Good afternoon. Thank you for giving me this opportunity.
What I want to talk about is price formation in the oil market and how we got from $20 to $140 and back down to $120.
What's important to know is that the oil market, between 1985 and 2003, had a very large “spare capacity”, unused capacity. We had over-invested in the seventies when oil prices went up and demand suddenly declined. During those 20 years, OPEC had to shut down a large amount of production. That spare capacity, between 1985 and 2003, shrunk a little bit every year but kept oil prices at a very low level, between $18 and $20. At these prices, we have under-invested in the industry for something like 20 years.
Think about it. It meant that for every new barrel of demand we had, we didn't need to go and find oil or produce oil. We just needed some of the producers to turn on the tap. If you look at how we met the rising demand during those 20 years, over 60% came from opening the tap. That didn't cost a lot of money.
In 2003, 2004, and 2005 there were two shocks, a supply shock and a demand shock, which basically wiped out the spare capacity. The supply shock happened in 2003 when there was the Venezuelan strike, the situation in Nigeria, and then the Iraq war. We removed a lot of barrels from the market at a time when the world was starting to witness a demand shock, not only from China but also from certain places in the Middle East and in the United States. In 2004 we had incredible demand in the United States. These two shocks at the same time have removed all the spare capacity, and without spare capacity, oil markets work in a very different way.
Think about it. Before that, if you were an investor or speculator, you weren't really willing to play on that market, because any decision by OPEC could increase or decrease production by a very large amount and completely change the price structure. So there was a political risk, an OPEC risk, which for a lot of financial players was unacceptable.
As spare capacity wilted, we saw the emergence of the supply narrative. According to this narrative, we don't have enough oil, peak oil is here, and demand is rising.
I have my own slightly different opinion on that, but this narrative is very powerful among financial players, much less so among the industry players. Oil companies don't get that worked up about peak oil, but the narrative is important because it tells you that we're entering an era of scarcity, so this is the time to invest and put money into oil. That movement and that supply narrative, in a way, has created another phenomenon, which is the key to understanding oil prices. It's what I call the financialization of oil markets.
Before 2003 or 2004, oil markets were small commodity markets with few players, some of them very large, who were able to move a lot of barrels in arbitrage. In 2003 you had something like 50 financial institutions on the NYMEX. Today there are over 400 financial institutions trading on the NYMEX. So when you removed that spare capacity and added into the mix the supply narrative, that scarcity element, you brought into the market a lot of players. Many of them didn't know much about the commodity but saw one price trajectory, which seemed to them a good way to make money and to put money into play.
The financialization of the oil market is important because, between 2005 and 2008, the key oil price indicators became something other than supply and demand. I'm a fundamentalist. I've been doing this for 15 years. I know how to look at supply and demand and forecast oil prices. It worked very well until 2002. But between 2003 and 2005, the key indicator for forecasting the movement of oil prices became the amount of money coming into the exchange. It was purely the amount of money coming into the exchange, and later on, between 2006 and 2007, it was largely the position of the non-commercials, the net lengths of the non-commercials. So these specific speculators—and I have a lot of trouble with that term, for I would call them investors—were directing the magnitude and the shape and the trajectory of oil prices.
That's very important. Suddenly it's not the physical players but the financial players who are directing, just because of their weight and their size, the direction of oil prices.
As that market matured, in a way, and these players became a lot more savvy, suddenly we started to see other phenomena appearing, and what happened in the last 12 months is actually very intriguing. As all these financial players come into the market, suddenly they're making arbitrage: they're not only putting money in oil, but they're deciding, if they're putting money into oil, to take it from somewhere else. They're making portfolio arbitrage across all the asset classes. This is what I call it. Oil becomes an asset class per se. Suddenly they're deciding one day to invest in the dollar; the next day the dollar is going down, so they're investing in oil, or they're investing in the Canadian dollar, or whatever. They're making this arbitrage among their portfolio assets. That obviously has brought in more money, because new players have come in who are largely university endowments and pension funds—what are called more passive money, in general.
This arbitrage has somehow linked oil prices with other fundamentals, with what I call the “macro macro-fundamentals”. Suddenly oil prices in the last 12 months.... If you want really to understand what happened to oil prices, you need to correlate oil prices with the U.S. dollar and U.S. interest rates. The mortgage crisis in the United States, which has had an impact on loosening interest rates and weakening the dollar, had a tremendous impact on oil prices. You have a very good correlation there.
And actually we see it happening in the reverse now: as the dollar is strengthening, oil is weakening. In that sense, oil has become a financial asset, where the fundamentals matter. After all, we have under-invested for a long time. The physical supply and demand balances until now have been fairly tight. I think they're probably reversing a little bit in the next year and a half, because oil prices have started to destroy demand, but what you had in a way is macro-fundamentals and oil fundamentals having become, both together, the key driver of the oil prices.
I'll stop it here. I'll take questions later.