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3 rd OPEC Sum m it Ministerial Sym posium Day - Session I V The Role of OPEC in Providing Petroleum and Prom oting Stability Riyadh, 1 5 Novem ber 2 0 0 7 OPEC: Todays m arket dilem m a and tom orrow s econom ic challenge By Ali

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3 rd OPEC Sum m it

Ministerial Sym posium Day - Session I V The Role of OPEC in Providing Petroleum and Prom oting Stability Riyadh, 1 5 Novem ber 2 0 0 7

OPEC: Today’s m arket dilem m a and tom orrow ’s econom ic challenge

By Ali Aissaoui, Head of Econom ics & Research Arab Petroleum I nvestm ents Corporation ( API CORP)

Handout – Com m ents and feedback to: aaissaoui@apicorp-arabia.com

3 rd OPEC Sum m it Ali Aissaoui Slide 2

About the author

Ali Aissaoui is Head of Economics & Research at the Arab Petroleum Investments Corporation (APICORP). He is formerly an advisor to the Algerian government

  • n energy policy issues and member/ chairman of the

OPEC Board of Governors. Prior to joining APICORP, Ali Aissaoui was Senior Research Fellow at the Oxford Institute for Energy Studies. At APICORP he set up and head a research unit in charge of scanning the Corporation’s environment, framing its business strategy and assessing and monitoring country risks and petroleum industry risks. Ali Aissaoui is a member of several professional associations including the Oxford Energy Policy Club and the Paris Energy, Oil and Gas Club. He is the author and co-author of three books as well as numerous commentaries, op-ed and analyses articles on energy markets and the political economy of the major petroleum-exporting countries of the Middle East and North Africa.

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3 rd OPEC Sum m it Ali Aissaoui Slide 3

Outline of presentation

  • Responding to a rapidly changing

m arketplace

  • Shaping LT price expectations and a

com m on investm ent policy

  • I nform ing public policy on econom ic

diversification

  • Possible sub-them es for the panel

discussion

3 rd OPEC Sum m it Ali Aissaoui Slide 4

1 . Responding to a rapidly changing m arketplace

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3 rd OPEC Sum m it Ali Aissaoui Slide 5

Oil prices on the upsw ing: OPEC’s capacity to m aintain stability questioned

2 0 4 0 6 0 8 0 1 0 0 Ja n- 8 6 Ma y- 9 0 Se p- 9 4 Ja n- 9 9 Ma y- 0 3 Se p- 0 7 WTI S pot pric e (US $/ bl))

Focus on t he cu rren t u pw ard cycle

APICORP Research using EIA- DOE w eekly dat abase

3 rd OPEC Sum m it Ali Aissaoui Slide 6

Multifaceted Reasons for High Oil Prices

Factors influencing OPEC's balancing act W hat has determ ined recent trends? Global oil dem and Stronger than anticipated dem and in China, OPEC area, and I ndia Non- OPEC supply and refining capacity Failure to invest ( or denied

  • pportunities?) despite strong

m arket signals OPEC production capacity Proactive approach to investm ent resulting in tightness of spare capacity I nventory levels and m ovem ents Disconnect betw een levels of inventories and spot prices Hedging pressures and speculative activities Very long contango shifting unexpectedly to backw ardation Geopolitical developm ents in key oil-producing areas Heightened tensions and uncertainties in the Middle East Stances and consequences of US m onetary and fiscal policies Sharp depreciation of the US dollar against other currencies

APICORP Research

Fundamentals dynamics Non fundame ntals

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3 rd OPEC Sum m it Ali Aissaoui Slide 7

Has speculation contributed to high com m odity prices?

  • I n assessing the direction of causality

betw een m ovem ents in spot and futures prices and changes in speculative position, the I MF staff found ( I MF’s W EO - Sept 2 0 0 6 – Chap 5 -

Box 5 .1 )

– No causal influence on prices by speculative activity ( as m easured by net long noncom m ercial positions on the NYMEX) – Little support for the hypothesis that speculation affects either LT price levels or ST price sw ings

  • Have the I MF staff m em bers overlooked

som ething?

3 rd OPEC Sum m it Ali Aissaoui Slide 8

W hat has m ost changed that has m ade difficult OPEC’s policy stance and actions?

10 20 30 40 50 60 70 80 90 250 300 350 400 US inventories excluding SPR ( million barrels) W TI spot prices ( US$/ bl) )

Data for 1 9 8 6 -2 0 0 2 Data for 2 0 0 3 -2 0 0 7

APICORP Research using EIA-DOE w eekly database

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3 rd OPEC Sum m it Ali Aissaoui Slide 9

High levels of inventories are associated w ith contango and low levels w ith backw ardation

  • 4
  • 3
  • 2
  • 1

1 2 3 4 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 WTI futures basis (US $/ bl)

  • 1 0 0
  • 8 0
  • 6 0
  • 4 0
  • 2 0

2 0 4 0 6 0 8 0 1 0 0 Variation in US S tocks (m illion barrels) API CORP Research using EI A-DOE w eekly dat abase Va ria tion in US crude oil stocks ( e x cluding SPR) ( 4- week minus 52- w eek moving averages) W TI future s ba sis ( First t o second mont h spread)

3 rd OPEC Sum m it Ali Aissaoui Slide 1 0

A m ore com prehensive interpretation

le v e ls o f in v e n t o r ie s H e d g in g d e m a n d f r o m r isk - a v e r se m a r k e t p a r t icip a n t s R isk p r e m iu m s se t t le d b e t w e e n h e d g e r s a n d f u t u r e s in v e st o r s/ sp e cu la t o r s B a ck w a r d a t io n Co n t a n g o

A P I C O R P R e s e a r c h

Co st o f st o r a g e • I n t e r e st r a t e • Co n v e n ie n ce y ie ld •

S p

  • t
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3 rd OPEC Sum m it Ali Aissaoui Slide 1 1

Com m odity investm ents on the rise

  • Recent theoretical and em pirical

researches have dem onstrated the superior perform ance of com m odity futures investm ents in term s of:

– historical risk-return profile – inflation-hedging properties – portfolio diversification benefits

  • Com m odity investm ents have rapidly

developed as an attractive alternative to traditional asset classes.

3 rd OPEC Sum m it Ali Aissaoui Slide 1 2

Low levels of inventories induce higher com m odity investm ent returns

Reference period from December 1990 to December 2006

Equally Weighted Index High Inventory Portfolio Low I nventory Portfolio Annualized Returns 8.98% 4.62% 13.34% Volatility 8.93% 11.27% 10.80% Sharpe Ratio 0.55 0.05 0.86

Source: Gorton et al. (July 2007)

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3 rd OPEC Sum m it Ali Aissaoui Slide 1 3

Com m odity investors focus their strategies on backw ardated contracts, m ostly petroleum products

  • 2 0
  • 1 0

1 0 2 0 3 0 4 0

  • 25
  • 2 0
  • 1 5
  • 10
  • 5

5 10 Ave rage annual ba ckw arda tion ( % ) Total annualized returns (%)

Source: Morgan St anley - June 2007 Pet roleum cont act s highlight ed by APICORP Research

Brent Gas oil Gasoline W TI

Nickel

Heat ing oil

Cocoa Corn Coffee Sugar Alum inum Gold Wheat Silver Zinc Cott on Soy beans Lead Live catt le Fe e de r cattle Le an hogs Copp Natural gas Kansas w heat

3 rd OPEC Sum m it Ali Aissaoui Slide 1 4

OPEC’s tough balancing act and policy Dilem m a…

  • I n discouraging inventories build up

backw ardation facilitates OPEC stabilizing role, but attracts m ore speculation

  • OPEC’s policy dilem m a is how to

encourage backw ardation w ithout letting speculators com prom ise its efforts

  • No easy solution as long as OPEC’s sole

policy instrum ent is lim ited to quantitative adjustm ents to output

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3 rd OPEC Sum m it Ali Aissaoui Slide 1 5

2 . Shaping LT price expectations and a com m on investm ent policy

3 rd OPEC Sum m it Ali Aissaoui Slide 1 6

Traditional fram ew ork for investm ent assum es

  • Exogenous price

expectations

  • Uncoordinated

investm ents to m eet the “residual” dem and for OPEC

A ssume an

  • il price path

(exogenous) D etermine global oil demand A ssess N

  • n-O

P E C supply D educt demand for O P E C

  • il

A ssume O P E C will invest to meet the demand

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3 rd OPEC Sum m it Ali Aissaoui Slide 1 7

Extension of the traditional fram ew ork

  • To allow for the

determ ination of an endogenous price using the perm anent incom e hypothesis

  • Assum ing

coordinated fiscal and investm ent policies

Assume this (endogenous)

  • il price path

Determine global oil demand Determine non-OPEC supply Demand for OPEC

  • il

Sustainable “permanent income” and resulting price path Policy coordination on royalty, tax and I nvestment?

3 rd OPEC Sum m it Ali Aissaoui Slide 1 8

Perm anent incom e hypothesis

  • Translation of Milton Friedm an’s

“perm anent incom e hypothesis” assum ing governm ents are forw ard looking

  • Accordingly, governm ents’ spending

decisions are determ ined by longer-term incom e expectations

  • A perm anent incom e is calculated as the net

present value ( NPV) of petroleum ( oil and gas) tax revenue stream s consistent w ith a production profile and a depletion horizon

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3 rd OPEC Sum m it Ali Aissaoui Slide 1 9

Basic set of assum ptions

  • Proven reserves
  • nly ( far-distant

future URR discounted)

  • All productions

valued at international prices

  • Oil and gas prices

LT-correlated

  • Governm ents’ take

decreasing w ith costs

APICORP Research

Data include all 12 OPEC MCs

Proven reserves R/ P ratio Gtoe years Oil proven reserves 122 72 Gas proven reserves 81 172 Total proven reserves 203 93 2006 2030 Gas/ Oil price ratio (% ) 75 75 Government's take (% ) 70 60 2006

3 rd OPEC Sum m it Ali Aissaoui Slide 2 0

The “residual” dem and for OPEC

  • W orld oil dem and, non-OPEC supply and

the dem and for OPEC oil as assum ed by the OPEC Secretariat in its reference scenario ( W orld Oil Outlook 2 0 0 7 )

  • Dem and for OPEC w ould develop to

som e 5 0 Mb/ d of crude oil and 1 0 Mb/ d

  • f condensate in 2 0 3 0 ( total equivalent
  • f 3 ,0 0 0 Mt)
  • W hen including natural gas, total OPEC

petroleum output w ould reach som e 4 ,0 0 0 Mt at that horizon .

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3 rd OPEC Sum m it Ali Aissaoui Slide 2 1

Long term production profiles based on current proven reserves

500 1000 1500 2000 2500 3000 3500 4000 4500 1 9 6 0 1 9 7 0 1 9 8 0 1 9 9 0 2 0 0 0 2 0 1 0 2 0 2 0 2 0 3 0 2 0 4 0 2 0 5 0 2 0 6 0 2 0 7 0 2 0 8 0 2 0 9 0 2 1 0 0 M illio n t o n p e r y e a r 10 20 30 40 50 60 70 80 90 m illio n b a rre l p e r d a y Oil and gas production profile Crude oil & condensate production profile

APICORP Research 3 rd OPEC Sum m it Ali Aissaoui Slide 2 2

The resulting real LT oil price ( illustrative

  • nly) is obtained as a sim ple function of:
  • The perm anent

incom e per capita ( taken as a param eter)

  • The NPV of the

assum ed production per capita

  • And a real

constant discounting factor

20 40 60 80 1 00 1 20 0 % 5 % 1 0% Discounting factor O i l p r i c e ( U S $ / b l )

Holding current level per capita income constant

API CORP Research

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3 rd OPEC Sum m it Ali Aissaoui Slide 2 3

Key steps for a com m on investm ent policy

  • W orking out a LT price expectation that

w ould sustain a perm anent incom e is a first step for a com m on investm ent policy

  • The next step should be directed tow ards

the convergence of fiscal policies or harm onization of royalties and taxes

  • The latter step needs a stronger political

underpinning

3 rd OPEC Sum m it Ali Aissaoui Slide 2 4

3 . I nform ing public policy on econom ic diversification

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3 rd OPEC Sum m it Ali Aissaoui Slide 2 5

Defining econom ic diversification

  • A process that leads to a

grow ing num ber of econom ic

  • utput being produced
  • I nvolves
  • Diversification of incom e-based

GDP

  • diversification of exports
  • Diversification of fiscal revenues

3 rd OPEC Sum m it Ali Aissaoui Slide 2 6

How diversified ( or dependent) are OPEC econom ies?

  • Above OPEC average:

Qatar, I raq, Angola, Kuw ait, Saudi Arabia

  • I ndonesia and UAE

relatively m ore diversified

  • Libya, Algeria,

Venezuela and I ran in- betw een

  • I ndonesia, w hich

com pares w ith

Norw ay, appears to

have achieved a significant degree of diversification

Norway

UAE I ran Algeria Libya KSA

OPEC

  • Petroleum share in GDP

60%

Share in total exports Share in fiscal revenues

0% 100% 100%

A P I C O R P R e s e a r c h

Qatar Kuwait

OPEC

Angola Venezuela I ndonesia Nigeria I raq

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3 rd OPEC Sum m it Ali Aissaoui Slide 2 7

The case being m ade for econom ic diversification

Three m ain argum ents:

  • A. Lim its to the petroleum perm anent

incom e B. Difficulty of stabilizing the corresponding stream of revenues C. I nability of the petroleum sector to provide sufficient jobs

3 rd OPEC Sum m it Ali Aissaoui Slide 2 8

  • A. Lim its to the petroleum

perm anent incom e

Factoring in dom estic consum ption

500 1000 1500 2000 2500 3000 3500 4000 4500 1 9 6 0 1 9 7 0 1 9 8 0 1 9 9 0 2 0 0 0 2 0 1 0 2 0 2 0 2 0 3 0 2 0 4 0 2 0 5 0 2 0 6 0 2 0 7 0 2 0 8 0 2 0 9 0 2 1 0 0 M illio n t o n p e r y e a r 10 20 30 40 50 60 70 80 90 m illio n b a r r e l p e r d a y Oil and gas production profile Crude oil & condensate production profile Oil products domest ic demand Oil and gas domest ic demand A PI C O R P R e s e a r c h

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3 rd OPEC Sum m it Ali Aissaoui Slide 2 9

Resulting NPV of export-generated incom es

Products to the dom estic m arket priced at cost

Period 2006-2050 Unit Crude oil price US$/ bl Real discount factor % 5% 10% 5% 10% 5% 10% NPV of export rent per cap US$ 10,666 6,344 15,803 9,329 21,070 12,438 Ratio to 2006 GDP/ cap Unit 3.4 2.0 5.1 3.0 6.7 4.0 Constant 2006 rent per capita US$ 13,864 6,999 13,864 6,999 13,864 6,999

API CORP Research Simulations

NPV of export-generated rents US$50/ bl US$75/ bl US$100/ bl

3 rd OPEC Sum m it Ali Aissaoui Slide 3 0

Fluctuating OPEC’s governm ent petroleum incom e

5 0 0 1 0 0 0 1 5 0 0 2 0 0 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 OPEC's government petroleum income per capita ( US$) Nom inal Real ( inflation+ dollar) Base: Sep 2 0 0 7

APICORP Research using OPEC database and ow n estimations

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3 rd OPEC Sum m it Ali Aissaoui Slide 3 1

  • B. Difficulty of stabilizing petroleum

incom es

  • Stabilizing oil prices: Lim its to OPEC’s

current policy instrum ent

  • Rem oving price uncertainty: Lim its to

“sovereign hedging”

  • Stabilizing incom e flow s: Mixed

experiences of Stabilization Funds in the OPEC area

3 rd OPEC Sum m it Ali Aissaoui Slide 3 2

  • C. I nability of the petroleum

sector to provide sufficient jobs

  • Relatively low

em ploym ent-to- population ratios w ithin OPEC

  • Unem ploym ent

rates w ithin OPEC double the w orld’s average

  • OPEC average

labour intensity of GDP ( inverse social productivity) conceals w ide country differences

End-2006/ Mid-2007 estimates Unit World OPEC Population mn 6,602.0 571.5 Working age population (15 years + ) % 65.1 62.9 Labour force participation rate

1

% 69.8 64.4 Employment-to-population ratio

2

% 67.4 56.5 Official unemployment

3

% 6.3 12.2 Labour intensity of GDP (inverse productivity) E/ $mn 60.2 113.6

1 Labour force as a share of working age population 2 Proportion of the working-age population that is employed 3 Proportion of labor force that is unemployed but "actively seeking employment"

API CORP Research using data from I LO

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3 rd OPEC Sum m it Ali Aissaoui Slide 3 3

Major country variances w ithin OPEC

50 100 150 200 250 300 350 400 10,000 20,000 30,000 40,000 50,000 60,000 GDP per capita La bour inte nsity of GDP Nigeria Qatar UAE Kuw ait Saudi Arabia Libya Venezuela Algeria Angola I raq I ndonesia

APICORP Research

OPEC

I ran

3 rd OPEC Sum m it Ali Aissaoui Slide 3 4

Strategies and patterns of diversification

  • Diversification inside the highly productive

petroleum industry:

  • Low -labour content: Vertical along

the hydrocarbon value chain ( focus on refining/ petrochem icals)

  • Moderate-labour content: Horizontal

across oil services and supply industries w ith local content

  • Diversification outside the petroleum

industry: Differing labour-content

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3 rd OPEC Sum m it Ali Aissaoui Slide 3 5

4 . Possible sub-them es for the panel discussion

3 rd OPEC Sum m it Ali Aissaoui Slide 3 6

Sub-them es for the panel discussion

  • Has W all Street been driving the oil m arket? I f so, w hat can

be done to neutralize speculators on the futures m arket? Should OPEC rectify/ replace its current policy instrum ent?

  • I s an endogenous price path derived from a perm anent

incom e hypothesis com patible w ith OPEC’s other objectives

  • f containing a supply shift tow ards non-conventional

sources of oil or a dem and shift tow ards alternative energy products?

  • How feasible is it for OPEC to coordinate a com m on

investm ent policy. Does it need to harm onize existing royalty/ tax system s?

  • W hat long term strategy for econom ic diversification:

Specializing in petroleum , leveraging it, or m oving aw ay from it?