August 02, 2005
New highs for oil
Why did oil prices make new highs this week?
The above graph displays the price of the September 2005 NYMEX light crude contract over the last five months. Two weeks ago, I commented on a significant move down in oil prices, attributing it primarily to the dramatic arrest of the previously spectacular growth of Chinese oil demand. Beginning July 21, that downward move abruptly ended, and oil prices have been climbing steadily since. By today, the effects of the earlier downward trend had been completely erased.
One possibility is that the market developed doubts about the accuracy of the new Chinese data, with the Oil Drum quoting the Oil and Gas Journal as still predicting 8.2% growth in Chinese demand for petroleum products in 2005 and 6.7% for 2006. On the other hand, Morgan Stanley's Asian specialist Andy Xie continues to cheerlead for the oil bears. According to the LA Times,
[Xie said] demand for oil imports this year had dropped in China, India, South Korea, Taiwan and Thailand, countries that account for 16% of world usage and made up 44% of last year's increase in consumption. The reason, Xie said, was weakening economies and the use of other fuels.
I frankly profess to be puzzled by these conflicting analyses, and in any case don't see why such disagreements would be manifest in first a steady drift down and then a steady drift back up. By contrast, the market's reaction to yesterday's news of the death of Saudi's King Fahd made immediate sense to me. Although the majority opinion might be represented by New Era Investor's conclusion that nothing had really changed in Saudi Arabia, I was more inclined to share the thoughts expressed by Soj at Daily Kos:
[T]he way I see it, Abdullah and his allies are just one forced abdication or assassination away from being replaced by Sultan and the more conservative, anti-western Saudi royals.
The Capital Spectator spelled out the implications of this scenario in further detail:
"This is the largest royal family in the world and there will be a struggle as princes compete for positions of power," Mai Yamani, who watches the Middle East from [her] post at the London-based research center Chatham House, tells Bloomberg News.
The Saudi kingdom, home to a quarter of the world's known oil reserves, is a powder keg waiting to explode. When it explodes, and by how much is the question. To be sure, the heavy hand of the royals has kept the would-be revolutionaries from lighting the fuse. How long can they keep it up?
If a full-fledged conflict were to emerge over the succession of power after Fahd, or after Abdullah, it would have the potential to generate an oil shock that would make all the episodes the world has seen up to this point look like a walk in the park. Even a fairly small probability of such an event would be enough to justify a substantial price premium. For example, if there is even a 5% chance of oil going to $140 a barrel within the year, that possibility is enough to justify a $4 increase in the price of each barrel of oil: [(140 - 60) x (0.05) = 4.0].
Worries like that could easily explain oil's price rebound, I'm thinking. But nobody had a clue about the king's death before Monday. Or did they?
Perhaps you recall this story from July 20, just before oil prices started their move back up. It was an account about Prince Bandar, Saudi Arabia's longtime ambassador to the U.S. and one of the most influential Saudis in world politics:
The Saudi Foreign Ministry said Bandar-- who had held the post for 22 years but had been out of Washington for most of the past year-- was stepping down for "personal reasons."
Bandar's resignation coincides with looming changes in Saudi Arabia's ruling hierarchy. King Fahd is seriously ill. Crown Prince Abdullah, who has been de facto ruler during Fahd's long illness and will become king after Fahd's death, is expected to name Prince Sultan-- Bandar's father-- as the next crown prince.
That Bandar was stepping down for "personal reasons" I greatly doubted at the time. In retrospect, it is abundantly clear that this was all about preparation for the Saudi power succession. I can easily suppose that, although I was not sufficiently clever to connect all the dots at the time, others might well have been.
For those of my readers who are convinced that markets can never see past the end of their nose (and I know you're out there), attributing this degree of clairvoyance to oil traders will seem nothing short of fantastical, and I must admit that I find it a surprising possibility to consider myself. But I have seen something similar happen many times before in other markets-- a stock price starts drifting up for a few weeks, and you can't find a word of coherent explanation in the popular press at the time, but then later there appears a big news story that turns out to justify completely what the stock price had been doing all that time.
Speaking of dissing the market's wisdom, the Oil Drum reports on Senator Chuck Schumer's (D-NY) fortunately unsuccessful efforts to include in the energy bill language that would have encouraged the Department of Energy to use the Strategic Petroleum Reserve in order to bring some relief to consumers who are paying too much for gasoline. It's perhaps a little unfair to the senator to attack him on this with pure logic, but I can't resist the impulse to do it anyway. It makes no sense to blame the current oil price on the OPEC cartel, since OPEC production has increased, not decreased, as prices have gone up. If we attribute the high oil prices to strong global demand, then the only way to bring that demand down is with higher prices. If we attribute the high prices to a risk premium arising from concerns such as a possible civil war in Saudi Arabia, we darn well better keep that oil in the SPR because the market is saying we might soon need desperately to draw on the SPR for its original intended purpose. If we attribute the high prices to the impending arrival of global production peaks, then we absolutely need those high prices to keep western civilization running. And if we attribute the high prices to the irresponsible actions of reckless speculators, well, then oil prices are soon going to crash on their own without needing any assistance from the senator or anybody else.
Other than that, Senator Schumer, your suggestion makes perfect sense to me.
Posted by James Hamilton at August 2, 2005 10:25 PMdigg this | reddit
Thanxs for your insight. I think more profs should have a blog...
Posted by: Onno at August 3, 2005 02:55 AM
Your point about markets is absolutely key.
There *is* inside information in markets which drives market prices. Your best approach to a stock price on equity markets is always to assume that a sustained trend (with no discernible cause due to public information) is the result of insiders leaking information into the market and traders acting on it.
Even the devotees of market efficiency assume that the market is 'Type II' efficient ie that someone with inside information can consistently earn superior risk adjusted returns. It is not 'Type III efficient' ie even insiders cannot earn superior returns. (an interesting related question is whether the existence of market makers prevent this benefiting from inside information at least if dealing in size-- spreads on securities widen and liquidity tightens in advance of major news announcements for example).
Oil is no different and as a huge, fungible, global and liquid market insider trading would be particularly easy. In fact, the remit of the FSA or the SEC doesn't reach to those who can inside trade on the oil market. Some Saudi Billionaire, or his fund manager, would have had the nod and been building a position in anticipation.
In the long run, the market is a weighing machine (supply and demand), in the short run it is a voting machine. It helps if some of the voters know how the machine works ;-).
Posted by: John at August 3, 2005 04:17 AM
Thanks! You've given me several good points to bring up in my letter to Schumer...
Posted by: the oil drum (ianqui) at August 3, 2005 06:24 AM
According to Lee Raymond, CEO of EXXON, crude oil would be nowhere near where it is today were it not for speculation (a la hedge funds per Boone Pickens et al, etc.). Throw in a little terrorist premium, the now completed SPR build and solid demand from China and India and you need look no further.
So far, no big deal.
Posted by: Hank Riehl at August 3, 2005 09:13 AM
crude prices have retreated slightly today because EIA reported a 200K barrel stock build.
this is to be expected since we've been having all these refinery outages and have created a bit of a bottleneck for crude products in excess and unprocessed. our refinery problems will likely extend into next week, i guess the question becomes, will we have another build? perhaps a more significant one?
Posted by: billy at August 3, 2005 09:23 AM
How exposed are the major oil companies to a supply interruption in saudi arabia? Presumably, some will be winners and some will be losers depending on how much of their supply comes from the saudis. Who's most at risk?
Posted by: Mark Sullivan at August 3, 2005 10:37 AM
The Saudis nationalized their oil fields long time ago so their production is solely marketed by the Saudi Aramco company. All E&Ps and integrated majors will benefit because crude prices will shoot up. Refiners and retailer may suffer due to supply disruption, higher input cost, and reduced demand for refined products.
Posted by: RoyYoung at August 3, 2005 11:04 AM
I've seen published reports of a $10-15/barrel "fear premium and Saudi oil minister Al-Naimi thinks there's a $20 speculation premium. That puts the value of the oil back down in the $25-30 range. The "premiums" are high because there's a lot of money chasing the investments. Will the premiums drop? If Andy Xie is right, they will. I think I agree with him.
Posted by: papa at August 3, 2005 03:24 PM
Dear Professor Hamilton,
It seems to me that too much effort is being spent in predicting the catastrophic season beguinning with the reaching of peak oil. Perhaps we are overlooking that the only long term reason why the price of crude has been increasing now for more than one year and will continue to increase except for a worldwide recession is that worldwide supplies are not able to meet fast increasing worldwide demand.
Professor, can you imagine that one morning, 5-10 years from now, even before we reach peak oil, the world could be facing a shortage of perhaps 5 million barrels per day? What will be the price then? Where will we find these barrels?
In spite of conservation, bio-fuels, increased nuclear energy, wind, solar, new technologies such as fuel cells, hybrids, oil will continue to be needed.
I urge you to visit our web site and welcome your comments.
Juan A. Granados, President
Oil Shale Information Center, Inc.
a Colorado non-profit corporation
9451 SW 97 Street
Miami, FL 33176
Ph. 305 270 8779; fax. 305 595 1883
Posted by: Juan A. Granados at August 4, 2005 05:49 AM
Does it really matter why the crude markets rose?
I've been involved with the futures markets in various capacities for over 20 years now - and am continually fascinated by the need for most for a "reason" why a move occurs. Who cares? Particularly, when upon deeper analysis, many of the proffered reasons are illogical.
There are a myriad of possible reasons why crude has risen recently - but to a trader, none of them matter past the actuality of rising price.
And all that price really represents, is a consensus distillation of current information and future speculations. Different people react to different data in different ways at different times - this "need" for a causative reason entirely misses the point: Instead of saying events drive prices, perhaps we might be better served in thinking that prices drive our interpretations of events.
Food for thought.
Posted by: Jon at August 4, 2005 06:45 AM
For what its worth, there has been speculation about Fahdís death since early May. Missed meetings, rumors in Kuwait, an abrupt return or the royal family, significant change in troop movements, his hospital stay, etc. Iím by no means an oil analyst, I just read too many blogs when I should be working but the information was out there.
Posted by: Darren at August 4, 2005 07:09 AM
Jon, I agree that it can be very hard to make these judgments, and my interpretations can certainly be wrong. But, like it or not, the world is changing, and any number of policy, business, and financial decisions depend on what we think the nature of that change is. So, I think it is important to try to form the best picture we can of what is really going on. I agree there's no point in trying to interpret each day's price fluctuations. But I'm very interested in what forces may be driving the broader trends.
Posted by: JDH at August 4, 2005 08:10 AM
Don't get me wrong - it is absolutely worth looking at and analyzing macro trends in price and trying to figure out what might be driving them. Can be quite profitable as well.
My point was more oriented toward the shorter-term "noise" factors present in everyday and short-term trading. As Darren points out, it wasn't exactly a secret that King Fahd was gravely ill - therefore, one could posit that the market had already built this premium into price and the last couple of days are nothing more than mere icing combined with a rush of the Johnny-come-latelys who always seem to be buyers at the top.
As for "change" - of course. Again, I won't disagree with you per se - but where I get concerned is when people draw conclusions based on false assumptions: Oil prices rising due to increased demand is very different than oil prices rising due to decreased supply is very different than oil prices rising due to risk of supply interruption is very different than oil prices rising due the role of "always long" commodity funds.
Stepping back slightly - all this is the textbook example of why futures exist/are useful. People see "risk" in varying ways - and these markets allow them to hedge it quite well. Dovetails nicely with your earlier discussions thereof.
Posted by: Jon at August 4, 2005 08:43 AM
1. incidentally, Mai Yamani is a she, namely a highly qualified saudi woman with deep inside - the surname !!! - knowledge of things saudi. Does not even wear a veil. Worth underlining.
2. perhaps both explanations have their merit, and they are perhaps not independant of each other. Certainly, since LTCM, i would not discount the capacity of hedge funds to take seriously insane positions in a market.
3. In spite of all the explanations about lower energy intensity and/or dependance on oil in developed countries, I still remain puzzled by the relatively low impact this 5 year oil shock has had on economic growth in the OECD area.
4. two major industrialising countries - china and india - with massive energy demand elasticities and, perhaps, an approaching oil peak ? Sounds like interesting times ahead.
Posted by: 4degreesnorth at August 4, 2005 09:03 AM
Thanks, 4degreesnorth. Although I was quoting someone else on Yamani, it seemed important to correct this error with a bracket correction to the original post.
Posted by: JDH at August 4, 2005 09:29 AM
I suggest you please take a look at this link: http://www.energybulletin.net/6244.html. I'm wondering what your thoughts are on its analysis of the globalised economy being predicated on exponential growth.
Posted by: albert at August 4, 2005 12:16 PM
Albert, statements such as the following in the report you cite,
"to support this doctrine of material consumption, economists must assume that the natural world offers a limitless source of the raw materials necessary for the finished goods that are to be consumed,"
suggest to me a rather profound lack of economic training on the part of the authors of this report.
For those willing to make an effort to try to communicate to economists the issues that they feel we may have been overlooking, my suggestion would be to make sure that a discussion of the incentives that people face and how they respond to them plays a key role in the discussion. Because that's really the way economists tend to think about these issues, not some abstract notions about Adam Smith's "invisible hand." I think it would be helpful if more people in the peak oil community were to try to get their notions about "what economists assume" by talking to economists rather than talking to each other.
Posted by: JDH at August 4, 2005 01:11 PM
some people want to control the oil price. that is a natural geopolitical objective. it used to be controlled by 'swing producers' turning the tap on a little or off a little. but when we reach maximum production ( no room to manoeuver production upwards for the swing producer) the oil price goes up to $40 and no one has the spare capacity to shift it. we are the hostages of the maximum level of production, all of us.
so the only way to regain 'swing' power is to invade iraq. ( but that did not work out.)
so the only way left is to speculate / bid up supplies and futures, until oil is at $60. who can afford to do that ? the oil producers with their surpluses, the oil companies (ditto) and the countries diversifying out of the dollar. (weaker dollar automatically = stronger oil price).
but particularly the people already involved in oil. with oil at $40 and rate of flow maxed out - no room to manoeuver. with oil bid up to $60 ( the higher it goes the more play money the oil men have) the freedom to manoeuver and thus to have geopolitical clout - is restored. you use the market as the lever, not production.
is this nonsense ? maybe. but remember how kissinger solved the 1974 oil price hike. by recycling. 'charge us what you will, but stick the dollars back into investments that in turn allow us to pay your prices . . .'
if this is not the answer, try looking in this general area.
it is a wrestling match with geopolitical economic leverage as the prize.
Posted by: gillies at August 4, 2005 03:28 PM
Oh dear. Old Saudi hand must come in again. The commentary on King Fahds death has been massively ignorant and wrong. Sultan is NOT the leader of the hardline faction. His boy, Bandar, has just returned after serving as the longest running ambassador to the US of anybody. They are the corrupt pro-western faction. Yes, Naif, who runs the Interior Ministry is a tough guy. But it is the new king, Abdullah, who is closest to the religious conservatives, not the (now) Sudeiri Six, the full brothers of the late Fahd. These include Sultan, the defense minister, whose military is entirely built by the US, Naif, and Salman, the
governor of Riyadh province. Abdullah commands the tribally based National Guard, the more traditional and religiously conservative group.
The ones to watch are the al-Faisals, the most likely candidates in the third generation to jump up, the sons of the most revered of the sons of the founder, the late King Faisal. Their leaders include Foreign Minister, Saud al-Faisal and leaders include Foreign Minister, Saud al-Faisal and the new ambassador to the US, Turki bin Faisal, longtime intelligence chief, the guy who hired Osama bin Laden to run things for the Saudis in the Afghan mujahjeddin. Saud went to Harvard and Turki to Princeton. The replacement of Bandar bin Sultan with Turki bin Faisal is the real story here.
Posted by: Barkley Rosser at August 4, 2005 06:00 PM
The discussions about efficiency of markets that I have read posted on this site have ignored the external costs and risks to society created by the continued emission of greenhouse gases from the mining and combustion of fossil fuels, including oil. Evidence is mounting that these gases could trigger changes in climate patterns that could result in sea level rise and shifts in rainfall patterns; the economic damages will be significant. Government policy is the only tool that can be used to stimulate markets to correct this fundamental oversight. I suggest that the appropriate government policy is a tax based on avoided externalities -- the cost of our military actions in oil producing countries and health costs of air pollution are the most obvious current external costs that are not reflected in market pricing. Greenhouse gas emissions are a huge problem for tomorrow -- but when? And how? It seems to me that energy taxes should be tied to the avoided cost of economic damages caused by these current and future external costs. With respect to climate that would mean estimating the cost of replacing infrastructure and businesses that would be destroyed or rendered unusable by a probable catastrophic climate change scenario. Avoided health costs, ecological impacts and the costs of war could also be determined and monitized into this tax. For example, one component of the tax could be determined by estimating the cost of replacing or relocating all the people, ecosystems, buildings and businesses displaced by a 3-meter rise in sea level in say 50 years. Poppycock, you say -- this will never happen in 50-years. Fine, what about 1-meters in 20-years. Or 3-meters in 100-years? But since this is all about money, power and people, let's have a discussion about the real consequences of current policy in terms that everybody can understand .......
Posted by: David E. Bruderly at August 5, 2005 03:29 PM
Mr. Bruderly raises an interesting point about markets and how they react to subsidy -- i.e. external costs. For instance, I doubt that US$62 per barrel is the *true* cost of petroleum. It is however presently at about the level that business and markets will transact.
I suspect that the external military costs to keep the price to this level is irrelevant to the market -- any military costs are covered through taxes and other mechanisms.
The current military romps in Iraq and Afghanistan cannot be cheap. In fact, I wonder whether this type of subsidy might not provide some sort of value-added economic stimulus through weapons production and payrolls.
As for Mr Bruderly's concerns for climate change impacts, these become most serious on a decadal scale -- well beyond the relatively short time frame that markets or economic systems comprehend. If the markets have difficulties with pricing peak-oil within a decade, I doubt they'll be any use in proactively addressing climate change.
As well, I believe that we are well beyond the threshold of effective emission reductions, so 'brace for impact'.
Posted by: muhandis at August 5, 2005 04:29 PM
It does matter very much that the price of oil has been increasing during the last year and is now more than $62.00 barrel, because it will continue to increase indefinitely unless we do something about it.
We have a responsibility to look 5, 10, 15, 25 years and beyond at the serious events that endanger our National and Economic Security, the security of our transportation system and the wellbeing of we americans, our children and grandchildren.
It has been evident for more than one year now that worldwide supplies of crude are tighter and tighter facing an increasing worldwide demand (some of this new demand is exponentially increasing).
These are facts and realities that present us all with a national challenge that requires recognition and responsible leadership at all levels of our governments, civic organizations, educational institutions and society.
When will it be too late?
Juan A. Granados, President
Shale Oil Information Center, Inc.
a Colorado non-profit corporation
9451 SW 97 Street
Miami, FL 33176
Ph. 305 270 8779; Fax. 305 595 1883;
Posted by: Juan A. Granados at August 6, 2005 02:49 PM
David Bruderly might find the new British idea of a carbon tax which everyone must pay for their individual use of carbon fuels - whether in transport, heating or whatever, and as they use it, as a step forward. The idea being that everyone is given a quota and after you use it up, then you can buy what else you need from others who are not using all of theirs.
Posted by: The Oil Drum (heading out) at August 8, 2005 07:16 PM
On an energy equivalent basis oil should be about 6.0 time the price of natural gas (~$6.30 per mmbtu) or about $37.8 per bbl. The difference is due to all the uncertainty listed here. Many petroleum engineers don't not believe that the reserve numbers in the middle east are correct. Refining capacity is a problem and manpower in the energy business is a major constraint.
Petroleum Engineer, MBA
Posted by: David Mercier at August 11, 2005 05:23 PM