EDHEC Position Paper Oil Prices and Speculation
EDHEC Position Paper Oil Prices and Speculation
EDHEC Position Paper Oil Prices and Speculation
393-400 promenade des Anglais 06202 Nice Cedex 3 Tel.: +33 (0)4 93 18 78 24 Fax: +33 (0)4 93 18 78 41 E-mail: research@edhec-risk.com Web: www.edhec-risk.com
October 2008
Hilary Till
Research Associate at the EDHEC Risk and Asset Management Research Centre, Co-Founder of Premia Capital Management, LLC
Abstract
In US dollar terms, crude oil prices increased 525% from the end of 2001 through July 31st, 2008. Was this rally yet another speculative bubble? Specifically, has the oil rally been based on speculative excess rather than fundamental supply-and-demand factors? In summary, our position paper argues that with the fundamental supply-and-demand balance so tight and that with effective OPEC spare capacity so low it is logical to see very high prices to ration demand and/or encourage additional supply. That is the job and message of price, even if the message is unpopular. We discuss how many facets of the world oil market are too opaque, including future productive capacity estimates from important suppliers, inventory statistics from important non-OECD consumers, and summary position data from over-the-counter derivatives participants. For policymakers and their economists to make sound decisions, there must simply be more transparency in these markets. We take the position that the petroleum-complex futures markets contribute to the transparency of the oil markets. Even when fundamental data on the oil markets are sparse or opaque, large-scale supply-and-demand shifts leave footprints in futures-price relationships, from which one can potentially infer the markets fundamentals. Our paper provides several case-studies on this type of analysis. In the presence of active futures markets, an observer need not be a member of a cartel or a large corporation to gain insights into the oil market. That said, we accept that, as has been known since at least 1941, one can expect interaction effects between futures trading activity and market fundamentals, which in turn can result in prices temporarily overshooting (or undershooting) longer-term averages. Our paper provides several concrete examples of these phenomena as well. We also note how the magnitude of the oil-price rally varies significantly depending on whether the price of oil is denominated in dollars, euros, or ounces of gold, with the appreciation greatest when it is denominated in dollars. Therefore, the currency effect must be included as one of the fundamental factors behind the oil-price rally. Our position paper covers the many nuances and caveats that unavoidably come with such a complex system as the world oil markets, including the requirement to be modest in claiming to identify any single factor at any single time as the sole driver in the evolution of price. Our future research will explicitly include the impact of geopolitical issues on the price of oil, but for this paper it is sufficient to note that effective oil-production spare capacity is sufficiently low that any potential supply disruptions, whatever their cause, would be expected to have a disproportionately large impact on price.
The work presented herein is a detailed summary of academic research conducted by EDHEC. The opinions expressed are those of the authors. EDHEC Business School declines all reponsibility for any errors or omissions.
Before co-founding Premia Capital, Ms Till was the Chief of Derivatives Strategies at Putnam Investments and prior to this position was a quantitative analyst at Harvard Management Company. She has a BA with General Honors in Statistics from the University of Chicago and an MSc in Statistics from the London School of Economics (LSE). She studied at the LSE under a private fellowship administered by the Fulbright Commission. Ms Till serves on the North American Advisory Board of the London School of Economics; she is also a member of the Curriculum Committee of the Chartered Alternative Investment Analyst (CAIA) Association. In addition, she is a Research Associate at the EDHEC Risk and Asset Management Research Centre. Ms Till served as a reviewer for the Journal of Alternative Investments in 2003, 2007, and 2008; in 2005, she was a referee for the Financial Analysts Journal.
Ms Tills research work on behalf of the EDHEC Risk and Asset Management Research Centre has been cited in the Journal of Finance and in the Journal of Structured Finance as well as by the Bank of Japan, the Banque de France, the European Central Bank, the Bank for International Settlements, the International Monetary Fund, and the US Senates Permanent Subcommittee on Investigations.
Table of Contents
Abstract 02 Introduction 05 1.The Role of Price and Oil Supply-and-Demand Data 06 2. Role of Currency and Store-of-Value 28 3. Conclusion 33 4. Endnotes 34 5. Appendix 35 References 44
Introduction
In US dollar terms, crude oil prices increased 525% from the end of 2001 through July 31st, 2008. Is this rally yet another speculative bubble like the late 1990s technology-stock boom or, more topically, is it going to be like the bubble in US residential real-estate values, which, in turn, is currently deflating in a surprisingly rapid fashion? Specifically, has the oil rally been based on speculative excess rather than fundamental supply-anddemand factors? In our paper, we will argue that the available evidence suggests that the answer to this question is a qualified no, but we acknowledge (1) that there are many areas of data uncertainty in the oil markets, which need to be resolved, given how critical oil is to the global economy; and (2) that in the short-term it is fully plausible for the activity of market participants to have a strong influence on price.1 This position paper will be the first of a two-part series. In Part 1, we will narrowly examine these issues using the framework of a market professional. In Part 2, we will present a composite perspective of two financial economists and a market professional on the drivers of the price of oil. Part 2 will include the impact of geopolitical issues, which is essential to a complete discussion of this subject.2 In the first section of this paper, we will explain how futures traders view the role of price, followed by an examination of data and public statements from the International Energy Agency (IEA) on the present state of the oil market. We will then discuss how useful petroleum-complex futures markets are in their price-discovery function: even when fundamental data on the oil markets are sparse or opaque, large-scale supply-and-demand shifts leave footprints
1 - This paper was written before the market events of the week of September 29th, 2008. We expect that new lessons will be learned about the short-term interaction effects of trading activity with market fundamentals, noting that on Monday, September 29th, after a financial system bail-out package did not pass the US House of Representatives, all commodities in the Dow Jones AIG Commodity Index declined, except gold, with oil futures witnessing the steepest drop in price. Simultaneously, the S&P 500 equity index declined -8.8% while the VIX (the equity implied volatility indicator) jumped to 46.7%. Essentially, both the equity market and the basket of industrially-useful commodities behaved as one market. 2 - The EDHEC Risk and Asset Management Research Centre (EDHEC-Risk) includes both academically trained financial economists and quantitative market practitioners.
in futures-price relationships, from which one can potentially infer the oil markets fundamentals. In the presence of active futures markets, an observer need not be a member of a cartel or a large corporation to gain insights into the oil market. We will also discuss how, in the short-term, the actions of traders (and their algorithmic strategies) can impact price, particularly in a commodity that is exhibiting scarcity. We will conclude the papers first section by stating that it would be extremely unfortunate if the oil markets were made even more opaque, which could occur if it became public policy, particularly in the United States, to limit oil futures trading (beyond what is needed to prohibit actual or attempted market manipulation). In the papers final section, we will note how an analysis of oil-price drivers is made more complicated by trends in currency values; and that, objectively, one should not exclude this factor in policy debates on the causes of the present oil-price rally. We will then conclude with a discussion on the debate surrounding oil as a store-of-value.
can draw on storage; price does not need to ration demand. Now, for commodities with difficult storage situations, price has to do a lot (or all) of the work of equilibrating supply and demand, leading to very volatile spot commodity prices. A defining feature of a number of commodities is the long lead-time between making a production decision and the actual production of the commodity. It is impossible to foresee exactly what demand will be by the time a commodity is produced. This is why supply and demand will frequently not be in balance, leading to large price volatility for some commodities. In the case of oil, it is prohibitively expensive to store more than several months worth of global consumption. Rowland (1997) explained the situation as follows: From wellheads around the globe to burner tips, the worlds oil stocks tie up enormous amounts of oil and capital. The volume of oil has been estimated at some 7-to 8-billion barrels of inventory, which is the equivalent of over 100 days of global oil output or 2 years of production from Saudi Arabia, the worlds largest producer and exporter of crude oil. Even at todays low interest rates, annual financial carrying costs tied up in holding these stocks amount to more than the entire net income of the Royal Dutch/ Shell Group. One can look at the aftermath of Hurricane Katrina in the United States in 2005 for a good concrete example of the dynamic interplay between an oil products price and its supply-and-demand situation. With the onset of Hurricane Katrina, the price of gasoline (petrol) rallied 18% in four days before falling back about the same amount fifteen days later (see figure 1).
Were the markets irrational in rallying so much in four days, given how short-lived these price increases were? According to a 2005 Dow Jones Newswire report, [Hurricane] Katrina shut in nearly all of oil and gas production in the Gulf of Mexico The large scale supply disruption and fear of an economic shock triggered a massive government response. The outages prompted the Bush administration to release Strategic Petroleum Reserve oil, waive airpollution rules on fuels, and ease restrictions on use of foreign-flagged vessels to carry fuel in US waters. Further, Members of the Organisation for Economic Co-operation and Development agreed to [release] 2 million barrels a day of crude oil and petroleum products from their strategic stocks for 30 days. One could argue that this unprecedented government response caused gasoline prices to decline from their post-Katrina peak. Further, and as also illustrated in figure 1, with that response, fears of an economic slump diminished, which in turn caused deferred interest-rate contracts to decline, as the market resumed pricing in the expectation that the Federal Reserve Board could continue tightening interest rates at the time.
With this brief example, we see how the dynamic change in the price of gasoline induced an international and domestic response to increase supplies; and that once achieved, the price responded by quickly decreasing. Quite simply: price did its job.
The Fundamentals: Oil Supply-andDemand Data We admit that the way that an oil-futures trader analyses a commodity market by granting primacy to the role of price may not be satisfactory to those outside the profession. Therefore, let us turn to an objective examination of oil supply-anddemand data.
Surowiecki (2008) succintly summarises the fundamental supply-and-demand reasons for the increase in oil prices this decade: Between 2000 and 2007, world demand for petroleum rose by nearly nine million barrels a day, but OPEC [the Organization of Petroleum Exporting Countries] has been consistently unable, or unwilling, to significantly increase supply, and production by non-OPEC members has only risen by just four million barrels per day.3
3 - The BP Statistical Review of World Energy June 2008 confirms Surowieckis factual assertions.
Dr. Fatih Birol, chief economist for the IEA, clearly explained the situation to Pagnamenta of The Times [of London]: The days of the international [Western] oil companies are coming to a glorious end because their reserves are declining and they will have difficulty accessing new reserves. In the future we expect most of the new oil to come from a very small number of national [non-Western, government-owned] oil companies (2008). Figure 3 illustrates the IEAs expectation of supply decreases in both North America and Europe.
Source: Murti et al. of Goldman Sachs (2008). - Data Sources: IEA, Goldman Sachs Research Estimates.
report. The IEAs table of world oil supply and demand is reproduced in appendix A. The IEA has been unambiguous about how to interpret its data, which is publicly and freely available on its website. On the supply side, Oil production in nonOPEC countries is set to peak within the next two years, leaving the world increasingly dependent on supplies from [OPEC]. Figure 2 shows why there may be increased caution in predicting non-OPEC supply growth: this potential source of production growth has consistently failed to meet expectations, as noted and graphically illustrated by Goldman Sachs researchers.
As of July 2008, effective spare capacity6 in OPEC was only 1.5 million barrels per day, according to the IEA (2008b). Figure 4 puts this excess-capacity cushion in historical context. 1.5 million barrels per day was an exceptionally small safety cushion, given how finely balanced global oil supply and demand is. Given the risk of supply disruptions due to naturally-occuring weather events as well as to well telegraphed and perhaps well rehearsed geopolitical confrontations, one would have preferred (and would prefer) this spare-capacity cushion to be much higher.
4 - One should note that the IEA does revise its data, even data dating back several years. Market participants tend to focus on the IEAs current and near-term data, and understand that such data are only estimates that may be later revised. 5 - The IEA summarises its history and mission as follows: The IEA acts as energy policy advisor to [28] member countries in their effort to ensure reliable, affordable and clean energy for their citizens. Founded during the oil crisis of 1973-74, the IEAs initial role was to co-ordinate measures in times of oil supply emergencies. As energy markets have changed, so has the IEA. Its mandate has broadened to incorporate energy security, economic development and environmental protection. Current work focuses on climate change policies, market reform, energy technology collaboration and outreach to the rest of the world, especially major consumers and producers of energy like China, India, Russia and the OPEC countries. 6 - Spare capacity refers to production capacity less actual production; it quantifies the possible increase in supply in the short-term, explains Khan (2008).
Source: Murti et al. of Goldman Sachs (2008). Data Sources: IEA, Goldman Sachs Research Estimates.
Source: IEA (2008b). Figure 6: Oil per capita consumption rises rapidly in response to the GDP growth afforded by inexpensive labor, then levels off in a service economy at saturation
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"The two lower lines are the Energy Information Administration's (EIA's) high-growth case for China and India. 2007 estimates are from the EIA." Source: Bannister (2007). (Note: The Energy Information Administration [EIA] is a statistical agency of the U.S. Department of Energy.)
7 - We should add that oil prices are low only in some oil-producing countries. Some countries have recently abolished their subsidies, including Nigeria.
Figure 7: Panel A - China Net Fuel Imports: Monthly Data - January 2006 through June 2008
Source: Reuters Calculations Based on Official Data; Graphic Based on Thomson Reuters/Catherine Trevethan.
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Data Source: China General Administration of Customs Reuters Calculations; Graphic Based on Thomson Reuters/Catherine Trevethan.
Figure 7: Panel C - US and China Oil Consumption in Thousands of Barrels per Day (2004 to 2007)
Chinas oil demand after the Olympic Games: On the one hand, the recent strength in crude and oil product imports may diminish after the Olympics, provided that stocks are ample. However, demand will likely rebound as temporary measures to curb pollution are lifted. On the other hand, ongoing power shortages could herald a spike in gasoil [heating oil] use, even though high prices may also deter small-scale power generation. Finally, it is unclear whether the government
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may adopt policies that could potentially induce further changes to the supply and demand picture, notably regarding import taxes and end-user prices. Stated more directly, the IEA was unable to state whether the surging oil imports were due to political decisions and directives in advance of the Beijing Olympics or to the underlying strength of the Chinese economy.
Figure 8: Daily Crude, Soybeans and Copper Futures Prices (01/05/05 through 03/24/05)
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Figure 9: July Gasoline vs. Heating Oil Spread Differential as of the 5th Business Day of June 1985 through 2005
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Figure 11: Change in the value of August Gasoline Crack Spread from 2/13-to-3/31 of Each Year (1986 to 2008)
order to accomplish this task. But in midMarch 2008, the gasoline crack spread actually went negative. Crude oil was more valuable than its refined product, gasoline. This is illustrated in figure 10. Further, the gasoline crack spread for August deliveries had typically increased from mid-February to the end of March, again reflecting the typical need to allow refineries sufficient profitability to create enough gasoline to service US summer demand. Again, this did not occur this year, as illustrated in figure 11. The story told by the gasoline crack spreads mirrors the fundamental data reported
by the IEA: high prices were effective in curbing US (and, for that matter, European) demand. The IEAs 8/12/08 report stated that in OECD North America oil product demand had shrunk -2.2% year-over-year, while in OECD Europe oil product demand had fallen -2.3%. Further, the US Federal Highway Administration reported that the number of vehicle-miles traveled (VMT) had actually declined since 2006. Rural VMT were down -4.1% year-over-year, as of May 2008, suggesting that US motorists sharply reduced leisure driving, as the IEA stated in its 8/12/08 report.
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In 2008, the heating-oil crack spread told a story different from that of the gasoline crack spread, as shown in figure 12. This spread indicated extraordinary demand for middle distillates in mid-March. On May 22nd, 2008, the front-month heating-oil crack spread traded to $36.12, as shown in figure 13. According to NYMEX futures data available on Bloomberg, the front-month heating-oil crack spread had not traded at such a high level since 1/3/89. There were no severe weather events, supply disruptions, or large-scale trading blowups on this particular date, so it was not immediately apparent why this relationship should spike extraordinarily. That said, on May 12th, 2008, a devastating earthquake did occur in Sichuan, China. The heating-oil spread then remained at quite high levels until 7/28/08. After the Sichuan earthquake in mid-May, there were a number of Reuters articles that reported that Chinese oil companies were importing diesel for back-up generators in earthquake-hit areas with damaged power supply grids. Also, throughout 2008, a number of Reuters articles provided reports of preOlympic petroleum-product stocking that
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was occurring to ensure that there would be no shortages during the historic (and very successful) Beijing Olympics, which ran from 8/8/08 to 8/24/08. Starting in late August 2008, further financial-press reports on Chinese preOlympic and post-Olympic demand began filtering through. Two reports in particular, one in Forbes and one from the Financial Times, stand out. According to Wang (2008) in Forbes: Chinas nine-month spree importing refined petroleum products is likely to end in the fall, as the close of the Summer Games spells surplus inventories of gasoline and diesel. A slackening of demand in the worlds second-biggest oil consumer may help ease upward pressure on global oil prices.
China stepped up refined oil shipments from abroad in May to bolster its stockpile from the Olympics, which ended Aug. 24, and in the process became a net gasoline/diesel importer for the first time. PetroChina is bound to halt imports and revive exports in September, according to traders on Tuesday. It is preparing to ship 60,000 tons of gasoline, likely to Southeast Asia, next month.
Under a strict directive of Beijing to avoid any shortage of fuel during the Olympics, Chinas state-controlled refiners, PetroChina and China Petroleum and Chemical Corp. (Sinopec), boosted their refined oil imports, which topped 960,000 tons in June. The import frenzy was one of a number of developments that drove global oil prices sky-high in July. Oil has fallen sharply since [then] ; Chinas revived exporting of refined fuel products could lead to further easing (italics added).
According to Hille (2008) in the Financial Times: Chinas state-owned oil companies are likely to stop imports of refined products such as diesel and petrol next month after a nine-month buying spree that has left stockpiles overflowing, one of Asias largest refiners said. Industry experts have attributed the buying binge to political orders to refiners to avoid shortages during the Olympics. The import wave had been boosted by tax rebates granted to Sinopec and PetroChina for imports of refined products (2008) (italics added). Commodity-market participants frequently monitor the levels of the Baltic Exchange9 indices, which measure the cost of shipping
various types of cargo across international routes. The Baltic Dry Index (BDI), for example, is a measure of the cost of shipping raw materials [and can sometimes be a] good yardstick of commodity [demand] and, by extension, global economic growth, according to Gongloff (2008) in the Wall Street Journal. Figure 14 shows how the BDI reached its peak on 5/20/08, indicating extraordinary demand for shipping dry-bulk commodities up until that point. Examples of dry-bulk commodities include essential raw materials such as coal, iron ore, and grain. Notes Orton-Jones (2007), Other indexes supplied by the Baltic Exchange include the Baltic Dirty Tanker Index and the Baltic Clean Tanker Index (dirty tankers carry crude oil and fuels that leave a residue, where clean tankers contain diesel, gasoline, and jet fuel.) In viewing figure 14, we see that thus far this year, the clean-tanker index peaked on 6/19/08 while the dirty-tanker index peaked on 7/23/08. These indices are averages of the costs of booking shipping across six and twelve international routes respectively. Geman (2005) has explained, As more ships go to China, fewer are available to ferry goods between other parts of the world, causing a supply shortage and price rises. Therefore, when there is particular demand for shipping by Chinese
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9 - The Baltic indices are managed by the Baltic Exchange in London, which is the global marketplace for brokering shipping contracts.
Data Source: Bloomberg. Figure 15: Rolling Front-Month NYMEX WTI Oil Futures (1/31/08 to 9/12/08)
industries, one would expect this demand to be reflected in the levels of international indices as well. In viewing figures 13 and 14, we see that the peaks in the costs of global shipping occurred at about the same time as the heating-oil crack spread was trading at extraordinary levels. These observations are consistent with the hypothesis that brief intense demand from China during the countrys pre-Olympic preparations may have contributed to the petroleum-complex rally of the time.10,11
Clearly, we need to be very modest in claiming to have solved the puzzle of what caused the price of oil to peak in July 2008 (see figure 15, which shows the July 2008 price spike). There is a limit on how much we can infer about market fundamentals from price relationships. What Jacobs and Levy (1989) noted for the stock market is equally true for the oil market: The stock market is a complex system. The market is permeated by a web of interrelated return effects.
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10 - At this point in the paper, we should admit one of the complications with explaining information conveyed by price. The following is intuitively understood by traders, but has arguably not been sufficiently quantified (at least in the practitioner journals) except by Abdulali et al. (2002) and by Weinstein and Abdulali (2002). The price of an investment should not be a point asset value. Instead, price should be parameterised, according to the volume that needs to be transacted, over what timeframe this needs to occur, and what the investors risk tolerance is. Perhaps this general framework will become quite important for commodities as well, with risk tolerance not only meaning an aversion to losing money, but also an aversion to inadvertently violating a government mandate (or political order). 11 - We need to carefully caveat our analysis here. In this section, we are solely pointing to the pre-Beijing-Olympics stockpiling as a plausible explanation for the acceleration in the price of oil during the first seven months of 2008. A separate analysis is required for explaining the long-term rise in the price of crude, especially from 2004 to 2008; this will be the task of a forthcoming EDHEC Publication on the structural (and geopolitical) causes of the current oil shock.
Other Market Fundamentals: Light Sweet Crude Oil and Strict Environmental Mandates
Verleger12 (2008a) outlines additional fundamental reasons for the oil markets 2008 spike. Crude oil spare capacity is concentrated in heavy sour crude oil with total production of light sweet crude oil at only 12 to 15 million barrels per day out of a worldwide crude production of 81 million barrels per day. Nigeria is the leading producer of light crude with a capacity of 2.6 million barrels per day. However, civil strife has lately reduced output. Verleger (2008b) noted that in the spring of 2008, light sweet crude markets tightened as the available supply of this crude was reduced further by US Department of Energy (DOE) actions to top up the US Strategic Petroleum Reserve (SPR), removing 60,000 barrels of light sweet crude from the market. Why is the availability of light-sweet crude oil (even on the margin) so important? Verleger (2008a) explains that both the European Union (EU) and the United States have required refiners to cut sulfur content in diesel fuel from much higher levels. The rules went into effect in the US in 2006 and will be phased in in the EU by the end of this year. In the absence of sufficient complex
Verleger (2008a) continues: over the last six months, one can observe an extraordinarily tight link between the price of Brent crude (a sweet crude produced in the North Sea that is a key benchmark) and the spot price of low-sulfur gasoil, an indicator of the spot price of diesel fuel in Europe. The linkage is tight and the econometrics are compelling. The conclusion is clear: European demands for very-low-sulfur diesel are driving crude prices up. To be complete, one should note that Verleger has been even-handed in describing the political causes of the oil rally. The US receives its share of blame, too. On 12/11/07, Verleger testified before the US Senate, calling for the DOE to cease filling the SPR with light sweet crude oil, regardless of price, and instead, use sour crude oil, which was in relative surplus. His testimony is in Verleger (2007).
12 - Dr. Philip K. Verleger, Jr., is a professor of global strategy and international management at the Haskayne School of Business, University of Calgary, Alberta, Canada. 13 - We should add that Tchilinguirian (2008b) emphasises the need to examine the global supply-and-demand trends over the past four to five years in combination. Demandside factors, brought on by the emergence of markets such as China, India or the Middle East as new large consumers of oil have taken the limelight as explanatory variables in the distortion of previously established pricing relations. Yet, it is important to understand that their effect has been magnified by the underlying constraints in productive capacity, be it in the upstream or downstream sectors, in particular during a period that also saw oil-product specifications tighten in the Atlantic Basin. Tchilinguirian (2008a, 2008b) writes that refining capacity additions in Asia and in the Middle East over Q408-2Q09 could lead to a reversion towards more typical price-spread relations between oil products and crude oil, notably for distillate products like gasoil and jet/kerosene. Reliance in India is bringing online a large and very complex export-oriented refinery at Jamnagar while China is adding refining capacity domestically at Huizou and Qingdao. Reliance's new refinery will boost light product supply on Asian markets, but this 580 kb/d plant is also capable of meeting tighter European and US product standards and supplying those markets as well. By adding domestic capacity, China will be in a better position to address its growing demand for transport fuels and occasional spikes in diesel demand on shortfalls in power generation, moderating its product-import-dependency. All in all, crack spreads for light products in 2009 [may therefore] average lower than what we experienced in 2008. Any blow-outs in light-to-heavy crude-oil price differentials on the other hand are likely to be more contained with further additions of complex refining capacity. The bottom end of the product barrel will be affected as well and the typical discount of heavy-fuel-oil-to-crude-oil in 2009 is [currently] expected to average below what was seen in 2008. (As noted in footnote 11, we will be covering the structural causes of the oil-price rally in greater depth in a future EDHEC Publication.) For the purposes of this paper, we note that one can infer the progress of these fundamental developments by monitoring current and forward price-spread differentials, as revealed by the futures markets. This type of analysis is also found in Tchilinguirian (2006).
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14 - Sesit (2005) quotes from Professor Niall Ferguson of Harvard University and George Magnus, senior economic advisor at UBS, on the similarities between the current era of globalisation and the last one, which occurred from the 1880s until the onset of World War I. In each case, both eras resulted in greater global prosperity, but also large economic dislocations. The first era obviously ended disastrously. 15 - To be complete, one should also note that agricultural futures trading was suspended in the US during World Wars One and Two, by degrees, as rationing and prioritising war objectives overrode other economic objectives. 16 - The Kingdom of Saudi Arabia and the Secretariats of the International Energy Agency (IEA), the International Energy Forum (IEF) and the Organisation of Petroleum Exporting Countries (OPEC) each called for the enhancement of the quality, completeness and timeliness of oil data submitted through the monthly Joint Oil Data Initiative (JODI). Also, in order to further improve market transparency and stability, the seven organisations involved in JODI APEC (Asia Pacific Economic Cooperation), Eurostat, IEA, IEF, OLADE (Latin American Energy Organisation), OPEC and UNSD (United Nations Statistics Division) are called upon to start work to cover annual data, that includes, among other things, upstream and downstream capacities and expansion plans, noted the Jeddah Joint Statement (2008).
17 - We need to sound another note of caution here. Presenting the global oil market as a confrontation between a swing producer such as Saudia Arabia and a swing consumer such as China is clearly an oversimplification. That said, it does make sense to focus on China since it is the main importer of oil in Asia; as such, its marginal imports determine the market price (as with soybeans and copper). However, the supply-and-demand imbalance on the global oil market derives from the growing demand from all Asian countries that are registering rapid economic growth. 18 - The UK Treasury summarises its mission as follows: The Treasury is the United Kingdom's economics and finance ministry. It is responsible for formulating and implementing the Government's financial and economic policy. Its aim is to raise the rate of sustainable growth, and achieve rising prosperity and a better quality of life with economic and employment opportunities for all. 19- One should also note that opacity is not only related to the size of OTC transactions but also to the identity of the market participants in the financial oil market.
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Extrapolative Behavior in Tight Markets Gilbert (2007) explains why temporarily large price rises in commodity markets occur. Commodity markets are characterized by very low short-run elasticities of both production and consumption, although longrun supply elasticities are probably high. [I]n a tight market in which only minimum stocks are held, the long-run price becomes irrelevant. With inelastic short-run supply and demand curves, the market clearing price ceases to be well-defined, not in the sense that the market does not clear, but in the sense that it will be very difficult to assess in advance at what price market clearing will result. Fundamentals-based analysis may show where the price will finish but this will provide very little guide as to where it will go in the meantime (italics added).
Gilbert further explains that when markets become tight, inelastic supply and demand make prices somewhat arbitrary, at least in the short term. There will always be a market clearing price but its level may depend on incidental, and not fundamental, features of the market (italics added). Gilbert specifically tests the metals markets for extrapolative behavior. When one regresses todays price on yesterdays price and finds that the coefficient on the previous days price is greater than 1, this is extrapolative behavior, where the price process can be called explosive. If the coefficient is only slightly greater than 1, then the process is mildly explosive. In examining LME data from January 2003 to September 2007, Gilbert found that extrapolative behavior has been a feature
Dynamic Hedging and Negative Gamma In the case of oil, Verleger (2007) explained how the activity of traders may have (temporarily) interacted with market fundamentals to magnify the oil-price rally in the fall of 2007. Verleger noted how large-scale industrial consumers, such as airlines, had purchased out-of-the-money call options on oil futures contracts in order to protect against price rises. Obviously, someone had to sell the industrial consumers these options: the money-center banks. As crude oil rose towards the level(s) where there was a concentration of call-option strikes, this might have created a cascade of dynamic-hedging purchases by bank dealers, who in turn were hedging the options they had written. This might have caused the oil price to (temporarily) rise still further.
In the terminology of derivatives traders, the bank dealers likely had maximum negative gamma: their exposure to being short crude was rising at an accelerating rate, forcing them to purchase crude oil contracts at an accelerating rate, too. Once market participants became aware of this interaction effect, it became common to note where the concentrations of option strikes are in the crude-oil futures market. Futures traders do not have access to data in the OTC market, where the large-scale transactions are taking place, but one expects some of this activity to show up in NYMEX option open interest, as bank dealers likely hedge some of their OTC derivatives exposure in the exchange-traded market. Therefore, one of the tools in the arsenal of a short-horizon oil futures trader has become to examine where the concentrations of option strikes are on the NYMEX.
Liquidation Pressure Futures traders are also aware that the effects of traders having to liquidate large positions can also be a temporary, but meaningful, driver of price.
Because there are vigorously enforced laws in the United States regarding actual or attempted manipulation of physical energy markets, the accumulation of extremely large derivatives positions in the US energy markets, which in turn do not have a welldefined commercial purpose, is a very risky activity since a trader will not be able to resolve a position in the physical markets without triggering regulatory scrutiny. Till (2008b) describes a CFTC and US Department of Justice action against a major international oil company in which the company was fined $303 million for attempting to manipulate one US delivery locations physical propane market. The firms positions were initially entered into through the forward OTC markets. This case was particularly striking since the firm had actually failed in this attempted manipulation and had lost at least $10 million in attempting to carry out this market corner. Therefore, a large holder of energy derivatives contracts will generally not resolve his position in the physical markets, if there is no legitimate commercial reason to do so. If that holder then needs to liquidate a position, then that participant needs to have another
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of losses, a cycle of investor redemptions occur and/or the funds prime brokers demand the reduction of leverage, and the funds net asset value thereby declines precipitously as the fund sells off holdings in a distressed fashion. This critical liquidation cycle obviously has a (temporary) effect on the price of the funds holdings, illustrating another interaction effect between traders and price. The cycle is illustrated in figure 16. De Souza and Smirnov were not specifically addressing liquidations in the commodity markets, but their work definitely has applicability to the energy markets, again as the case of Amaranth demonstrated, and as discussed in Till (2006b, 2008a).
Credit and Risk Environment In addition to idiosyncratic hedge-fund blow-ups, the commodity markets in general, and the oil markets in particular, have arguably not been immune to the periodic bouts of financial de-risking and deleveraging that occurred from the spring of 2006 through the spring of 2008, again over short time-horizons. This phenomenon was commented on in November 2007 in
24
Figure 17: Deleveraring of Risky Investments - May 10, 2006 through June 13, 2006
25
26
These examples indicate that over the short term it is very plausible that the actions of traders have had (and will have) an impact on the price of commodities, including oil. But what does that mean for public policy? Jacks (2007) examined what happened to commodity-price volatility, across countries and commodities, before and after specific commodity-contract trading was prohibited in the past. For example, wheat futures trading was banned in Berlin (Germany) from 1897 to 1900; and onion futures trading has been banned in the US since 1958. Jacks (2007) also examined commodityprice volatility before and after the establishment of futures markets, also across time and across countries. He generally (but not always) found that commodityprice volatility was greater when there were not futures markets than when there were, over one-year, three-year, and fiveyear timeframes. Appendix E summarises his findings. In other words, his study showed that price opacity actually (at least historically) made markets more volatile over one-year-plus timeframes, which we would regard as sub-optimal.
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Market participants have surmised that oil exporters may at least partly be diversifying some of their currency exposure in euros, given that the turning points in the price of oil have frequently mirrored the turning points in the euro/dollar exchange-rate
This graph raises all kinds of questions. Is the rise in the price of oil at least partly a currency effect? And then, obviously, to what degree do the price of oil and the value of the dollar. Is the cause-and-effect relationship between the two actually twoway?
Figure 21: E/$ vs. Crude Oil (in $) (8/17/06 to 5/2/08)
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Source: Woo of Barclays Capital (2008). Note: ECB refers to the European Central Bank.
The potential interaction between the price of oil and the value of the dollar is illustrated in figure 23. One impact of this observed relationship is for investors to seek store-of-value hedges for their dollar-denominated financial portfolios. This was a key lesson for US fiduciaries from the inflationary experience of the 1970s. Figure 24 illustrates the historical evolution of the asset mix for Harvard Universitys endowment, which now
includes a 33% weighting to real assets, including a 17% allocation to commodities. (The commodity allocation within the policy portfolio includes not only a diversified basket of commodity futures contracts, but also timber and agricultural land.)
29
Figure 25 illustrates how investors have followed Harvards example in allocating to commodity futures contracts. The use of commodity-futures contracts as a store-of-value or as an inflationary hedge has attracted some controversy in a wide variety of contexts. For example, did index investments
30
in 2008 cause the oil-price rally that we have seen thus far? According to data provided in a report released by the CFTC on 9/11/08, this is an unlikely cause, given that total OTC and on-exchange commodity index investment activity in oil-futures-contract-equivalents actually declined from December 31st, 2007, through June 30th, 2008 (see figure 26).
20 - Dr. Mohamed A. El-Erian was the President and CEO of Harvard Management Company, the universitys endowment management company, as of 8/21/07 when this table was produced. Dr. El-Erian is now the Co-CEO and Co-CIO of PIMCO.
3/31/08 398,000
6/30/08 363,000
408,000
The historical writings of Holbrook Working21 frequently provide insight and a sense of constancy in how to frame the ongoing (tumultuous) debates on futures trading. Working (1970) described how fragile the existence of the futures-trading business in Chicago had been since its inception in the nineteenth century. He also described how the Grain Futures Administration22 in the 1940s was led by statisticians who were trained in the natural sciences and who therefore allowed the data to provide answers to important policy questions. Judging by the CFTCs exhaustive data-gathering effort that went into the production of its 9/11/08 report, one can say that this tradition is continuing. Several of the principles that guide our current understanding of futures markets date to Working. One is that futures markets need to be considered socially useful for them to thrive and prosper. When, in 1958, onionfutures trading was not seen as socially useful it was banned, for example. Another Working principle is that a futures contract has to be commercially useful to hedgers. Once hedgers are attracted to a futures market, speculation follows, and not the other way around. Sanders et al. (2008) describe how, historically, agricultural researchers found that there was an inadequacy of speculative services provided to offset commercial hedging demand. Sanders et al. (2008) discuss how there now needs to be a fundamental re-evaluation of futures markets. As of the spring of 2008, they find evidence that increased short hedging
has followed long-only speculation in the agricultural futures markets (including when one classifies index investors as speculators). That said, it appears that there may have been a period of adjustment in the agricultural futures markets from 2004 to mid-2005 in accommodating the increased flows from index investors. Sanders et al. (2008) also find that because of this increased short hedging, the level of speculative activity is not currently high in proportion to hedging activity, when evaluating the 2006 to April 2008 data in the agricultural futures markets. The authors use Holbrook Workings speculative T index to evaluate the proportion of speculators to commercial hedgers. Workings T index is defined in appendix F. The consistent position of this paper is for there to be increased transparency across all facets of the oil market, so that if overthe-counter oil derivatives data become available in the same format and ease of use as with NYMEX oil futures data, researchers will be able to calculate Workings T index to determine whether speculation is at a particularly high level in relationship to commercial hedging. Also, if index-investor positions in the oil markets are clearly broken out in CFTC reports, one can ensure that index positions are classified as non-commercial hedging in establishing whether indexers are substantially larger than the oil markets commercial-hedging needs. Drawing from Working (1970) once again, it will be a matter of public policy to decide
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21 - Holbrook Working (1895 to 1985) was a Stanford University professor whose writings on the economic role of futures trading are considered fundamental to our present understanding of these markets. 22 - The Grain Futures Administration (1922 to 1936) and the Grain Futures Commission (1922 to 1936) preceded the Commodity Exchange Administration (1936 to 1942), Commodity Exchange Authority (1947-1974), and the Commodity Exchange Commission (1936 to 1974). The Commodity Exchange Commission and the Commodity Exchange Authority merged in 1974 to form the present Commodity Futures Trading Commission.
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3. Conclusion
In our paper we would like to be modest23 in claiming to having solved the puzzle of what caused the oil-price rally that extended into July 2008 (thus far). What we can say is that there are plausible fundamental explanations that arise from any number of incidental factors that can come into play when supply and demand are balanced so tightly, especially in light sweet crude oil. In 2008, these incidental factors could be argued to include a temporary spike in diesel imports by China in advance of the Beijing Olympics, purchases of light sweet crude by the US Department of Energy for the Strategic Petroleum Reserve, instability in Nigeria, and tightening environmental requirements in Europe. Then, at least through July 2008, there may have been a self-reinforcing feedback loop between the price of oil and the value of the dollar, which likely occurred as oil exporters attempted to diversify their dollar windfalls into other currencies. We also fully acknowledge that in the short term it is very plausible for the actions of traders to influence (again temporarily) the price of a commodity, especially one that is exhibiting scarcity. The natural conclusion to observing that many seemingly inconsequential factors, in combination, could lead to such a large rise in the price of crude oil is that the market is signaling a pressing need for an increase in spare capacity in light-sweet crude oil, however achieved. We also realise that in both the United States and in continental Europe there is a long history, dating to at least the 1890sthe last great era of globalisationof scrutiny and scepticism of commodity futures markets. Over the past 120 years, two determinations have prevented futures trading from
23 - We acknowledge that, ultimately, only dynamic conceptual frameworks will likely be satisfactory in comprehensively explaining the evolution of the price of crude oil during the first seven months of 2008. One can readily understand the decisions of each type of market participant at the individual level, as discussed in our paper. But what becomes extremely complicated is taking into consideration (and modeling) the feedback effects of collective behavior (Williams and Wright 1991) particularly during times of scarcity. This type of modeling is admittedly beyond the scope of this practitioner-oriented paper.
generally being banned or heavily restricted. The first supportive determination has been a general (although not unanimous) recognition by policymakers that futures markets serve a legitimate social purpose. The second determination has been to base public policy on an objective examination of extensively gathered facts, which are summarised via appropriate statistical measures. In 2008, we believe that public policy governing futures markets should continue to rely on this framework. There are preliminary indications that this will indeed continue to be the case. Finally, we would emphasise that all efforts to make data transparent on the oil markets, whether regarding supply, demand, or market-participant statistics, are extremely important for making informed publicpolicy decisions about these markets.
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4. Endnotes
Research assistance from Katherine Farren, Premia Capital Management, and from Richard Seefeldt, independent consultant, is gratefully acknowledged. The author would also like to note that the interpretation of commodity-price relationships was jointly developed with Joseph Eagleeye of Premia Capital; and that discussions with Kenneth Armstead were very helpful in the development of this article. She would also like to thank Benot Maffe, Robert Greer, and Hendrik Schwarz for their very insightful comments. That said, the author takes responsibility for the content of the article, including any inadvertent errors or omissions. In addition, some of this articles ideas were previously discussed in Till (2000, 2006a, 2008a, and 2008b) and in Till and Eagleeye (2005).
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Notes: OMR stands for Oil Market Report; and NGL stands for Natural Gas Liquids. Source: IEA (2008b).
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Appendix B Table on Degree of Satisfaction of Joint Oil Data Initiative (JODI) Partners with International Data
This table assesses the degree of JODI partners satisfaction with data provided by participants with regard to submission, timeliness and completeness for the period from July to December 2007.
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Compared to the last exercise (from January to June 2007), progress has been made on the JODI data collection process. The number of participating countries/economies with three smiley faces went up from 39 to 45 (out of 97). However, the percentage of smiley faces decreased from 62% to 60% and 14 countries/economies did not submit any data in 2007.
Appendix B Table on Degree of Satisfaction of Joint Oil Data Initiative (JODI) Partners with International Data
[T]imeliness remains a problem for almost half of the participants. Eight of them improved the timeliness of their submissions whereas it deteriorated for only five countries. With respect to completeness, the situation deteriorated for nine participating countries since the last exercise whereas it improved for only seven of them. Lack of information on stock data for non-OECD countries remains a concern. More than 70 countries/economies are now in a position to report data with only a onemonth delay.
Source: JODI (2008).
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Appendix C An Example of Interpreting Fundamental Information From Price-Relationship Data: The Danger of Structural Breaks
Prior to 2004, if there was scarcity in the crude-oil market, one could expect two outcomes: (1) high prices; and (2) frontmonth prices that trade at a large premium to deferred-delivery contracts. In the latter case, there would be a negative return to storage: by holding onto the commodity, one would be receiving a lower return in the future. Therefore, in this state of the world, the market would be encouraging immediate use of the commodity (rather than hoarding).
Figure C-1: WTI Front-to-Back Spread vs. Front-Month Crude Monthly Data - 12/86 to 12/03
When, by contrast, a futures curve trades in contango, the front-month price trades at a discount to the deferred-delivery contract. In times of surplus, inventory holders receive a return-to-storage, as represented by the size of the contango, since they can buy the crude oil immediately at a lower price and lock in positive returns to storage by simultaneously selling the higher-priced contract for a future delivery. If inventories breach primary storage capacity, the crude curve will trade into deeper contango, so as
The past structural relationship of crude oil to its curve is illustrated in figure C-1. There had been a +52% correlation between the level of outright crude prices and the level of front-to-back-month calendar spreads.24 When the front-month price trades at a premium to the deferred-delivery contracts, this is known as backwardation. This has been the historically consistent curve shape25 for crude oil futures prices, so consistent that a 1995 Journal of Finance article discussed why the crude oil futures should trade mainly in structural backwardation.
to provide a return for placing the commodity in more expensive, secondary storage (or even tertiary storage). In other words, the more there are crude stocks that need storage, the more the crude curve trades in contango. Correspondingly, the scarcer crude oil is, the more the crude curve trades in backwardation. One would thus normally expect backwardation to be associated with high prices.
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24 - A calendar spread is the difference in price between two different delivery months for a futures contract. A front-to-back-month calendar spread is the difference in price between the immediately deliverable futures contract and the next deferred delivery month contract. When the front-month futures price is greater than the back-month price, the spread is positive. 25 - By futures curve shape, we mean whether a futures market is trading in backwardation or contango. Futures traders frequently refer to the term structure of a futures contract as a curve:" the futures prices for each maturity are on the y-axis while the maturity of each contract is plotted on the x-axis, which thereby traces out a futures price curve.
Appendix C An Example of Interpreting Fundamental Information From Price-Relationship Data: The Danger of Structural Breaks
Figure C-2: WTI Front-to-Back Spread vs. Front-Month Crude Monthly Data - 1/04 to 5/07
The crude curves structural relationship changed from 2004 to the summer of 2007. During that time period, the level of crudeoil prices became -75% correlated with its corresponding calendar spread (see figure C-2). Through the summer of 2007, the structural rigidities in the crude oil market translated into large contangos and high flat prices. This had been extremely unusual in the previous seventeen years (and contrary to many market participants understanding of the technical features of the crude oil futures markets). What changed in 2004? Note figure 4 in the body of the paper. 2004 was the year that OPECs immediately deliverable spare capacity collapsed. Why does this matter? The first item in this explanation is to note that the IEA (2008b) has stated that the OECD presently has inventories to service fifty-three days of demand. Secondly, as explained in Harrington (2005), the true inventories for crude oil should be represented as above-ground stocks plus
excess capacity. Historically, the markets could tolerate relatively low oil inventories (measured in days of demand) because there was sufficient swing capacity that could be brought on stream relatively quickly in the case of any supply disruption. By 2004, this excess supply cushion had dropped to sufficiently low levels that there were two market responses: (1) there were (and are) continuously high spot prices to encourage either consumer conservation or the development of alternative energy supplies, and (2) the market undertook precautionary stock building, which arguably led to the persistent (but not continuous) contangos that the crude oil market began experiencing in late 2004. The size of the contangos may have been amplified periodically by storage capacity inadequate for the precautionary inventory holdings. Figure C-3 illustrates the growth of yearly inventories (stock-holdings) in OECD countries. In this concrete example, we see how in one state-of-the-world, high prices are associated with backwardation, while in another, high prices are associated with contango. This example shows how the interpretation of
39
Appendix C An Example of Interpreting Fundamental Information From Price-Relationship Data: The Danger of Structural Breaks
Figure C-3: Total Closing Oil Stocks in OECD - (1999 to 2007)
fundamental information from transparent futures markets, such as in the oil market, can be quite difficult, particularly during times of surprising structural breaks with the past.
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Appendix D Summary of US House of Representatives Bill on Futures Market Oversight: Press Release from US House of Representatives Committee on Agriculture (9/18/08)
WASHINGTON - Today, the House of Representatives voted to approve a bipartisan bill to increase the transparency, oversight, and anti-manipulation authority over commodity futures and options markets. The House overwhelmingly passed H.R. 6604, the Commodity Markets Transparency and Accountability Act of 2008, a bill sponsored by House Agriculture Committee Chairman Collin C. Peterson of Minnesota, by a vote of 283-133. H.R. 6604 strengthens trader position limits on oil and other futures markets as a way to prevent potential price distortions caused by excessive speculative trading. It directs the CFTC to get a clearer picture of the over-the-counter (OTC) markets, and it calls for new full-time CFTC staff to improve enforcement, prevent manipulation, and prosecute fraud. Commodities markets have seen significant changes in recent years, Chairman Peterson said. Trading volume is at record levels, tradable products are more complex, and an unexplained lack of convergence between futures and cash prices in some contracts has called into question the effectiveness of these markets as a source of price discovery and risk management. I am proud that we could work across party lines today to pass this bill which will bring muchneeded transparency to commodities and futures markets for the benefit of producers, processors and consumers. Provisions included in The Commodity Markets Transparency and Accountability Act would: Require foreign boards of trade to share trading data and adopt speculative position limits on contracts that trade US commodities similar to US-regulated exchanges.
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RequiretheCFTCtosettradinglimitsfor all agricultural and energy commodities, in order to prevent excessive speculation. Limit eligibility for hedge exemptions to bona-fide hedgers. Codify CFTC recommendations to improve transparency in dark markets by disaggregating index fund and other data in energy and agricultural markets as well as requiring detailed reporting from index traders and swap dealers. Call for a minimum of 100 full-time CFTC employees to enforce manipulation and prevent fraud. Despite record trading volume in the futures and options markets, CFTC staffing is at its lowest level since the agency was created in 1974. Authorize CFTC to take action if it finds disruption in over-the-counter markets for energy and gas. RequiretheCFTCtostudytheeffectiveness of establishing position limits in over-thecounter markets. Congressional oversight of commodity futures trading is under the jurisdiction of the House Agriculture Committee, chaired by Congressman Peterson. The Committee approved H.R. 6604 by voice vote on July 24, 2008. It was brought to the House floor on July 30 under suspension of House rules, but it did not receive the two-thirds majority needed to pass.
Source: US House of Representatives Committee on Agriculture (2008).
Appendix E Price Volatility in 16 Markets Before and After the Establishment of Futures
Note: Figures in bold are those consistent with the hypothesis of dampened price volatility in the presence of futures markets; significance for criteria I-II refers to t-test on differences in means; significance for criterion III refers to an F-test for pooled and non-pooled estimates. This table is directly drawn from Jacks (2007).
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