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July 25, 2008
Oil prices and economic fundamentals
Oil was selling for $123 a barrel on May 7, and that's where it closed this week. Sounds like a calm and rational market, except for the fact that just last week it was going for $145.
Which price was right, $123, $145, or something else? Before you let anybody give you an answer to that question, try to get them to comment first on the following two facts. (1) According to the Energy Information Administration, China consumed 7.6 million barrels of petroleum each day of 2007, which is 860,000 barrels/day more than in 2005. (2) EIA also reports that the world as a whole produced 84.6 million barrels of oil per day in 2007, which is 30 thousand barrels per day less than 2005.
Now, how could it be that China is burning 860,000 b/d more than it used to, but no more is being produced? Well, it could be that there are errors in the consumption or production numbers, and both will likely be revised. Or it could be that we're drawing down global inventories. But the most natural inference is that somebody else in the world must have been persuaded to reduce their consumption of oil between 2005 and 2007 to free the barrels now being used in China. And indeed, according to preliminary EIA estimates, petroleum consumption in the U.S., Japan, and those countries in Europe for which data are now available fell by 760,000 b/d between 2005 and 2007.
Here's the framework I would propose for answering the question of how much the price of oil should have risen since 2005-- the price of oil needed to go up by whatever it took to persuade places like the U.S., Europe, and Japan to reduce their consumption by the amount that China, the newly industrialized countries, and oil-producing countries were increasing theirs.
And how big a price increase would that be, exactly? Somebody who claims to know that would need to have more confidence in their estimate of the price-elasticity of oil demand than I have in mine. But if your answer is that a much smaller price increase than the one we observed would have been sufficient to produce the requisite decline in quantity demanded, that would seem to imply that, since price went up by much more than you believe was needed to reduce demand, the quantity demanded must have fallen by much more than was called for. One place that might have been expected to show up is in the form of an accumulation of inventories. The black line in the figure below shows the average seasonal behavior of U.S. crude oil inventories. The red line demonstrates that current inventories are if anything below normal. On what basis, then, could one insist that the quantity of oil consumed has fallen more than was necessary?
OK, suppose you believed that the price increase we actually saw-- from $42/barrel in January 2005 to $96 in December 2007-- was just the right amount to accomplish the task of balancing global demand and supply for 2007. Should the price have held steady from there in 2008? Figures reported by Rigzone imply that China imported an additional 8.97 million tons of crude and 2.96 million tons of refined product in the first half of 2008 compared with 2007:H1, which converts to a 480,000 barrel/day increase. Where's that supposed to come from? A U.S. recession, which many of us were anticipating in January, certainly would have brought demand down. But current U.S. GDP growth is likely to come in higher than many of us had predicted earlier, meaning if you gave one answer for the correct price of oil in January, you should be giving a higher value for that number today. On the other hand, the data coming in the last two weeks have raised the probability of a recession in Europe. If that occurs, it will bring a reduction in the quantity demanded from those areas even if the price begins to fall. Whatever the correct price of oil was two weeks ago, I think it's a lower value today.
What about the delayed response of quantity demanded to the price increases already in place? If that proves to be substantial (and I'm of the opinion that it will), U.S. petroleum consumption should continue to decline during 2008 even with no further price increases and no recession. There's also been some increase in global production this year, and more is expected. Won't that be enough to satisfy those new and thirsty Chinese vehicles? If so, $123/barrel may be way too high a price.
But don't forget, while you're doing these calculations, you'll need to meet Chinese demand for 2009, and 2010, and 2011.... Which, if you project the current trend and tried to satisfy entirely by cuts in U.S. consumption, would have us down to consuming zero barrels of oil in the United States in about 17 years.
Is the price of oil today too high given the fundamentals? Could be. Is it too low? Could be. But one thing I'm sure that's too high is the confidence on the part of those who insist they know the answer.
Posted by James Hamilton at July 25, 2008 04:33 PMdigg this | reddit
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» What’s That Got to Do With the Price of Oil in China? from Outside The Beltway | OTB
Yesterday the price of oil on world markets closed at $123 a barrel, just where it was at the beginning of May this year. Oil economist James Hamilton has an excellent post that suggests that the fundamentals of supply and demand may well be the major... [Read More]
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» Oil Bubble from Political Animal
OIL BUBBLE?....Is the recent risk in oil prices a speculative bubble? Via Mark Thoma, economist Jim Hamilton tackles that question here. Shorter Hamilton: if you think it's a bubble, what makes you so sure you know what the price should... [Read More]
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» Are Speculators to Blame for Oil Prices? Resources to Inform from DiscussEconomics Blog
*Updated July 26rd, 2008* Here is a list of resources online that are in the midst of the discussion regarding the role of speculators in driving the price of oil sky high. Let us know if we've forgotten some important / useful articles. We'll be conti... [Read More]
Tracked on July 26, 2008 09:09 AM
» hello? from Interfluidity
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Tracked on July 27, 2008 02:51 AM
According to Bloomberg, over the past year, the price of oil has traded inversely to the U.S. dollar 90% of the time (and I doubt that this is merely a coincidence).
A higher oil price weakens the U.S. dollar and vice versa which means DickF is correct that our debased dollar is driving inflation higher. What do you think would be most likely to finally break this inverse correlation between the price of oil and the U.S. dollar?
Posted by: Charlie Stromeyer Jr at July 25, 2008 05:43 PM
"Is the price of oil today too high given the fundamentals? Could be. Is it too low? Could be. But one thing I'm sure that's too high is the confidence on the part of those who insist they know the answer."
My friend and I are recent college graduates in radically different fields: English and Philosophy for him, and Economics, Accounting and Finance for me.
In a conversation we had, he expressed his desire to teach English in Brazil and noted that he always would be employed because of the booming economy there. He asked what I thought about investing in Brazil. I replied that the country was heavily dependent upon commodities, and that many economists and financial experts believed the exponential increase in the price of commodities was something of a bubble (Negative real interest rates).
Shrugging his shoulders, he then declared Brazil the perfect short (A concept I had explained to him earlier. He's green). But I hesitated again, telling him that many experts believed the prices were justified on firm foundation values!
When he asked whether I believed it was a bubble or not, I told him I had no idea. I glad that has become somewhat of the rational position!
Posted by: Kevin A at July 25, 2008 06:37 PM
A question for the economic historians, among others--
Historically, developing countries have experienced wicked boom and bust cycles. Why should we expect present day China et al to be different?
Using history as a guide, we should expect a ginormous contraction following the current boom.
Or, is the Chinese central planner better able to control the boom/bust cycles relative to the late 19th/early 20th century market economy?
The point is, a multi-year conraction in developing countries could potentially drive the price of oil back to the $20 - $40 range. Sounds just as crazy as $150 oil did 10 years ago when oil was ~$10/bbl.
Posted by: tjgje at July 25, 2008 07:18 PM
The thing that has been driving Chinese demand is that they subsidize the price of oil for domestic consumption. This is an expensive thing to do at these prices, but the last thing the Chinese government wants to do right now, after a very rough year (Tibet, Earthquake), is to irritate the people before the Olympics by raising prices. I would guess that they might start doing that in the fall.
Posted by: Fat Man at July 25, 2008 07:53 PM
If I recall correctly, world wide demand for crude basically increases in all but the most severe economic conditions, and even then, the year over year declines have been a) infrequent over the past 28 years and b) small.
Ignoring the turmoil surrounding the OPEC embargo and the subsequent period in the early 80's for just a moment, *worldwide* demand only dipped once in 1993. Non-OECD consumers made up for declines in the OECD post 9/11.
Since 1993 non-OECD oil demand has grown at a robust rate far exceeding OECD growth. While it seems possible a 2% reduction in crude use in the US and certain other OECD countries might bring world wide demand growth approaching flat, it does seem unlikely that growth will remain flat for too long unless an unusually dire economic future lays before us.
That brings us back to the 70's / 80's, the only comparable period from a price escalation perspective. But prices rose then due to politically driven scarcity, not real or perceived tight supply.
Maybe the intertwined housing and financial crisis will help delay what many perceive to be a looming energy crisis of historic proportions.
In an old spreadsheet I've been down this road before -- using EIA stats up to 2005, I worked out the "energy effectiveness" of various geopolitical regions as a ratio to the ex-OECD:
energy effectiveness gdp/mtoe EE:exOECD EE World 4,045,130,044 1.75 ex-OECD 2,307,142,182 1.00 OECD 5,626,651,206 2.44 EU 6,457,069,568 2.80 G7 5,588,988,533 2.42 US 4,930,908,823 2.14 CAN 3,075,582,251 1.33
Canada is an anomaly - I take the number to be a reflection of the massive energy required to produce... energy, from oil sands.
Reduce the marginal use of crude all one wants in the OECD, its not going to forever provide "virtual slack" for the growing ex-OECD regions.
Posted by: Mike at July 25, 2008 08:07 PM
Do you feel that the lagged effects of demand destruction could account for any of this whipsaw motion? Presumably, a lot of substitution and conservation efforts require considerable time and capital to enact.
Posted by: ndk at July 25, 2008 08:09 PM
Erg, sorry, RTFP. I don't see as much in the way of decreased oil intensity here because most of our oil use has no good substitute goods. In the '70's, we were using plenty of oil for electricity generation, which is relatively easy to swap over compared to the combined footprint of hundreds of millions of vehicles with no proven workable alternative.
Posted by: ndk at July 25, 2008 08:27 PM
Personally I think a lot of the self-conservation efforts done in the fair and nice weather of spring and summer are going to go by the wayside in the nastier North American weather (and elsewhere in the world) in fall and winter.
Maybe that's just our experience; each year we reduce our consumption in the nice weather - riding more than driving; but my wife's commute is not so nice to do on a bike in the rain and dark, so in the fall our consumption starts to rise anew.
Ultimately slightly lower prices and the effect of near term memory turning what was once high into the new normal suggests to me that the average consumer will go back to old habits.
On the plus side, its doubtful there will be a renewed surge of SUV production anytime soon!
I'm fond of the Peak oil theory but not wedded to it, although lacking serious supply growth evidence I have decided to conclude until proven otherwise that "peak" production is closer at hand than we are ready for and this price escalation episode is merely a sign of things to come.
Posted by: Mike at July 25, 2008 08:54 PM
Yep, lots of cross-currents in motion, Professor.
Why the big drop in price in the course of one week?
I have no evidence whatsoever for this: I presume the banks and broker/dealers have been using the Treasuries swapped from the Fed as funding for commodity speculation. The run up in oil prices was becoming politically intolerable, as evidenced by the Congressional hearings with the oil company executives. So, Treasury and the New York Federal Reserve (Geithner) said, 'Okay guys, we are happy to make loans of Treasuries to you, so that you can sell them and survive what we hope is a short episode of choppy waters. But, lay off the oil and food speculation, as Congress may soon coming knocking on your and our doors.'
The economic and earnings news last week and this week was bad, but par for the course of the last six/nine months, seems to me. Hence, my search for other reasons for the big drop in oil prices.
Posted by: jg at July 25, 2008 09:30 PM
Which is funny as hell because it helped make the economy look better than it really was with the hoarding and overordering going on in these sensative industry segments. Now we have record inventory to work off.
Don't even start me on the ag boom. That effer going bust will suck like it did in the early 80's. Breadbasket to the deadbasket. It won't feel good nationally either. Canada,Aussies and Brazil are going to feel the pain next when China slashed investment post-smoggy games.
Lower prices is fine, but prices fell during the mid-70's recession and that was when the economy keeled over mid-74. Lower prices usually mean the end of the game.
Maybe that 5 dollar gas wouldn't seem so bad when you have no job this December and your health insurance company just mailed your new prems have raised 300 a month.
Posted by: Sandman at July 25, 2008 09:42 PM
It is called Peak Oil
"EIA also reports that the world as a whole produced 84.6 million barrels of oil per day in 2007, which is 30 thousand barrels per day less than 2005. ..."
And we know that the price of oil was increasing the whole way, yet more net barrels did not come to market. We know that old wells were brought back into production and every drilling rig in the world is currently leased and drilling. There is only one answer and that is that depletion is now beginning to outrun production. Peak Oil my friends ...
And with Peak Oil comes other peaks such as peak credit, peak money and peak worldwide GDP.
What we will see going forward is lower highs and lower lows for world GDP while at some point the leveraged debt based fractional banking system will implode because of bad debt and fewer new loans.
Posted by: Michael McKinlay at July 26, 2008 12:00 AM
I can simply add that in Spain, demand is slowing at the stations.
Posted by: IM at July 26, 2008 12:35 AM
Supply and demand for physical oil are no doubt very important variables. But we cannot possibly understand a multivariate problem without considering all the important variables. I believe one such is speculative futures contracts which has a strong asymmetry between buying and selling. A large number of speculators with no ability to take possession of oil are/were buying futures, whereas only producers are/were selling futures. (The actual numbers are unavailable because speculators used a loophole to buy through intermediaries that were exempt from reporting requirements. You can thank Phil Gramm for that!) This (in addition to physical demand and supply considerations) drove up the price of oil. The game could not go on for ever. The clearest indication that the game was coming to an end was when a Wall street "analyst" predicted the price of oil would reach $200 a barrel, in what one might say is a thinly-veiled attempt to unload their positions at a high price on unsuspecting late entrants.
Posted by: Anonymous at July 26, 2008 02:14 AM
I agree with the other commenters. I would add that the Brazilian stock market has just had a major decline, and that Spain is in a recession.
jg, there is truth to what you say. I know this because I am a professional money manager who also trades the price of oil, and my colleagues (i.e., hedge funds) reduced their net long positions in oil futures to the lowest level since February 2007 just right before the new all time peak high in the price of oil.
Disclosure: still long the Brazilian real and still short the price of oil.
Posted by: Charlie Stromeyer Jr at July 26, 2008 04:51 AM
To balance out the ban on naked shorts in financials, me thinks, the PPT should push for a ban on naked longs in commodities.
Posted by: tide is out at July 26, 2008 05:18 AM
tide is out, senate Republicans just blocked action on the oil speculation bill:
The incompetence of both Republicans and Democrats is the main reason why I have been an Independent for the past twelve years.
More importantly, Jesus Reyes Heroles who is the CEO of Petroleos Mexicanos (Pemex) recently said that he agrees with some analysts that the price of oil would be about $80 a barrell if it were not for speculators. Does anyone happen to know how Mr. Heroles arrived at this estimate?
Posted by: Charlie Stromeyer Jr at July 26, 2008 06:20 AM
Charlie, do you know of anyone espousing such numbers who has provided an explanation of how their estimate can be reconciled with facts (1) and (2) stated at the beginning of my post?
Posted by: JDH at July 26, 2008 06:31 AM
JDH, the only prominent oil analyst I know of who has reconciled such a target price with facts (1) and (2) is Ed Morse of Lehman Brothers:
WARNING: the stock of Lehman Brothers (ticker LEH) is down 75% over the past year which suggests that Lehman does not know what it is doing.
Posted by: Charlie Stromeyer Jr at July 26, 2008 06:57 AM
I agree with JDH, and would argue that while oil prices may well decline in the short term from current levels, descriptions of of those prices as a "bubble" are purely polemical until/unless they are accompanied by evidence of large quantities of previously unaccounted for supplies hidden in storage somewhere. So long as the balance between supply, consumption, and storage of oil keeps being measured on a monthly time scale and the figures are accurate, then the quoted prices are the market clearing prices for that month to bring things in balance. The short duration of the market time scale makes the connection between the purchase of an oil contract and its end economic usage/reality a lot tighter than what happened in the Tech stock bubble, the real estate bubble (much longer duration asset) and the Dutch tulip bubble.
That said, there is some emerging evidence that the spike in oil from high 120$ to $140 was at least partly driven by a short squeeze.
Posted by: Josh Stern at July 26, 2008 08:17 AM
Just wanted to add to the above that I actually do think the common sense position that the doubling of end user and realized producer prices will, in time, decrease demand and increase supply. And when that happens prices will fall further and people will say "See, we told you it was a bubble." But it isn't helpful to conflate speculative bubbles with unforseen supply/demand imbalances.
Posted by: Josh Stern at July 26, 2008 08:23 AM
JDH - part of the reconcilliation of points 1 + 2 in your post is that the world is, each year, outsourcing more and more production to non OECD countries such as China.
US (and OECD nations) oil use has not actually declined, its simply being used elsewhere (China et al) to produce the goods we (US and OECD and obviously some non OECD) later import.
I'd add that this is not unlike the situation with carbon and GHG emissions which are increasingly being outsourced from the US each year to energy producer and goods and materials exporter nations.
Look at the nations with declining domestic basic manufacturing and you'll see a higher level of "energy efficiency" because they are increasingly outsourcing that activity to so-called less efficient nations. Sure, there are some actual efficiency issues the developing world needs to address too.
I believe this goes a long way to explaining 1 + 2.
Posted by: Mike at July 26, 2008 09:34 AM
Why the drop from 145 to 125? Some of it was oversold markets, but the drop started as soon as the rumors got out that we were sending diplomats to Iran. In addition, China took 3 million cars off of the roads to clean up the air for the olympics, that transaltes to at least 125000 barrels a day, possibly two or three times that much. Wait until the Olympics are over and we start running off at the mouth about Iran again, then it will be off to the races. Who pays the Chinese oils subsidies? Why, we do by debasing our currency. They have dollars and they have to spend them, they are a time wasting asset.
Posted by: FredW at July 26, 2008 09:41 AM
Back in about 2001 I argued that California's wildly escalating electricity prices were due to demand. Not longer after we learned that the California market was broken by government rules which Enron took advantage of to manipulate the market and engage in criminal fraud. At the time, the pundits said electricity was going up in price due to normal market demand caused by "server farms" and California's growing population, and a few power plants undergoing routine maintenance. I learned my lesson and I no longer believe the "rational argument" for today's wild oil price ride. Sure, it could be normal supply versus demand or it could just as easily be Enron-style market manipulation of a new sort.
Posted by: Eric at July 26, 2008 10:08 AM
From: I copy and paste with emphasis added: http://www.outsidethebeltway.com/archives/2008/07/whats_that_got_to_do_with_the_price_of_oil_in_china/
The Chinese government subsidizes the price of gasoline in China to the tune of roughly 50%. I’m not opposed either to increasing our domestic oil production or reducing our domestic oil consumption but, if we really want to bring down the price of oil in the near term, negotiating with the Chinese to have them trim their subsidies a bit should be a high priority item in the next administration. I'm betting it won't be. What do you think?
This kind of hard-wired entitlement-driven sentiment is bullish for long-term o&g e&p equity investors. And bearish for US per capita wealth levels.
Posted by: GNP at July 26, 2008 11:02 AM
Parabolic or rapidly rising markets always correct hard.
But unlike the Nasdaq bubble, to use that period of inexcusable continually re-rationalizing of ever higher prices in comparison, *most* of oil's price is based on supply and demand.
Sure there are various unmeasurable premiums layered on top. If the Middle East was one big picnic of peace, price would be much much lower, perhaps for a few decades, because reserves would be ever more actively exploited in countries where that doesn't happen at present - Iraq to name one.
But that isn't the world situation and the cost of finding new and extracting new supplies elsewhere has only continued to rise, and supply isn't leading price lower but higher over the longer term. Valero learned this month that 15% of its supply from Mexico is suddenly cut, not likely to return. North Sea production has declined, as expected from a peaking area. Mexico's giant field, Cantarell - seriously declining as all fields eventually do once past peak. Conventional oil in Canada and the US - declining. Indonesia - declining. And so on. Non-OPEC production is and will probably forever be a smaller and smaller component of supply and again, unless we are all happy karma campers in the M.E. that alone is going to support higher and higher prices.
Oil should be used for things more important than shuttling humans around in small tin boxes with cup holders.
Posted by: Mike at July 26, 2008 11:05 AM
I agree with every comment so far. How might it be possible to manipulate the price of oil given that the global oil market is so huge? One possibility is that there could be some price manipulation via unregulated commodity exchanges such as ICE.
LEGAL DISCLAIMER: I do NOT in any way mean to imply that any manipulation has actually occurred via ICE.
Posted by: Charlie Stromeyer Jr at July 26, 2008 11:34 AM
This analysis seems to neglect the supply side. Look at it this way: For decades oil consumption increased without any increase in the price. From this article you would think such a thing would be impossible, but the point is that long-run price trends are driven by supply (i.e. the cost of producing a barrel of oil) not demand. As we saw in the 70s, lots of weird stuff can happen over the span of a few years, but eventually supply catches up and the price reverts back to the long-run trend.
The only way things could be different now is according to some version of the "peak oil" hypothesis, which is just another way of saying that the cost of producing a barrel has finally started to trend upward. That may be true, but I doubt it can explain the magnitude of the increase we've seen over the past couple of years. This is why I expect oil to fall back to double digits with in the next few years. And that's consistent with the decline in inventories: If price is temporarily high, producers will draw down their stocks to take advantage of the high price.
Posted by: Jim at July 26, 2008 11:55 AM
In response to Eric, there's a key difference between electricity markets and every other market I can think of.
Electricity is hard and expensive to store, and significant storage only happens as part of the integrated system. This means that the supply and demand have to be balanced on an on-going basis. In most US systems, the balancing happens every 5 seconds. In that kind of system, well timed "outages" of key generating stations can lead to astonishingly high prices on the spot market. These are the kinds of processes that Enron and others were taking advantage of in California.
Oil is simply not at all comparable. It has to balance on a time scale of a few months, not a few seconds. Producers have abundant and cheap storage, and consumers have de facto storage as well, ranging from their heating oil tanks to the gas tanks on their cars. The market just can't be gamed the way California's electricity market was.
Posted by: Karl at July 26, 2008 12:10 PM
Jim may be correct. In November, the IEA will release an important study of the status of the world's top 400 oil fields which may provide important new evidence for the peak oil debate.
By the way, my fellow Bostonian and money manager Kenneth Heebner has what is supposedly an awesome map of Ghawar but I have never seen it.
Posted by: Charlie Stromeyer Jr at July 26, 2008 12:13 PM
There are two problems with taking points 1) and 2) at face value. They are :
1) As prices get higher, China will also see demand destruction.
2) Technology can enable a consumer to get more with less. This has already been in effect since 1975, and is accelerating.
I don't think Oil will ever get above $250/barrel. There are just too many technologies that are more cost effective than oil at $250, and they will transition fast enough to prevent demand inelasticity from lasting long enough for prices to hit $250.
Posted by: GK at July 26, 2008 01:16 PM
Two comments. First, shouldn't the third figure be normalized for the level of consumption (e.g., days of oil on hand)? Secondly, if normalization doesn't change the picture much, could we be seeing speculation here? (Buyers are holding off on the idea that price will go lower.)
Posted by: don at July 26, 2008 02:24 PM
"I don't think Oil will ever get above $250/barrel. There are just too many technologies that are more cost effective than oil at $250,"
You are right for the wrong reason. Oil will not reach $250 soon because there would be massive demand destruction and a financial meltdown.
There are no technologies that can be scaled to produce transportation fuel on the scale of oil, not even close.
In the long run oil will hit $250 probably sooner than you think.
Posted by: Michael McKinlay at July 26, 2008 02:26 PM
Remember, the Chinese DID increase their prices significantly around July 1, but I think we will have a tough time figuring out how much demand destruction that caused, because of the disruption from the Olympics. How do you do a price elasticity calculation when you have major markets fixing prices?
I believe that market prices are being set by the EXPECTATION of what supply might be, which means you have to deal with the uncertainty of supply disruptions. Remember all the predictions coming from Morgan Stanley and Goldman Sachs saying the price of oil will go to this or that because of this or that supply disruption? All their thinking was based on a guess as to what worldwide supply would be on a given date, if this and this and that happened.
So the market is not really responding to true supply and demand, but EXPECTED supply and demand, which is really a guess.
Three months ago I was concerned about military action against Iran causing the Straits of Hormuz to be closed. Since then the window for the Bush administration and the Israelis to take that action has shrunk, but is still open. Stupid move that might be, even if they did take action, I am somewhat confident that the US Navy would escort tankers through the straits, and any Iranian action against them would invite retaliation on Iranian military sites. The Iranians will back down on that threat. They might hold their own oil off the market, so figure that disruption. Can high sulfur Iranian oil be used for low sulfur diesel?
Posted by: randymiller at July 26, 2008 03:11 PM
Michael McKinlay: I agree with the thrust of what you say but if Israel or the USA militarily attack Iran, and Iran manages to block the Straits of Hormuz, oil prices could temporarily go much higher than $250 per barrel.
It is rather curious and somewhat amusing that all this tabloid and elite ink has been spilled on the role of "speculators" while ME geopolitics has been largely ignored except by folks in the biz.
On this subject, it is interesting to note that from 2004 to 2006 Israeli oil consumption declined by 9,030 barrels/day or -3.7%. However, natural gas consumption increased by 7BCF or +24% during that time. As offshore Gaza natural gas looks like it is increasingly "out of bounds", I'll bet some Israelis would like to see a natural gas pipeline connected to Syria.
Folks can make a bet on that play by buying Canadian-listed international o&g e&p companies such as Petro Canada, Stratic Energy and Dualex Energy. Have owned no. 2 and currently own no. 3. Am also hedged with US Oilfund Oct08 $60 and $70 puts.
DISCLAIMER: I am an unqualified risk-neutral retail investor and the above is for discussion purposes only. Talk to your investment advisor.
Posted by: GNP at July 26, 2008 04:23 PM
"In the long run oil will hit $250 probably sooner than you think. "
This reminds me of people who, when the Nasdaq hit 5000, scoffed at anyone who dared to suggest that the Nasdaq would not reach 10,000 for decades.
Or perhaps the people who thought houses could appreciate 15% a year forever, even if salaries were not rising.
$250 won't happen. If you think it will, you should be buying the Oil ETF (symbol USO) heavily, even buying on margin. Have you bought it.
"There are no technologies that can be scaled to produce transportation fuel on the scale of oil, not even close."
They don't have to replace all oil. They only have to replace 10-20% of demand. Plug-in hybrids will do this, as will cellulostic and algaic ethanol. Also, car weight is dropping quickly due to materials advances, which is dropping oil consumption.
Furthermore, expensive oil is a net positive economic force for society. Traffic deaths have plummeted (which cost the economy about $3 million each). Wear and tear on roads has reduced. Traffic has reduced. Environmental damage has reduced. The vast amount of land devoted to parking lots and gas stations can probably be trimmed by 5% (which is a LOT, once you see how much land is consumed by this).
Expensive oil, in the medium term, is a net positive for society.
Posted by: GK at July 26, 2008 04:23 PM
T. Boone Pickens who is America's most famous oil trader agrees with both Michael McKinlay and GK. Pickens says that oil will hit $300 a barrel within a decade, but he also has a plan to drastically reduce our dependence on oil by freeing up natural gas supplies from generating electricity via renewable energies and then running our transportation fleet via natural gas which would work for about 20-30 years until a new substitute technology is ready such as hydrogen:
Also, the newest issue of BusinessWeek raises the question of whether expensive oil is a net benefit:
Posted by: Charlie Stromeyer Jr at July 26, 2008 04:47 PM
And if it indicates speculation, could it be that, on net, speculators (at least those who don't have the option of keeping oil in the ground) are pushing the pice down?
Posted by: don at July 26, 2008 06:33 PM
Jim: The only way things could be different now is according to some version of the "peak oil" hypothesis, which is just another way of saying that the cost of producing a barrel has finally started to trend upward. That may be true, but I doubt it can explain the magnitude of the increase we've seen over the past couple of years.
Consumption has risen dramatically without affecting price dramatically over 20 some odd years because *production* also rose dramatically. Until it stopped rising dramatically.
Non-OPEC production growth significantly leveled off over the past few years even as China and other developing nations utilization grew far and away above total global production growth on a percentage basis. The lines will cross sooner than later.
The second issue is that, despite years of high crude prices and record earnings and therefore cash flow for investment into finding new sources of supply, reserve and production growth has been absolutely anemic. If history breaking profits in the sector, record setting prices month in month out, a very long run of high prices - if these factors can't spur the necessary investments to return substantive increases in supply then I argue that perhaps there's an awfully good reason which sounds a lot like peak oil.
I believe we are on the bumpy plateau. There are no new Saudi Arabias to be found in the world; any significant new find or unconventional source takes many years to bring on stream and costs will demand high crude prices.
A quote from the Financial Times paints a clear picture: 14.8m of the 16m barrels of new supply from non-Opec countries over the next five years will only go to make up for losses from old fields producing less each year.
Liquid fuel growth is likely to come more from biofuels than anywhere, yet this seems to cause us other problems.
Given the world wide output curve has more or less flat-lined over the past couple of years, and that non-OPEC crude output seems unlikely to ride to the rescue, the one hope for permanently lower prices remains with OPEC and specifically with Saudi Arabia. There is considerable debate as to whether they can progressively open the tap wider any ol' time they want to, as they have asserted over many years.
Bear in mind that production increases must take into account both the annual declines from exiting fields (~ 4 mboe/day) plus new demand (~ 1.5 mboe/day).
The US reducing its consumption by 2% barely makes a difference - roughly 400 thousand boe/day. That's 1/3 of a year's demand growth in new slack added to the system. If all the developed world reduced crude utilization that might give us a year of slack before we are back at the same problem.
Another factor to consider: demand is on the rise in producing countries. At some point countries such as Nigeria and others in the Middle East, particularly when faced with peak oil - everyone will get there one day - are going to be holding back some of their production for future domestic use.
All of this is manageable if enough time is available to plan and execute change. How confident are you that our consumer driven, quarterly reflective society will recognize the issues in sufficient time and make the changes required while we still have time to avert serious long term economic pain?
I'm not very confident at all. We have plenty of evidence of business and governmental nearsightedness all around us ranging from GM and their ilk producing vehicles which haven't made sense from a fuel utilization perspective for many years, to the mind boggling financial crisis made possible by a lack of oversight and common sense.
Hybrids and electric cars and other fuels all sound wonderful, provided there is sufficient time and an economy robust enough to enable sufficient numbers of transportation users to make the switch. Do we have time? That's the 5 trillion dollar question isn't it?
Posted by: Mike at July 26, 2008 07:29 PM
1. Buyers finally realized that the ME nations had no real excess capacity.
2. Future supply increases were impossible, given the declines in production in VZ, Mexico, and Russia.
3. Chinese and other Asian nations would increase, per capita, for decades.
4. Peak oil, if not here, was on the horizon.
5. All the above were exacerbated by SemGroup's mis-placed hedges, contracts that were significant in size.
6. Concsciousness of above by Goldman, MS, etc., including banks like BOC which had increased earnings from Trading Accounts.
Posted by: Bucky at July 26, 2008 11:48 PM
Again, I agree with every comment. randymiller is correct that the Chinese recently and partially reduced their gasoline subsidies. Actually, the high growth rate of demand for oil from China has been slowing a bit, but it remains to be seen if this slowdown is sustainable after the Beijing Olympics.
Mike, there is already significant demand growth for oil, gasoline etc. coming from the Middle Eastern economies. Also, in relative terms, the major integrated oil companies such as Exxon Mobil have been spending a record percentage of their revenues on share buybacks versus new exploration.
Disclosure: long shares of Sinopec (SNP) since July 15 but ready to sell at any moment.
Posted by: Charlie Stromeyer Jr at July 27, 2008 04:24 AM
A question for anyone: Do you think that when we discuss the possibility of global peak oil production that we should only consider conventional sources in order to simplify the debate?
Two items to consider: The U.S. Geological Survey just said that there may be 90 billion barrels of oil in the Arctic:
Also, last November 8, Petrobras found the Tupi oil field 155 miles off of Brazil's coast which may contain 8 billion barrels of recoverable oil.
Disclosure: I am in favor of drilling for oil in the Arctic, and I plan to buy shares of Petrobras (PBR) when I think that the price of oil has bottomed.
Posted by: Charlie Stromeyer Jr at July 27, 2008 04:56 AM
Consumption has risen dramatically without affecting price dramatically over 20 some odd years because *production* also rose dramatically. Until it stopped rising dramatically.
You mean in 1973? Because we've seen this before. I'm not saying that costs aren't going up in the long run at all, but I'm very skeptical that "peak oil" can account for much of the increases over the past few years. The cost of producing oil is still far below current prices. The information about global oil reserves has not been so dramatically negative, and there are technologies that will kick in that have to truncate the upside potential of oil prices.
Posted by: Jim at July 27, 2008 07:21 AM
skyrocketing oil prices help russia, hurt china, and provides enormous pressure to break the democratic hold on energy policy in the u.s.
if this causes china to be mad at iran, so much the better.
Posted by: cjm at July 27, 2008 10:33 AM
A few thoughts:
Oil inventories are on the scale of weeks or a few months. So "news" that affects expectations of prices within that timescale will affect current prices. If war with Iran looks more likely, those with oil in inventory will be less inclined to part with it, expecting it to be more expensive to replace. (Note that this does not extend out years into the future -- the Republican talking point that opening offshore will lower prices in anticipation of the increased supply is bunk. Did the price drop after Brazil's new field was announced?) Other than "news", short-term price fluctuations are driven by inventory reports. The last couple of weekly reports from EIA have shown unexpectedly large increases in gasoline stocks, suggesting refiners will be buying less crude in the near future.
Second, I don't believe that speculators have driven the market up, but the market may be in overshoot in a different sense. Short-term demand elasticity is very low, so a supply shortfall results in a dramatic price increase to clear the market. But long-term elasticity is considerably higher (I've heard estimates around -0.5). Witness plunging SUV sales, booming sales of hybrids, subcompacts, and scooters. On an even longer timescale, people will choose housing closer to work (or vice versa), communities will invest in transit, etc. On the supply side, I do believe in Peak Oil, but I think high prices will slow the decline considerably. There's still a lot of oil out there, it's just harder and more expensive to get than before. Continued high prices will drive the investment to keep us on plateau or only slowly declining. So, it's possible that $125 is justified by short-term fundamentals, but that long-term fundamentals will only support a price of $90, or whatever. We may have overshot the longer-term equilibrium due to inelasticities, not speculators. (Or we may not have, time will tell).
Posted by: lilnev at July 27, 2008 11:30 AM
this is a MESSAGE for the guy who calls himself SANDMAN:
did u watch the results of the last CONSUMER SENTIMENT survey??? (It was released last friday and it covers the third week of july)
There u can see the medium term inflation expectations of US households:
amazingly the expected inflation fell after only 2 weeks of OIL repricing.....;
a massive sell-off of commodities might:
(1) lower the long term interest rate (via expected inflation)boosting home sales;
(2) increase the short term real personal income boosting consumer spending.
All this could ultimately sustain mfg. industrial production, i.e. the supply side of the economy (the only thing that matters over a medium/long term horizon)
Posted by: TRITTER at July 27, 2008 11:35 AM
In this BusinessWeek article I referred to which discusses the benefits of higher oil prices are some economists who argue for a carbon tax (i.e., a tax on CO2 emissions):
Why would a carbon tax possibly be better than a cap and trade system:
Disclosure: long the global price of carbon and shares of Climate Exchange Plc.
Posted by: Charlie Stromeyer Jr at July 27, 2008 11:58 AM
The peak oil fear mongers are predicting world collapse, but this is a bump in the road of technological progress. Call it the coming Elliot wave,(fire->iron->boats->oil->planes->moon->internet->ai ...)
There may be peak oil, but there is not going to be a peak in energy.
Technological means can access untapped solar, thermal, nuclear energy reserves on decade time scales. The global economy must address the addiction to cheap oil energy and adapt.
The male-investment (global energy resession) in the oil infrastructure must be dismantled, and a new energy source with exponential growth potential must be found. It's just right in front of our faces, and the high oil prices will just hasten the weaning process. Credit will flow when there's energy to supply it. Deflation will come to the oil-dependent sectors of the economy.
With it, will come new energy boom: innovation, monopolization, corruption, speculation, and regulation, like we saw with oil.
This time, it looks like solar (even though I'm not sure of the exact form of distribution) is the next wave. Oil, and it's CO2 warming hydrocarbons, good riddance!
Posted by: Fewlesh at July 27, 2008 12:53 PM
It does look like this recent blip was a bubble that popped. But Randy Miller mentions a mostly not mentioned fundamental that affects rational expectations, namely the probability of war with Iran. That probability just dropped rather sharply a week or so again when Bush sent Undersecretary Burns to meet with Iranians directly in negotiations. That looks like the pinprick that popped the bubble, more than anything else, certainly more than all the mumbling about offshore oil drilling that some politically oriented people are whooping up (although not in this more informed venue).
Posted by: Barkley Rosser at July 27, 2008 01:30 PM
Absolutely. Some of the peak oil doomsters strongly insist that the world of 2040 will be so poor that car ownership will be extremely rare. Nonsense.
Posted by: GK at July 27, 2008 02:28 PM
Tjgje, You articulated several questions that have intrigued me for some time.
Clearly boom/busts are not over. But an increasingly integrated world capitalist economy, an increasingly global labour market, and greater use of new information technologies such as just-in-time inventory techniques should help attenuate the volatility.
Does the authoritarian central planner overcome the time inconsistency problem better than western central banks? Will the Chinese authorities implement discretionary policy better than western authorities?
For one, I suspect the undemocratic nature of the Chinese and similar regimes is highly exaggerated by self-serving western special interests to the extent that public opinion and special interest groups still play a significant role in shaping policy in most authoritarian regimes.
For another, the western banks that have successfully adopted inflation targeting policies are still essentially command and control institutions. The explicit mandate of these central banks has simply been narrowed to price stability after decades of pursuing full employment and similar contradictory objectives.
Will the Chinese make better use of fractional reserve banking more successfully than the questionable performance of western central banks in the recent past? One policy working in the favour of the Chinese are the huge surpluses and foreign currency reserves. The Chinese enjoy considerable latitude to allow the international value of their currency to climb in an attempt to slow exports and increase competition for locally produced goods. Moreover, I'm not aware of Chinese institutions such as independent, powerful trade unions that enjoy the market power to pass along price increases.
I agree that oil prices could possibly decline to the US$20 to $40 range. Pundits and industry analysts claim the current marginal barrel costs over $60/barrel to produce. As that price is cleary endogenous, a multi-year contraction of the global economy could push that marginal cost of oil production much lower.
Posted by: GNP at July 27, 2008 04:55 PM
One of your best posts, James.
One comment: while I completely understand your use of the All Liquids category from IEA Paris (84.6 Mb/day in 2007)--because this is the headline number that most people use--I assume you understand that most of the growth in the last 3-4 years has been in Natural Gas Liquids. Crude Oil only, a breakout category from EIA Washington, is flat now for nearly 3.5 years.
You made your point regardless.
However, as more general statement, because we have no growth in global crude oil supply, and NGL's are specialized, it's a driving force behind the incredible move in coal.
Meanwhile, natural gas remains the last hydrocarbon imprisoned by geography--and without a single, global price.
But that will change.
Posted by: Gregor Macdonald at July 27, 2008 06:35 PM
The USA has a $831 Billion/yr trade deficit, a $711 Billion/yr current account deficit and a federal budget balance in deficit north of $550 Billion/yr... You do not need to be a rocket scientist to know that the dollar exchange rate will continue to disintegrate until the USA gets its act together and again establishes a positive trade balance and a fiscally responsible government. At the rate we have been going, you can certainly expect oil to cost $170/bbl even if oil prices remain stabilized at 80 euros/bbl within 3 years. Add in the inexorable demand growth from Latin America, Russia, Asia and Africa, you can make the sure bet that oil entering the international market for sale will continue to decline indefinitely, and that demand will continue to outpace supply in international markets for several decades until alternative fuels, capital investment, and infrastructure are in place to replace petroleum as a fuel. Remember, it took more than 100 years to build the culture we now run on oil.... Any guesses as to how long it will take to find, adopt, and build the plant and equipment to replace that which now runs on oil? ... I would give it 20 to 30 years under the best of circumstances.
Its a shame too... We saw the handwriting on the wall back in 1973, and have been in denial for the last 35 years. Had we made the sacrifices and investments necessary over the last three decades, the oil crisis would not have occurred in America, and the country would be considerably wealthier than it is now.
Posted by: MarkS at July 27, 2008 07:12 PM
Oops. Small clarification to my above post. It looks like you are using the All Liquids data from EIA Washington. My remarks are not altered, as a result of this. The All Liquids data from both EIA Washington and IEA Paris are basically the same.
As for other remarks upthread, I am personally using the level of 90.00 as the price of the incremental barrel. I realize I am a tad high, and that others--like Statoil--are saying 70-80. However, I think the energy, metals, materials, and labor inputs to produce the new barrel of oil are probably accelerating at least as fast as the oil price. Accordingly, I believe that the EROEI of incremental NG production from North American shale, and, incremental global oil production is declining rapidly. I have little interest in the remarks made by the PEMEX chief. You're never going to get quality analysis from the NOC's. Instead, look at the remarks of the Petrobras (PBR/PBR-A) chief. Surely he is giddy about the Tupi and other offshore discoveries but I suspect he just got his first bill. And that was a bill just for testing. No wonder he is saying that 125.00 is "cheap."
What's the cost of the incremental barrel, and on more thematic level? Take Suncor production off line for the rest of the year, to find out. Or, start a new oil sands project today. Or sit in the shoes of of the Petrobras CEO. See what it will cost PEMEX to bring on a new field.
You get the idea.
Posted by: Gregor Macdonald at July 27, 2008 07:57 PM
What's the cost of an incremental barrel?
Try replacing power plant oil consumption in Mexico and the Middle East with natural gas fired plants (fired by gas currently being flared). Or give cash to Venezuelans instead of 12 cent gasoline. Or provide utility company financing for heating system replacement, with a cost savings guarantee, to New Englanders using heating oil.
Posted by: benamery21 at July 27, 2008 10:10 PM
Gregor Macdonald may be correct.
GNP, I prefer the Austrian business cycle theory over the artificial expansion and contraction of credit induced by modern central banking. However, I don't really know how the Austrian school compares to the contemporary Chinese economy.
This is because the contemporary Chinese economy is unique in world history in various ways. For example, China has had high GDP growth for many years while simultaneously having high unemployment. (Please note that I get my Chinese unemployment estimates from respected Chinese economists because the official statistics from the Chinese government are notoriously unreliable.)
Posted by: Charlie Stromeyer Jr at July 28, 2008 04:21 AM
I can understand the run-up in crude prices in the 18 months or so leading up to the end of 2007. IEA data clearly shows that there was a meaningful demand growth not fully offset by supply during that period. Perhaps crude went up too fast, perhaps too slow, but regardless it was supportive of higher prices.
What I do not get, and which I have yet to find a plausible explanation is the run-up in crude in 2Q08 when demand had moderated visibly in 1Q08 with supplies being adequate.
To keep in context, oil ran from $60 to $100 in 2007 alone on demand strength. Yet, in 2Q this year, oil spiked up from $100 to $145 on supply exceeding demand in 1Q08... and 2Q didn;t look to be a massive reversal back to strong demand, certainly not enough to explain a 45% spike in one quarter from elevated prices.
While I have no doubt that the future clearing price of oil one day could very well touch $200/bbl, in the near term (next 3-6 months) it won't be surprising if oil tracks back down to $100 either.
Posted by: Francis at July 28, 2008 08:05 AM
Re: Peak Oil
Its not so much that the world is running out of oil, its that it is running out of cheap oil. USD dollar devalutaion and the increasing real costs of bringing more oil to market makes rising real prices inevitable even if demand is temporarily slowed through slowing economic growth.
One gets a better sense of the long term price trends if the price of oil is charted vs. the Swiss Franc or other stable measure of value.
Call me cynical, but the pattern after an oil price shock in the US, is for gasoline price at the pumps to recede before an election (a la 2006)... we can't have an angry electorate when all the congressmen are trying to be reelected.
China and Japan hold the fate of the USD in their hands as both have larger reserves than the US federal reserve. At some point in time, China may decide to "dump" their USD but that would be a planned event and would be preceded by the Chinese discreetly purchasing hard assets beforehand.
Posted by: Broxburnboy at July 28, 2008 08:19 AM
Why would a carbon tax possibly be better than a cap and trade system
In theory they should be the same. In practice, cap-and-trade makes it a lot easier for the politicians to interfere and provide economic cover to their patrons.
Posted by: Dan Weber at July 28, 2008 09:09 AM
Broxburnboy, it is no discreet secret that the Chinese have been buying up hard assets like crazy, especially in places like Africa:
Disclosure: long various funds which invest in Africa.
Posted by: Charlie Stromeyer Jr at July 28, 2008 09:16 AM
Reply to Dan Weber
Yes, I'm aware of the Chinese buying hard assets. I think they will restrain the big dump until the US has exhausted personal savings and public credit which have driven the export boom to the US and the subsequent accumulation or US dollars.
China, Japan and all other holders of petro and war dollars have been buying up hard assets, but I believe there will come a time when the trickle becomes a flood... probably at the bottom of the credit collapse, when the dollars will come home to buy US real estate and equities.
disclosure: I have sold all my US equities and hedged my international holdings with exposure to precious metals.
Posted by: Broxburnboy at July 28, 2008 09:33 AM
Broxburnboy, you may be correct. I too am long precious metals and related equities.
Dan Weber, I don't like the idea of a carbon tax for 4 reasons:
1) I don't trust politicians with taxes. For example, how would they know how high to make the tax?
2) A tax doesn't provide the certain pollution reductions offered by a cap because a tax doesn't impose a legal limit.
3) A cap would create a marketplace in which anyone who can reduce levels of atmospheric carbon can sell those reductions for a profit.
Posted by: Charlie Stromeyer Jr at July 28, 2008 09:44 AM
Posted by: Fat Man at July 28, 2008 12:48 PM
Thanks for the link, Fat Man. Also, I see that I forgot to mention the 4th reason why I don't like the idea of a carbon tax:
4) A cap would more unleash the creativity of the private sector whereas a tax is more like a government mandate.
Posted by: Charlie Stromeyer Jr at July 28, 2008 01:12 PM
This is a great post and it strikes right at the heart of environmentalists who whine about US oil consumption. These naive dreamers think that they can stop people from consuming just because they want to go camping in the great outdoors. Bad news boys. China ain't gonna' stop.
But the success of the environmentalists can bring the US economy lower as China continues to boom. Is that the real solution to the problem?
In truth there is only one solution. Let my market go!! We need production of oil, production of coal, production of natural gas, production of nuclear, production of ethanol, production of solar, production of wind power, production of geothermal, production of water power, and production of forms of energy we don't even know about today. The only way that we will compete and the only way that we will actually clean up the environment from dirty fuel is to let the market produce. Any restriction on the production of the most efficient fuels is utter insanity, but recently I have met a lot of insane people.
Posted by: DickF at July 28, 2008 03:33 PM
I saw a very interesting statistics around March this year which depicted clearly that the incremental demand growth for oil was almost exclusively driven by countries with domestic oil/fuel subsidies (China alone was almost 3/4 of it all).
Since then we have seen OECD demand continued to deteriorate, and oil subsidizing nations all finding the cost of subsidies becoming to much of burden. India, Bangladesh, Taiwan, Malaysia, Indonesia, etc. have all either reduced subsidies or are in the process of eliminating them altogether.
China is the 800-lb gorilla out there and even then the country has recently raised domestic fuel prices, but perhaps not enough to create demand destruction given pent up demand.
Outside of a severe supply side shock, it seems that in the near term, the chances of oil returning to $100 is more reasonable than returning to the recent highs of $145 (I continue to struggle to find a rationale for oil jumping from $100 to $145 in 2Q08).
Posted by: Francis at July 28, 2008 05:57 PM
Article by Cordell Hicks:
Best summary of factors propping up oil prices I have read.
Posted by: Broxburnboy at July 29, 2008 09:00 AM
That brings us back to the 70's / 80's, the only comparable period from a price escalation perspective. But prices rose then due to politically driven scarcity, not real or perceived tight supply.
1990 also had a similar price increase and decline in consumption, in August, just before the year long recession in the US.
Posted by: aaron at July 29, 2008 11:20 AM
The crisis that looms for the US is the loss of the world’s currency role, now being replaced by oil.
How do you interpret Hicks' statement above?
Here is a hint. Oil is not a currency. It is priced in dollars. Now oil producers could choose to replace the dollar with some other currency, for example oil could be priced in euros or renminbi, but to say that oil will replace the dollar as the reserve currency demonstrates a serious lack of understanding currency.
Posted by: DickF at July 29, 2008 02:11 PM