increasing demands for supply.

III. BARRIERS to ENTRY

There are great barriers to entry into this market which include the incredible costs associated with start-up in the oil production and refiner business and including the various environmental regulations that must be carefully followed in oil production and refinement operations.

IV. GOVERNMENT INVOLVEMENT

The work entitled: "Financial Energy Markets and the Bubble in Energy Prices: Does the Increase in Energy Trading by Index and Hedge Funds Affect Energy Prices?" A document given in the form of a 'Testimony Before a Joint Hearing of the U.S. Senate Permanent Subcommittee on Investigations of the Committee on Homeland Security and the Governmental Affairs and Subcommittee on energy of the Committee on Energy and Natural Resources' December 11, 2007 by Edward N. Krapels, Special Advisor, Financial Energy Markets: Energy Security Analysis, Inc. Of Wakefield, Massachusetts states: "Even though many crude oil and natural gas producers, oil refiners, and petroleum product and natural gas consumers do not hedge, the fact remains that New York Mercantile Exchange (NYMEX)-traded West Texas Intermediate (WTI) crude oil and Intercontinental Exchange (ICE)-traded Brent crude oil, American and European heating oil and gasoline, and U.S. natural gas contracts have become benchmarks of 'both' physical commodities and financial assets whose price fluctuations affect the economics of the entire energy industry as well as those buying services form that industry. Thus, even purely commercial participants in oil and gas markets are just as affected by the force of financial energy markets as are the speculators and hedgers that use them every day." (2007) According to Krapels, (2007) market participants are divided by the U.S. Commodities Futures Trading Commission (CFTC) into: "...commercial and non-commercial classes." (2007) While a trader may be assigned a commercial classification in some commodities and then be classified as non-commercial in other commodities, a single trading entity "cannot be classified as both a commercial and non-commercial in the same commodity." (Krapels, 2007) it is additionally related "For the futures-only report, spreading measures the extent to which each non-commercial traders holds equal long and short futures positions. For the options-and-futures-combined report, spreading measures to the extent to which each non-commercial trader holds equal combined-long and combined-short positions." (CFTC, as cited in Krapels, 2007) Krapels states that there are areas where dismissal of causation should not be the projectory in keeping them consistent with normal economic analysis which include: (1) perfect storm episodes because there is a likelihood of time periods when the physical energy market condition and the trading strategies of financial market participants are aligned so well that the result is 'herding' or 'bubbles' or their opposite, crashes; and (2) Variations on the market power syndrome in which it is possible that the positions of some market participants - index funds as one example - are so large as to constitute witting or unwitting market power. A large-scale infusion or retreat from any of the various positions very large index funds might have price effects." (Krapels, 2007)

Average Annual Oil Prices

Source: Krapels (2007)

Krapels states that it is the responsibility of governments "...the same ones that have surrendered some of their controls to the market - to ensure that adequate flows of information exist to feed the markets to which they have entrusted their fates. Governments must insist that those who sell critical commodities and associated financial services - whether it be Saudi Arabia or ICE or NYMEX - disclose enough information to ensure that know abuses..." such as insider trading and problems that are preventable do not undermine critically the efficacy of the markets. At the end of the day, markets exist because governments allow them to." (Krapels, 2007) the United States Senate, Permanent Subcommittee on Investigations Committee on Homeland Security and Governmental Affairs report entitled: "Excessive Speculation in the Natural Gas Market" report sates that following the issuing of the 2006 Subcommittee report "the natural gas market entered a period of extreme price volatility punctuated by the collapse in September 2006 of Amaranth Advisors LLC, one of the largest hedge funds in the natural gas market. From the last week in August until the middle of September 2006, Amaranth's natural gas positions lost over $2 billion in value, precipitating the liquidation of the entire portfolio of the $8 billion fund." (Levin and Coleman, 2007) the Subcommittee's investigation of the natural gas prices behavior in the early 2006 market in which million of natural gas transactions were analyzed from trading records of the NYMEX and ICE, Amaranth and other's two principal exchanges for energy commodities along with interviews conducted among natural gas market participants. Findings of the Subcommittee include the fact that trading in the U.S. natural gas financial markets was dominated by Amaranth which "bought and sold thousands of natural gas contracts on a daily basis, and tens of thousands of contracts on certain days." (Levin and Coleman, 2007) the work of Caruso (2007) entitled: EIA Short-Term Energy and Winter Fuels Outlook" states that "U.S. average fuel expenditures are expected to be higher for all fuels this winter." (2007) Additionally Caruso states the following for the 'Short-Term Energy and Winter Fuels Outlook' for Winter 2007-08: (1) Winter 2007-08 is predicted to be 4% colder than the previous winter however; predictions are still 2% warmer than the 30-year average; (2) Natural gas prices are expected to be higher than last winter; (3) Natural gas heating bills are projected to be higher for all regions this winter; (4) Crude oil prices, having recently exceeded $80 per barrel, are projected to decline slowly over the forecast; (5) Multiple and hard-to-predict uncertainties drive the oil market forecast; (6) Retail gasoline prices are projected to be higher in 2008; (7) Retail heating oil prices are projected to be higher in 2008; (8) U.S. winter heating oil expenditures projected to increase for all regions; (9) Residential propane prices are expected to average about 23 cents per gallon higher than last winter; (10) Propane inventories are low; (11) Propane expenditures are projected to increase in all regions; and (12) Winter electricity expenditure increases are expected to be smaller than other fuels. (Caruso, 2007) the work of Dahl (2007) entitled: "What Goes Down Must Come Up" states that "Movements in crude oil markets explain almost all of the changes in gasoline prices over the period from 1999 to 2006." Additionally related is that historical analysis shows that 97% of the variation in the pre-tax price of gasoline between 1918 and 2006 can be explained by changes in crude oil prices. A one percent increase in U.S. income results in a 0.3% increase in gasoline demand within one year's time. Oil refinement has grown more complex in the period from 1990 to 2006 with an increase in various grades of gasoline from three to fourteen different grades requiring a reconfiguration of refineries operations at lower levels of production or alternatively requiring an investment to sustain the same output. Dahl states that the refinery sector is "cyclical, with profits varying wit capacity utilization. The magnitude of refiner profits is often exaggerated. From 1977 to 2005, the rate of return on investment in U.S. gasoline refining averaged less than 7%." (2007) the Energy Information Administration report "Performance Profiles of Major Energy Producers 2006" states that net income for major energy producers is stated at $131 billion for 2006 with return on stockholder's equity at 27.0% and cash flow from operations increased by 10%. Capital expenditures are stated to have increased 42% when comparing 2005 to 2006 expenditures of capital. The work of Ramin (2007) entitled: "Petrodollars, Asset Prices, and the Global Financial System" states five key conclusions, which are stated to have emerged from a study focusing on the global economy and the impact of petrodollars. Those five conclusions are as follows: (1) Oil exporter governments are poised to remain the predominant sources of global savings even with the decline in oil prices from their record highs; (2) the vast majority, or more than 80% of the oil savings flow to governments and central banks in oil-exporting countries; (3) Data on asset purchases capture less than half of petrodollar savings; Sovereign investment funds, which captured more than one-quarter or oil exporter savings during the past four years, provide a significant bid for risk assets, particularly in emerging markets; (5) the most profound impact in the rise of petrodollar savings is on the stability of the BWII system given the greater focus of oil exporters on financial return, in contrast to the non-financial objectives of Asian central banks that have maintained the existing regime." Toloui (2007) relates an enormous shift in the global distribution of savings has been witnessed over the last half of the decade as "progressively larger volumes of capital have flowed from emerging market countries to the developed world." (Toloui, 2007)