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New York Energy Forum Presentation to: April 10, 2008 Wall Street and the price of oil Adam Robinson Energy Research Analyst

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Presentation on theme: "New York Energy Forum Presentation to: April 10, 2008 Wall Street and the price of oil Adam Robinson Energy Research Analyst"— Presentation transcript:

1 New York Energy Forum Presentation to: April 10, 2008 Wall Street and the price of oil Adam Robinson Energy Research Analyst

2 Agenda I.Wall Street and todays oil price environment II.Wall Street and the term structure of oil prices III.Wall Street and the volatility of oil prices IV.Conclusions

3 Wall Street and the price of oil Wall Streets financial crisis temporarily breaking the links between the physical and financial markets for crude oil Wall Street facilitating huge financial demand for commodities The investment vehicles created by Wall Street to express that financial demand are artifacts of a less liquid market and create distortions in the term structure of oil prices Even when markets are functioning normally, if banks build up a concentrated position in the options market at particular strikes, they can affect crude oil price volatility 1

4 I. Wall Street and todays oil price environment

5 There are two markets pricing oil for delivery in five years Long-dated NYMEX WTI (and natural gas) have shot up WTI vs. HH NG 5-yr out in $/boe + 40/60 blended price ________________ Source: Bloomberg. 2

6 Price of US reserves valued through US M&A activity ________________ Source: John S. Herold Upstream M&A Review There are two markets pricing oil for delivery in five years While the price of US reserves has flat-lined 3

7 The market for US oil assets provides another data point for long- dated crude oil prices, holding US costs and politics constant Higher costs in the US could explain the difference… US Oil Production Costs US Tax Regime and Political Uncertainty Global Supply- Demand Balance Value of a US Oil Field Value of Long-Dated WTI Financial Demand for Crude Oil Global Supply- Demand Balance These should trend together if fundamentals are behind WTI price changes 4

8 But despite what some are saying, US costs are flattening ________________ Source: US Bureau of Labor Statistics US PPI Oil Producer Cost Indices are flattening (3-month moving average) 5

9 US drilling cost rise and fall even more stark ________________ Source: US Bureau of Labor Statistics US Drilling cost PPI (3-month moving average) 6

10 Even deepwater drilling costs are flattening Deepwater Rig Day-Rates ________________ Source: ODS-Petrodata and Lehman Brothers Estimates 7

11 So with costs flat, what explains the markets divergence? Relative to the fundamentals, either US reserves are undervalued or WTI is overvalued Index of WTI/HH prices vs US reserves valued through US M&A activity ________________ Source: John S. Herold Upstream M&A Review 8

12 Wall Street turmoil may be allowing an arbitrage between the two markets to open Rule of thumb for the US: To find the arbitrage equilibrium, multiply reserve valuation by 3-4x to get expected minimum realized blended oil/gas price Assumptions Cost of proposed reserve acquisition: $15/bbl Lifting cost: $8/bbl R/P Ratio: 10 years Required minimum ROCE: 10% Government take = 40% Math Total capex = $15/bbl for 10 years = $150/bbl of daily capacity That requires $15/bbl of daily profit to make a 10% return on capex Assuming a 40% tax rate, profit before tax must equal $25/bbl Then you must cover capex of $15/bbl and lifting costs of $8/bbl, meaning your overall realized price must equal $25+$15+$8= $48, or 3.2x your capex cost If reserve owner expects a 20% ROCE, then expected realized oil price is $73 A 30% ROCE could be achieved if $100/bbl is realized 9

13 How Wall Street may have broken the markets link What may be preventing the arb? –No access to credit to purchase assets Many producer hedges already underwater –Counterparty risk and margin calls Grain elevator operators in 2008 –Inability especially of big players to hedge all production A big hedge could cause a major price drop (Mexico in Dec-06) Arb may work again if: –Confidence rebuilds in the US banking system –Financial instruments to mitigate these risks become more widespread 10

14 So is NYMEX overvalued or reserves undervalued? Cost of exploration and price of US oil assets are substitutes –Could provide an anchor to price of oil reserves as the arb closes, forcing NYMEX WTI down But in the meantime, in the absence of producer selling or links to the market for physical oil reserves, WTI prices can trade purely on financial flows 11

15 So what might be fair value for long-dated NYMEX WTI? Higher US costs appear to explain much of the rise in long-dated WTI prices until the divergence in October US monthly PPI data regressed against average monthly 5-yr out WTI prices 12

16 And if natural gas holds its gains, oil could drop even lower Stronger natural gas prices take pressure off of oil to rise in order to provide an incentive for upstream investment US monthly PPI data regressed against average monthly 5-yr out WTI prices 13

17 Meanwhile, thanks to Wall Street, financial prices have no physical price ceiling and can trade on almost anything WTI 1M vs. DXY IndexWTI 1M vs. Inflation* While correlations have recently strengthened, there is no longer-term relationship to justify the moves in the medium-term ________________ *Inflation compensation as measured by the difference between 10-year treasuries and 10-year TIPS Source: Bloomberg, Lehman Brothers Estimates 14

18 How does this play out? Oil stocks build if the price is too high for the physical market, causing suppliers to over- produce and consumers to under-consume But eventually inflation will be real or it wont –If commodity price inflation leads to core inflation, Fed will have to put a floor on interest rates, the dollar rallies and commodities tank –If the deflationary impact of the US recession offsets commodity price inflation, then investors have an expensive + unnecessary hedge vs inflation and commodities tank Meanwhile: High commodity prices may add to other pressures on the economy and aggravate the US recession and lower physical demand further High commodity prices may aggravate any transmission of US economic weakness to the rest of the OECD as well as emerging market economies Investors buy commodities as an inflation hedge, pushing up commodity prices, which then pushes up inflation What happens when Wall Street turmoil removes the physical ceiling on the financial market? 15

19 II. Wall Street and the term structure of oil prices

20 Wall Street as creator and seller of commodity indices After years of Wall Street going after pension funds, they finally started to listen early this decade Efficiency Frontier for a 60/40 Portfolio of Stocks (S&P500) and Bonds (U.S. Agg.) Volatility 60% LBCI 0% LBCI 25% LBCI 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 6%7%8%9%10%11%12%13%14% Return ________________ Source: Lehman Brothers estimates 16

21 Wall Street benchmark commodity indices are channeling investment into the wrong part of the curve In 1990s, liquidity only in the front Producer hedging or OPECs market power kept curves backwardated Passive investors are now herded into the front –GSCI roll has been negative since 2004 GSCI spot and roll returns, ________________ Source: Bloomberg, NYMEX, S&P GSCI Ideally a passive investor would buy a commodity and never sell it. So why invest at the very front of the futures curve? 17

22 But liquidity should no longer be an excuse Nymex WTI futures avg open interest ________________ Source: Bloomberg, NYMEX, S&P GSCI Particularly in the energy sub-indices, liquidity in the back of the curve has grown much more quickly than in the front 18

23 Investing exclusively in the front contract exposes passive investors to unnecessary risks Risk 1: Other investors agree with index players Risk 2: Index overcrowding Risk 3: No way to exit the front contract after a spike –Indices gave back all of their gains in natural gas after Hurricane Katrina and in oil after the Iraq War of 2003 in the four months following the spike –If oil spikes, it can hurt performance of non-energy commodities by weakening the global economy LBCI vs LBPB after 2003 Iraq War LBCI vs LBPB after Hurricane Katrina ________________ Source: Lehman Brothers estimates 19

24 Wall Street and new structured product innovation To address these risks, Wall Street is designing new indices that are likely to catch on, spreading index length along the oil curve and taking pressure off the front during roll periods New indices should focus on roll methods –Should balance transaction costs vs footprint New indices should invest in longer-dated futures but also take open interest into account If the ideal is the spot return ex-roll yield, why not buy the contract whose spot + roll return best correlates to the spot return? Lehman Pure Beta boosts index returns regardless of commodity weights used ________________ Source: Bloomberg, Lehman Brothers estimates 20

25 III. Wall Street and the volatility of oil prices

26 Oil market volatility likely to stay high for fundamental and flow-related reasons Tight markets become more volatile as demand runs up against supply limits, then retreats with additions of new capacity Stealth supply + black hole demand obscure signals about tightness Wall Street option-positioning now means that banks will tend to buy in a rising market and sell in a falling one, accentuating price swings 1M WTI Implied ATM Volatility (30-day rolling average to March 26, 2008) ________________ Source: Bloomberg 21

27 Telling the 2007 price story as a Wall Street options trader It all started with producers using options to hedge the falling market of late 2006 Banks sold $50 and $60 puts to producers Producers sold $70 and $80 calls to banks Banks also sold lottery tickets to hedge funds As oil prices dropped in early 2007, banks sold oil to hedge Once oil turned around, banks bought back their hedges As oil pushed to $70, banks started selling to hedge calls bought from producers On the other side of $80, banks had to worry about the calls they sold to hedge funds, buying and pushing prices quickly to $100 If hedge funds roll out their strikes to $120-$150, prices and volatility could continue to run higher 22

28 Telling the 2007 price story as a Wall Street options trader ________________ Source: Bloomberg, as of 29 Oct 07 WTI Dec 07 vs WTI Dec calls 23

29 IV. Conclusions

30 To conclude, Wall Street matters on many levels Wall Streets current crisis has made it difficult and scary for physical players to access the oil markets Meanwhile it has made it easier for financial players to enter And through options it has created more volatility in the market in certain times 24

31 How will Wall Street change the markets going forward? As more banks make markets and longer-dated liquidity deepens, it will be easier for producers to hedge oil price risk –May take some risk premium out of oil prices Wall Street also to convince pension funds to transfer length from front to back –Curve may shift to contango Current Wall Street turmoil may exacerbate China overcapacities vis-à-vis the stock market Refining business about to undergo massive changes –Requires new risk management solutions from Wall Street 25

32 ________________ Source: ODS-Petrodata and Lehman Brothers Estimates Most critical, Wall Street needs to fund frontier investments If cost inflation ending, non-OPEC supply may finally respond to higher prices Financing critical to development of the deepwater, arctic, biofuels, GTL and oil shale Wall Street will be critical to financing the supply gap post-2010 if the politics in OPEC do not improve OPEC production capacity growth vs. global oil demand growth 26

33 Analyst Certification I, Adam Robinson, hereby certify (1) that the views expressed in this research report accurately reflect my/our personal views about any or all of the subject securities or issuers referred to in this report and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. "To the extent that any of the views expressed in this research report are based on the firm's quantitative research model, Lehman Brothers hereby certify (1) that the views expressed in this research report accurately reflect the firm's quantitative research model and (2) that no part of the firm's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report." Important Disclosures Lehman Brothers Inc. and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. 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