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Thursday, March 09, 2006

Cracking the Oil Code

Background Information
Being the lifeblood of the world’s industrialized economies, crude oil is the most actively traded commodity. The world consumes roughly 80 million barrels of crude oil per day and uses petroleum products for a multitude of applications, including transportation, heating, and plastic production. Because oil is such an essential input in the production process, its price is closely followed and reported daily by the financial press. Also, most of the world’s heaviest consumers of petroleum rely on imports from Middle Eastern oil-producing nations. Since the formation of an international petroleum cartel, the Organization of Petroleum Exporting Countries (“OPEC”), the political importance of oil has escalated. In an effort to insulate the American economy from oil shocks, the U.S. government began stockpiling emergency oil reserves in 1977 as a national security policy.
The question of whether the price of oil is high or low based on market fundamentals is a contentious debate. Currently, oil is trading at about $60 per barrel in 2005 dollars, a relatively high price compared to historical averages. Many justify this price and remain bullish, adhering to the idea that the supply of petroleum is fixed and that increased demand from developing countries will drive the price higher as they accelerate growth. Others dismiss the current price as being irrational and the result of increased speculative activity by large alternative investment funds. This paper seeks to explain what determines the price of oil.Several different types of crude oil are produced and receive different market prices. For instance, North Sea crude, generally known as Brent crude, commands about a $1 premium to the OPEC Basket Price, which includes various blends of Dubai, Saharan, and Venezuelan crudes. The price quoted on the New York Mercantile Exchange, however, is for light-sweet, or West Texas Intermediate (“WTI”) crude. WTI is the most easily and widely refined crude in U.S. refineries, making it the most frequently quoted type of oil in the world. Light-sweet WTI crude on the NYMEX trades at about a $2 premium to the OPEC Basket Crude. Changes in the price of crude oil have large affects on the U.S. economy and are difficult to explain and predict. The quoted price of crude oil on the NYMEX represents the cost of one 42-gallon barrel of crude oil before transaction and transportation costs.

The Independent Variables, Functional Form, and Expected Signs of Coefficients
While it is clear that many variables affect the price of crude oil, determining the correct variables for an equation is difficult because there are several ways to measure a single phenomenon. Below are the independent variables and a detailed explanation of why each was chosen and what it means:
-Industrial Production Index: As the world’s economies grow, industrial production expands and global demand for oil increases. Because the United States economy consumes roughly 25% of the world’s crude oil, and meticulous monthly data is collected by the government, the Industrial Production Index was chosen to explain demand for oil in developed countries. The Industrial Production Index measures the monthly physical output of the manufacturing, mining, gas, and electricity industries. Other ways of measuring output, such as real GDP, are inferior to the Industrial Production Index for this model because real GDP measures output in the service and technology sectors, which consume less petroleum than heavy industries. Theory suggests that the relationship between industrial output and crude prices should be linear. Increases in industrial output should mean that oil demand has increased and that the price should rise. A positive (+) sign is expected.
-Non-OECD Consumption of Petroleum: This variable is a measure of oil consumption in the developing world. As the developing world industrializes, the world economy’s demand for petroleum accelerates. Both China and India are two of the fastest growing nations and consume large amounts of oil. Almost all literature concerning the price of oil cites Chinese demand as a driver of prices. The relationship between non-OECD consumption and the price of oil should be linear as well. As the consumption of a non-renewable resource increases, price should rise, so the expected sign of this coefficient is positive (+).
-Change in Crude Stocks: Changes in the commercial stocks of crude oil are an important driver behind changes in price. Quantities of crude oil stocks are stocks of oil held at refineries, in pipelines, in bulk terminals, or any quantities in transit to the aforementioned destinations. If this variable were the absolute level of crude stocks, an inverse function form would be theoretically accurate, because the impact of the stock levels on price would diminish as they increased. Because it is the change in stocks, only linear is appropriate. An increase in crude stocks should ease the market’s fear of a shortage, so the expected sign of this coefficient is negative (-).
-Change in U.S. Field Production: A disruption in U.S. field production should have a large impact on prices. Because the U.S. consumes more petroleum than it produces, it is forced to import crude oil from abroad. As more oil is produced in the United States, fears of a shortage will diminish and the price should fall. The relationship between changes in field production and the price of oil should be linear. The expected sign of this coefficient is negative (-).
-Change in OPEC Output: By restricting output, OPEC has been able to raise the price of oil. OPEC’s share of world oil production has decreased since the 1970’s because new oil fields have come on-line and market power has eroded; nevertheless, OPEC’s pricing power still exists. Theory suggests that the relationship between changes in OPEC output and the price of oil is linear. The expected sign of this coefficient is negative (-) because as OPEC increases output, the price of oil should fall.

NYMEX = -263.354 + 2.894 INDPROD + 0.061 NONOECD - 0.176 STOCKS
(11.600) (0.794) (-2.210)
+ 0.212 FIELDPROD + 0.062 OPEC
(0.9053) (0.676)
N = 42 Adjusted-R2 = 0.8795 DW = 1.400

INDPROD = the Industrial Production Index

OPEC = the percentage change in OPEC output


NONOECD = the percentage change in Non-OECD Consumption


STOCKS = the percentage change in commercial stocks


FIELDPROD = the percentage change in U.S. production

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