Some Analytical Aspects of the New Oil Market (Part 2)Professor Ferdinand E. Banks
December 7, 2007
The University of Uppsala, Uppsala Sweden
The School of Engineering, Asian Institute of Technology, Bangkok Thailand
Part 1 -- Part 2
4. SOME ASPECTS OF OPTIONS
As with futures, one of the most important things in studying options is the terminology, and readers should give it some extra thought. What an option does is to give the buyer the right, but not the obligation, to buy an asset at a specified price within a given period, where the end of that period is called the expiry or maturity date. The point is however that closing a futures position requires a transaction, while an options position can be closed simply by discarding the asset. For instance, If the price of a barrel of oil is $92/b, and I believe that the price of oil will go to $100/b, I might be able to buy an option to purchase a barrel of oil for $95/b at a cost of $3/b. If I am correct and the price goes to $100/b, then I can exercise the option and make a profit of $2/b ( = 100 ? 95 ? 3). I gain this by buying the oil at the exercise price (= $95/b) and selling it for $100/b, which can be called the market price. If the price fell instead of increased, the option could be thrown into the waste paper basket. One important item needs to be added to this example, which is the maturity period for the option. At the present time a week might be suitable.
Next, this example can be generalized somewhat. The $3 is the price of the option, or the premium. It is an up-front payment to the seller or writer of the option, while as mentioned, the $95/b is the exercise price. As opposed to futures, options are generally traded over-the-counter, while futures are traded (i.e. bought and sold) in an exchange (or auction market), where the price of the asset is always visible. In the example the maturity period was one week, which meant that if the option was an American option, it could be exercised at any time within the week, while if it was a European option it could only be exercised at the end of the week. Almost all options now are American options, to include those traded in Europe. As noted, the option can be exercised within the maturity period, or allowed to expire worthless - but in addition it might be possible to sell the option in an organized market. For instance, in the transaction above, it might make sense to sell the option rather than to exercise it, because someone might want the option bad enough to pay a price that makes a sale more attractive than exercising the option and then e.g. selling the oil that was obtained.
The above example had to do with a call option, which allows the buyer to purchase the underlying (i.e. oil) at the exercise price. But there are also put options, which allow an asset to be sold at a certain price. Suppose in the above example that the price of oil was $92/b, and I thought that it was going to fall by a large amount. Perhaps I would have been able to buy a put (i.e.) sell option for $3/b, and with an exercise price of 86/b. Suppose that the price descended to $82/b. I could then exercise the option, which means that I could buy oil at the market price of $82/b, and sell it at the exercise price of $86/b. Taking into consideration the premium, my profit would be (86 - 82 - 3) = $1/b. This may not sound like much, however the option contract would also most likely be for 1000 barrels, which means a profit of $1000 for a contract.
What I called the exercise price above is also called the strike price. As should be obvious, the premium of a call option will go up if the price of the underlying is rising or is expected to rise, while the premium of a put option will go up if the price of the underlying is falling or expected to fall. In either case, what the seller (i.e. writer) of the option wants is for the option to go unexercised, just as the buyer wants something to happen to the price so that he or she can exercise. As I explain in some detail in both of my textbooks, the price (premium) of an option depends on three things: the relation of the strike price of the option to the market price of the underlying; the maturity of the option or the time that the option has to run before it expires; and the volatility of the market price of the underlying.
If the strike price of a call option is at or close to the market price of the underlying, the option is said to be 'at-the-money'. If the price of the underlying is well under the strike price, so that there is absolutely no incentive to exercise the option, then the option is out-of-the-money. On the other hand if it makes sense to exercise the option, then it is called in-the-money. With a call option that would mean that the market price is above the strike price, while with a put option it means that the market price is below the strike price. To take the last case, oil is bought on the market for a low price, and sold for the strike price.
The expression intrinsic value is also used where what is called time value is concerned. The longer the running time of an option before the expiry date, the greater its time value - that is, the greater the chance that the option will move into-the-money where it will have intrinsic value. This is why the premium for a 30 day option is, ceteris paribus, greater than for a one week option. An out-of-the-money option has no intrinsic value, but it may have considerable time value. An option with only a day or two to run will usually have very little time value, but conceivably can have a great deal of intrinsic value.
Clearly, an option seller (i.e. writer) aims to set the value of an option so that it will be attractive to potential buyer, but at the same time will never be exercised. As I note in my new textbook, since the maximum that a writer can gain is premium income, while buyers can theoretically make a great deal of money, it is difficult to believe that there is a large supply of writers, however this is not the case. One reason is that the evidence reveals that a careful writer can do quite well financially. The thing to understand here is that writers are performing an insurance function, and this is something that would not take place if they were not remunerated for that service.
Finally, where the likelihood of exercise is concerned, perhaps the volatility of the underlying is the most important factor. The higher this volatility the greater the chance that the option will jump into the money, and so everything else being the same, the higher the premium. 'Some people' think that premiums can be calculated with the Black-Sholes-Merton option pricing equation, and I have heard this called the most important equation in finance. Well, really!
5. FINAL OBSERVATIONS AND CONCLUSIONS
At the present time I try to believe that just about everyone understands the worsening prospects for the global oil economy. I assume that since the price of oil was recently less than a dollar from the $100/b mark, the more vulgar forms of optimism cannot persist. As pointed out by Hoogeveen (2006), the world consumed the equivalent of 8.5 mb/d more energy in 2004 than the previous year, and if this was some sort of record, it was definitely exceeded the following year. In the 2004 figure China accounted for 40% of this energy growth, which for them included 900,000 b/d of oil, almost all of which was imported.
Amazingly enough, there are still highly intelligent and well-educated persons, with a passable background in energy matters, who are unable to deal with the new oil realities. One of these harbingers of good news made herself known to me about a year ago, and at almost the same time the official Swedish Energy Agency released its long awaited report on the world oil situation. Where the young lady is concerned, seismic technology is a "guess and a gamble". This serio-comic evaluation was almost certainly provoked by the failure of seismic and other technology to register the successes that she and her colleagues had predicted earlier. Furthermore, I was brusquely informed that when drilling, it is possible to miss a mega-size oil field by a matter of "feet". With all due respect, I interpret this kind of hokum as benighted contempt for mainstream science and technology. The same person insisted that the attempt to assess oil reserves should be characterized as "guesswork" - which to a minor extent it may be, and so the things written about peak oil is a bit like the usual nonsense about climate change: "it is written by people who know nothing about it".
The elite of oil geologists and petroleum engineers now seem to accept the peak oil thesis, which is probably one of the reasons why the executives of the major oil companies have stopped pretending that an output peak will never be experienced. Apparently the high-and-mighty are now ready to accept that since we have had peaks in huge land areas like North America and the former Soviet Union, there is a distinct possibility that we will confront a global peak some sad day. Similarly, a very large majority of acknowledged climatologists attach a high probability to global warming that has its basis in human behaviour. I have argued at great length that since addressing anthropogenic global warming (AGW) entails - among other things - restructuring our present energy technology, it may not make any difference whether AGW is the real deal or a chimera unless you live in the wrong place. I also suspect that the cost of doing the optimal thing about real or theoretical AGW is reasonable, although the longer we wait to accelerate this restructuring, the more expensive it will be.
Both the young lady mentioned above and the Swedish Energy Agency have great faith in the tar sand reserves of Northern Canada. I don't have any faith in them at all where significantly changing the international oil picture is concerned, at least in the next decade, and the Swedish Energy Agency brings to my mind an expression of George Orwell: "A system of indoor welfare". In their work on energy materials, I get the impression that that misguided organization fits perfectly the description that John Kenneth Galbraith once gave forecasters in the financial markets: they forecast because they are asked to carry out this function, and not because they know how. Tar sands and heavy oil can dramatically increase nominal reserves, but together with shale this is a distraction that the movers and shakers in the energy intensive countries have fortunately decided to discount. Both will probably be useful in the long-run, but at the present time much of the acceptance of these unconventional resources by energy companies is a ploy designed to raise share prices.
Going from the minor to the major, the International Energy Agency (IEA) has contended that OPEC will be able to supply 57 mb/d of the 121 mb/d of oil that they claim will be required in 2030. In my textbook I calculated the required OPEC output to be 60 mb/d if the fantasies of the IEA are to become reality, but regardless of assumptions and mathematical sleight-of-hand, neither 57 mb/d or 60 mb/d or anything in that neighbourhood has the slightest possibility of being realized, particularly since Saudi Arabia has never expressed a desire to sweeten the dreams of IEA forecasters. As long ago as l973, or perhaps even earlier, the government of Saudi Arabia made it clear that their present and future population took precedent over the motorists of the oil importing world, and put into context this meant that their production was unlikely to exceed 12 mb/d.
Several months ago Professor Paul W. MacAvoy of Yale University honoured me with an e-mail in which he made it clear that Saudi Arabia had four new large fields on the verge of exploitation, and so in general my opinions about oil availability were completely without value. This loony message must have been taken from his favourite Yale humour magazine, because Saudi Arabia is in no respects different from the remainder of the oil producing world.
According to Dr Fredrik Robelius of Uppsala University, 20 years ago 15 oil fields had the capacity to produce more than one million barrels of oil a day, while today there are only 4 fields: Ghawar in Saudi Arabia, Kirkuk in Iraq, Greater Burgan in Kuwait, and Cantarell in Mexico. Cantarell is the most recent among these to be brought into operation, but even so its output began to fall two years ago. Burgan has also peaked, and at best the output from Ghawar is probably on a plateau. This is the kind of information that all students of the oil market should keep in mind, because as noted by Chris Skrebowski, editor of the Petroleum Review, there are so many lies in circulation about oil that it is almost impossible to carry out a credible analysis. Skrebowski has also pointed out that "the time lag between discovery and first oil production for a major project is currently averaging over 6 years. A few large projects are taking as little as 4 years, but many others are taking up to 10 years. This means that there is now little or no chance of significantly altering the production outlook for 2010, while even that for 2012 is already largely determined."
In the light of these grim tidings, we have the right to ask why Dr Michael Lynch has come to the conclusion that the present high oil price can not only be overcome, but might reach the 20s in 2008. Moreover, in a curious flight of fancy, Lynch has noted that the price of oil is not rising but declining if expressed in grams of gold, which while true is an observation that is completely without any scientific relevance to anyone except possibly Steve Forbes - owner and publisher of the outstanding business publication Forbes - who has also repeatedly informed his readers that oil is greatly overvalued, and whose fondness for gold has led him to suggest the reinvention of the international monetary system so as to make gold the "reserve of last resort". When I hear this sort of thing, I think of one of Mr Forbes' favourite aphorisms: "With all thy getting get understanding". This is something that he should try to get it before oil becomes so scarce that he has to hitch his limo to a team of horses or mules. There are many facets to this topic, which explains the philosophy of the research firm Geopolitics Central (www.geopoliticscentral.com), which takes steps to examine all sides of energy issues. Before completing this presentation, I want to suggest why the large oil price rises of the last few years have not resulted in severe macroeconomic damage in some oil importing countries. To begin, the dollar has fallen in value, which has kept oil price increases from realizing their full force except in the U.S. However a large part of the oil price upsurge impacts transportation, and in the U.S. taxes on gasoline are relatively very low. This means that American motorists still avoid the levels of annoyance that have been imposed on e.g. Scandinavians by oil price rises.
Perhaps more important for many countries is immigration. To use an expression coined by Karl Marx, in some countries immigration has led to the mobilization of a reserve army of the unemployed (and to a certain extent employed) with enhanced work incentives, which means a higher aggregate productivity. Anyone who has lived in Australia should be able to accept that explanation. Of course, there is a social and political cost associated with this arrangement, however this rather sensitive topic cannot be discussed here.
Finally, while I can remember a ten year stretch in which almost everything I said about oil prices was out of line with reality, I felt and still feel that in terms of mainstream economics and finance, I was strictly in the groove. However, even if I am mistaken in my present evaluation of the oil market, which is not impossible, I feel that I am heading in the right direction. In fact if John von Neumann were here now, and he remembered what he wrote in his work on game theory, I feel sure he would agree that the primary issue is not what the oil price will be, but what it could be, and since we neither have nor can obtain a guarantee that this price will not be very bad news for very many of us, our actions should be determined by a policy of safety first.
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Professor Ferdinand E. Banks
December 7, 2007
The University of Uppsala, Uppsala Sweden
The School of Engineering, Asian Institute of Technology, Bangkok Thailand
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