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Oil and Mineral Commodities, and the Financial Crisis 30 March 2009


A short history of the commodites price boom ... 'when the tide goes out, you can see who's been swimming naked' (Warren Buffett) ... – PowerPoint PPT presentation

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Title: Oil and Mineral Commodities, and the Financial Crisis 30 March 2009

Oil and Mineral Commodities, and the Financial
Crisis 30 March 2009
  • Olle Östensson

  • A short history of the commodites price boom
  • Why did oil and mineral prices rise and why did
    they rise by so much?
  • The downturn How much was due to the financial
  • The recession
  • How deep and how long?
  • Will things go back to  normal ?

The commodity price boom
Crude oil prices 1960 to mid-2008, US/barrel
Source UNCTAD Commodity Price Bulletin
Reasons for the price increase
  • Demand
  • Two years 2003 and 2004 with above trend
  • Geographical differences
  • Expectations
  • Supply
  • Slow capacity expansion
  • Low spare capacity, concentrated in one place
  • Inventories
  • Supply-demand imbalances and price spikes in
    commodity markets
  • Other factors
  • US depreciation
  • Mismatch of refinery capacity
  • Speculation?

Global oil demand, change on previous year,
Source International Energy Agency, Oil Market
Report, various issues
Shares of increase in global oil demand
Large share for China, Middle East and Other Asia
but also for North America
Source International Energy Agency, Oil Market
Energy intensity, metric tons oil equivalent per
thousand US in nominal and PPP 2000 exchange
Source International Energy Agency
China was expected to follow the Korean path,
but didnt
Reasons for price spikes in commodity markets
  • Very low short term price elasticity of demand
    because of lack of substitutes and because use
    cannot be postponed
  • Very low short term elasticity of supply because
    of fixed capacity and high capacity utilization
    (a logical consequence of product
  • When prices are perceived to be rising, target
    inventory levels are raised because buyers want
    to avoid paying higher prices
  • If there is a perceived risk of shortage, target
    inventory levels are raised to avoid having to
    default on deliveries
  • Precautionary stocking is insensitive to price
    increases and will continue long after prices
    have exceeded reasonable levels

Supply side factors Capacity developments
  • Slow capacity increase
  • Low oil prices in the 1990s reduced the incentive
    to add to capacity
  • There was no spare capacity among non-OPEC
  • OPEC spare capacity
  • In the 1990s, OPEC had cut back production
  • As late as 2001, OPEC spare capacity was 5.6
    million barrels/day
  • In June 2008, it was 1.5 million barrels/day
    (less than a weeks world consumption), all in
    Saudi Arabia

Supply side factors Production costs
  • Production costs rose rapidly after 2000, both
    reducing incentives to invest and creating
    expectations about future price increases
  • The peak oil theory made arguments based on
    rising costs of production more credible

Production costs, conventional oil
Source US Energy Information Administration
Supply side factors Inventories
  • The history of inventory changes is ambiguous
    total OECD stocks were actually higher than
    normal in the first half of 2007
  • OECD stocks fell in early 2008, particularly in
    Asia, creating an imbalance
  • Official stock build ups took place throughout
    the period of price increases and rumours of
    massive increases in Chinese stocks abounded
  • Very little information was available about
    stocks in producing countries
  • It is likely that a general atmosphere of
    uncertainty contributed to precautionary stocking

A source of uncertainty Estimates of non-OPEC
supply growth have been too optimistic in recent
Estimate 1 year ahead
Estimate end of current year
Sources December editions of IEAs Oil Market
Summary of factors
Sources WTI Reuters OECD Days Supply
International Energy Agency and U.S. Energy
Information Administration estimates World
Excess Production Capacity U.S. Energy
Information Administration estimates.
Other factors
  • US depreciation
  • Demand rose particularly fast in the
    transportation sector
  • Refineries produce products in fixed proportions,
    composition of crude oil is crucial
  • A shortage of light crude oil may have further
    fuelled the price increases

Speculation? The argument
  • Low returns on stocks and other assets led hedge
    funds and other investors to invest in commodity
    markets, particularly oil
  • The volume of investment was very large and, it
    is argued, drove up prices

How do futures markets for commodities work?
  • Futures markets trade contracts for future
    delivery of a certain quantity of a commodity
  • The contracts are almost always cashed in and
    very seldom do buyers actually take delivery in
  • The attraction to investors or speculators
    compared to dealing in the physical commodity is
    (1) you avoid storage and handing costs and (2)
    you only have to pay a small part, usually 10 per
    cent, of the total price in advance therefore
    the potential for profits is very large

Who invested in oil futures and what was the
  • Banks and others sold commodity index funds,
    that is, financial instruments that were intended
    to replicate the price movements of commodities
  • Oil is usually a large component in the indices,
    since it is an important commodity in world trade
  • Since the sellers of commodity indices wanted to
    avoid losses, they hedged by buying contracts on
    commodity exchanges that corresponded to the
    indices that they sold thus they would be able
    to pay off the investors this activity was
    responsible for the vast majority of futures
    market investment
  • The sellers rolled over their hedges, that is,
    they sold the contracts for cash before the due
    date and bought new ones for more distant dates
  • Accordingly, no oil ever changed hands and the
    price of physical oil was not affected
  • The process can be compared to betting on the
    outcome of a tennis tournament the bettors do
    not decide who wins the Wimbledon

Who invested in oil futures and what was the
effect? (3)
  • No correlation between the amount invested in
    futures contracts and the price level
  • Changes in positions did not precede price
    changes, but followed them (US Commodity Futures
    Trading Commission)
  • Backwardation is the classical indication of a
    physical shortage, speculators exploit physical

(No Transcript)
Mineral commodities
  • Above trend growth in usage
  • Under investment in the 1980s and 1990s because
    of low prices therefore, capacity became a
  • Inventories were gradually depleted
  • Price spikes resulted from precautionary buying
    all buyers tried to ensure that they would be
    able to meet their needs

Average annual growth rates of usage of minerals,
per year
The main factor China
Surplus or deficit (-) of global production over
usage for lead and zinc, 1996-2007, per cent of
Average quarterly prices and end of quarter
inventories (LME) of lead and zinc, of 4th
quarter 2003 prices and end 2003 inventories
Iron ore prices, US/ton
Sources UNCTAD Iron Ore Trust Fund, TEX Report,
Metal Bulletin
Freight rates reflected the overall boom Example
Iron ore freight rates, 1999-2008, US/ton
Sources Drewry, SSY
The downturn
  • Did not happen at the same time for all
  • The recession in the US began in the 4th quarter
    of 2007 well before the collapse of Lehman
    Brothers in September 2008
  • It started as a typical recession brought on
    by a commodity price boom
  • High commodity prices lead to higher general
    inflation, deterring investment and constraining
  • Tightened monetary policies reinforce the trend,
    causing an end to the boom
  • But it became a financial crisis when the tide
    goes out, you can see whos been swimming naked
    (Warren Buffett)
  • As a result, worst recession since the Great

Characteristics of the recession for commodities
  • Widespread downturn led to falls in demand
  • Note Mineral commodities are used in
    construction, capital equipment and durable
    household goods, first sectors to be hit in the
  • Lack of credit led to
  • No trade finance
  • No working capital finance
  • No finance for investment
  • As a result, world trade was strangled and
    commodity demand fell precipitously

Monthly world crude steel production, change
Implications, oil and mineral exporters
  • Real exchange rate appreciation during boom
  • Undiversified exports and economic structure, low
    productivity growth
  • Subsidized fuel consumption, leading to
    allocation errors and inefficiencies
  • Widening income differences
  • Eventually, slow growth
  • But, the scenario takes place against a
    background of high incomes

Implications, oil importers
  • High energy costs act as a tax on development,
    reducing real income
  • For commodity exporters, effect is offset at
    least to some extent - by high prices for export
    products, and prices of most commodites have
    fallen less than oil prices
  • Exporters of manufactures experience income losses

Terms of trade, developing countries and
countries in transition
Source UNCTAD, Trade and Development Report, 2008
What happens now?
  • How long and how much will commodity prices be
  • Short to medium term
  • Long term

Short to medium term Prices have fallen by less
than generally thought Average 2008 and December
2008 (2000100)
Short to medium term, contd
  • Demand for food commodities has held up
    relatively well people have to eat, even in a
  • Minerals and metals producers have cut production
    drastically, reducing the impact on prices
  • Oil producers (OPEC) have instituted cutbacks,
    but quota limits are not observed

Short to medium term, contd
  • The impact on investment has been severe, but has
    mainly hit projects that are in the midst of the
    project cycle
  • Projects that were almost finished are going
    ahead but may not enter into production
  • Long term projects are continuing, but at lower
    spending rates
  • Prices have probably bottomed out and will start
    rising slowly towards the end of 2009

The long term 1. The new oil economy
  • The lesson learned from the oil crisis is that
    energy diversification is a necessity
  • This is reinforced by the need to slow climate
  • Accordingly, oil demand will grow more slowly
    than otherwise
  • A floor to prices will be set by production
    costs for alternatives US 50/barrel?
  • A ceiling will be set by moderate demand growth
    US 80/barrel?
  • OPEC discipline will hold up if prices fall too
  • Unknown factor risk for new supply shortages due
    to under investment in exploration and
  • What is the future for oil economies?

The long term 2. Minerals and metals
  • Chinese transformation from export orientation to
    push for domestic demand effect on minerals
  • In spite of this, minerals demand is likely to
    grow fast in emerging economies because of rising
    incomes and need to improve infrastructure
  • Because of cuts in investment, bottlenecks may
    emerge quickly and prices could rise to new
  • Reinforcement of existing pattern of production,
    Africa may have lost its opportunity…and Russia?

  • Thank you!
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