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OPEC Spare Capacity and Oil Price

Volatility

Yaser Faquih

Rice University

June 19, 2017

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Oil Prices 1997-2016

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But volatility is also critical!

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Oil Volatility 1997-2016

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Motivation: Why study oil volatility?

Volatility is also critical

Key source of uncertainty affecting the cost of inputsOil products factor in 98% of all consumer goods’ valuechain in the US (Sadorsky, 2008)Forecasting volatility is fundamental in the pricing ofenergy derivatives such as option

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References

Motivation: Why study oil volatility?

Volatility is also critical

Key source of uncertainty affecting the cost of inputs

Oil products factor in 98% of all consumer goods’ valuechain in the US (Sadorsky, 2008)Forecasting volatility is fundamental in the pricing ofenergy derivatives such as option

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References

Motivation: Why study oil volatility?

Volatility is also critical

Key source of uncertainty affecting the cost of inputsOil products factor in 98% of all consumer goods’ valuechain in the US (Sadorsky, 2008)

Forecasting volatility is fundamental in the pricing ofenergy derivatives such as option

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References

Motivation: Why study oil volatility?

Volatility is also critical

Key source of uncertainty affecting the cost of inputsOil products factor in 98% of all consumer goods’ valuechain in the US (Sadorsky, 2008)Forecasting volatility is fundamental in the pricing ofenergy derivatives such as option

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References

Motivation: Why study oil volatility?

Impact on investment decisions

Affects the value of the embedded real option, such asthe option to defer or cancel an oil related investment(Bernanke, 1983), (Dixit and Pindyck, 1994), (Kellogg,2014)

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Motivation: Why study oil volatility?

Impact on investment decisions

Affects the value of the embedded real option, such asthe option to defer or cancel an oil related investment(Bernanke, 1983), (Dixit and Pindyck, 1994), (Kellogg,2014)

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Motivation: Why study oil volatility?

Impact on business cycle

Wild price swings harmful to industry and economy,(Moran, 1981)

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Motivation: Why study oil volatility?

Impact on business cycle

Wild price swings harmful to industry and economy,(Moran, 1981)

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Variables of Interest

brent vol Volatility of Brent front-month price

rbrent difference of log Brent prices

vix: VIX index for the S&P500

rfw cover: difference of log OECD forward cover

brent 6m: Brent 6th month forward contract minus frontmonth contract price

sa spare share: Saudi idle spare capacity as a share ofworld demand

opec spare share: OPEC (excluding SA) idle sparecapacity as a share of world demand

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Testing for Stationarity

Variable TestStat CriticalValue10 CriticalValue5 CriticalValue1 Pvalue1 Brent -1.389 -2.571 -2.881 -3.464 0.58762 Brent Vol -3.696 -2.571 -2.881 -3.464 0.0042∗∗∗

3 FW Cover -1.589 -2.571 -2.881 -3.464 0.48924 VIX -3.924 -2.571 -2.881 -3.464 0.0019∗∗∗

5 SA Spare Share -2.849 -2.571 -2.881 -3.464 0.0516∗

6 OPEC Spare Share -2.748 -2.571 -2.881 -3.464 0.0661∗

7 Brent M6 -3.358 -2.571 -2.881 -3.464 0.0125∗∗

Table: ADF Test of Stationarity

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Figure: Brent 6-month spreads in $ per barrel vs volatility, andBrent 6-month spreads in % of front month price vs volatility

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Figure: Brent forward cover deviations from 3yr average in days vsvolatility, and Brent forward cover deviations from 3yr average in% vs volatility

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Special Commodity?

Oil (and gas) need specialized storage facilities

Costly to store relative to other bulk commodities (suchas copper)

Building new storage requires time

Running out of storage capacity induces a sharp pricedrop

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Special Commodity?

Oil (and gas) need specialized storage facilities

Costly to store relative to other bulk commodities (suchas copper)

Building new storage requires time

Running out of storage capacity induces a sharp pricedrop

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References

Special Commodity?

Oil (and gas) need specialized storage facilities

Costly to store relative to other bulk commodities (suchas copper)

Building new storage requires time

Running out of storage capacity induces a sharp pricedrop

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References

Special Commodity?

Oil (and gas) need specialized storage facilities

Costly to store relative to other bulk commodities (suchas copper)

Building new storage requires time

Running out of storage capacity induces a sharp pricedrop

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Figure: IRF: rBrent shock on Brent Vol

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Figure: IRF: VIX shock on Brent Vol

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Figure: IRF: Brent M6 shock on Brent Vol

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Figure: IRF: rFW cover shock on Brent Vol

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The Historical Saudi Role: Market Stability

Table: Examples of Recent Saudi Usage of Spare capacity toCounter Market Turbulence

Event Year Disruption Saudi Response DurationVenezuela Strike 2002 2 MBD 1MBD 3 monthsIraq Invation 2003 1.2 MBD for 2 months 0.6 MBD 2 monthsChina’s Demand Spike 2004 Demand unexpectedly up by 2 MBD 1.8 MBD 5 monthsHurricane Katrina, USA 2005 Shut down 1 MBD of prod for 4 months 1.8 MBD 4 monthsPrice Spike to $140/bbl 2008 Global concern about supply availability 500 kBD in April 3 months

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Figure: IRF: Brent M6 shock on SA Spare Share

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Figure: IRF: rBrent shock on SA Spare Share

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Figure: IRF: Volatility shock on SA Spare Share

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Figure: IRF: Brent M6 shock on OPEC Spare Share

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Figure: IRF: rBrent shock on OPEC Spare Share

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Figure: IRF: Volatility shock on OPEC Spare Share

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The Saudi Role vs. Other OPEC Members

The Similarities:

Both tend to produce more after a positive price shock

This is expected as they seek to utilize idle capacity togenerate income, while meeting any market shortage

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The Saudi Role vs. Other OPEC Members

The Similarities:

Both tend to produce more after a positive price shock

This is expected as they seek to utilize idle capacity togenerate income, while meeting any market shortage

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The Saudi Role vs. Other OPEC Members

The Differences:

Saudi Arabia aims to manage global inventories

They tend to cut production (i.e. increase idle sparecapacity) when inventories are high

Saudi Arabia also aims to counter high volatility

Increasing production when volatility increases

The rest of OPEC does not seem to be actively engage ininventory management

This highlights the historical swing-producer role of SA

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The Saudi Role vs. Other OPEC Members

The Differences:

Saudi Arabia aims to manage global inventories

They tend to cut production (i.e. increase idle sparecapacity) when inventories are high

Saudi Arabia also aims to counter high volatility

Increasing production when volatility increases

The rest of OPEC does not seem to be actively engage ininventory management

This highlights the historical swing-producer role of SA

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References

The Saudi Role vs. Other OPEC Members

The Differences:

Saudi Arabia aims to manage global inventories

They tend to cut production (i.e. increase idle sparecapacity) when inventories are high

Saudi Arabia also aims to counter high volatility

Increasing production when volatility increases

The rest of OPEC does not seem to be actively engage ininventory management

This highlights the historical swing-producer role of SA

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References

The Saudi Role vs. Other OPEC Members

The Differences:

Saudi Arabia aims to manage global inventories

They tend to cut production (i.e. increase idle sparecapacity) when inventories are high

Saudi Arabia also aims to counter high volatility

Increasing production when volatility increases

The rest of OPEC does not seem to be actively engage ininventory management

This highlights the historical swing-producer role of SA

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References

The Saudi Role vs. Other OPEC Members

The Differences:

Saudi Arabia aims to manage global inventories

They tend to cut production (i.e. increase idle sparecapacity) when inventories are high

Saudi Arabia also aims to counter high volatility

Increasing production when volatility increases

The rest of OPEC does not seem to be actively engage ininventory management

This highlights the historical swing-producer role of SA

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References

The Saudi Role vs. Other OPEC Members

The Differences:

Saudi Arabia aims to manage global inventories

They tend to cut production (i.e. increase idle sparecapacity) when inventories are high

Saudi Arabia also aims to counter high volatility

Increasing production when volatility increases

The rest of OPEC does not seem to be actively engage ininventory management

This highlights the historical swing-producer role of SA

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Conclusion

Understanding the drivers of oil price volatility is critical

The special storage requirements of oil (and energy)commodities means that volatility may shoot up evenwhen storage is ample

Evidence of shock transmission from the wider economyto oil markets

Saudi Arabia behaves differently compared to otherproducers in response to volatility spikes

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References

Bernanke, B. S. (1983). Irreversibility, uncertainty, and cyclicalinvestment. The Quarterly Journal of Economics 98(1),85–106.

Dixit, A. K. and R. S. Pindyck (1994). Investment underuncertainty. Princeton university press.

Harris, J. H. and B. Buyuksahin (2009). The role ofspeculators in the crude oil futures market.

Kellogg, R. (2014). The effect of uncertainty on investment:Evidence from texas oil drilling. American EconomicReview 104(6), 1698–1734.

Moran, T. H. (1981). Modeling opec behavior: economic andpolitical alternatives. International Organization 35(02),241–272.

Sadorsky, P. (2008). Assessing the impact of oil prices onfirms of different sizes: Its tough being in the middle.Energy Policy 36(10), 3854–3861.

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References

Silvennoinen, A. and S. Thorp (2013, April). Financialization,crisis and commodity correlation dynamics. Journal ofInternational Financial Markets, Institutions and Money 24,42–65.

Yaser Faquih OPEC Spare Capacity and Oil Price Volatility