May 08, 2011
Lower oil prices
Like a roller coaster ride, 2011 saw oil prices climb gradually, only to fall dramatically this last week. Here I offer my thoughts on some of the key contributing factors.
Let's begin with the relation between oil prices and the exchange rate. If the dollar depreciates by 1%, the dollar price of oil would have to go up 1% to keep the price paid outside the United States constant. This is a bit simplistic, one reason being that there is usually some third factor, such as a rise in incomes outside the United States, that is causing a change in both real oil prices and the exchange rate. Different factors affect the two series differently, so one might see a 1% depreciation correspond to an increase in dollar oil prices of more or less than 1%, or sometimes even an oil price decline. Between September 2009 and September 2010, a 1% depreciation of the exchange rate was associated on average with a 1.3% increase in the dollar price of commodities like oil or copper. The dollar rose about 3.5% against the euro between Wednesday and Friday, and the 4.5% decline in the price of copper could be pretty well explained by the exchange rate alone based on the recent correlations (3.5 x 1.3 = 4.5). But something more is involved in the 11% drop in the dollar price of crude oil observed those same two days.
Looking at the broader trend, the price of oil shot up 19% in February and March, during which the dollar depreciated against the euro by only 3%. The exchange rate can account for only a small part of recent movements in the price of oil.
What I believe should instead be the first place to begin any discussion of recent oil prices is the broader global trend of supply and demand. The graph below plots world oil consumption over the last 15 years. This increased by 7.3 million barrels per day between 2000 and 2005, but by only 1.2 mb/d between 2005 and 2010. But very importantly, consumption by China increased by 1.7 mb/d between 2005 and 2010.
Please note the necessary implications of this arithmetic: if China is consuming 1.7 mb/d more, but the world as a whole is only consuming 1.2 mb/d more, that means that people outside of China, as a group, have decreased our consumption by 500,000 b/d over the last 5 years. And the first question to ask anybody who claims that the price of oil has been "too high" recently, is, how much of a price increase do you think would have been necessary to persuade consumers outside of China to reduce consumption by a half-million barrels per day over a five-year period?
I've been talking about global consumption, though the EIA also reports data on world production. It's not accurate to conclude that if reported production exceeds reported consumption, then there must be excess supply with the difference going into inventories somewhere. The two series are collected from different sources, and the difference between reported production and reported consumption is often just reflecting errors in measuring the two series. But it's interesting to note that, from production data, it looks as if we're finally lifting above the five-year plateau, with the latest production figures showing significant increases relative to 2005 in countries such as the U.S., Brazil, Russia, Angola, Iraq, Azerbaijan, China, and Canada far in excess of the declines in the North Sea, Mexico, Venezuela, Indonesia, and Saudi Arabia over that period.
We can also look at direct oil inventory data for the United States. The black curve in the figure below plots the average seasonal behavior of U.S. crude oil inventories. The green curve gives the values for 2008. Inventories were significantly below normal in the first half of that year, making it difficult to insist that the price at that time, though rising quickly and very high by historical standards, was higher than it needed to be to keep demand from outstripping supply. By contrast, the orange curve (2011 data) indicates that current inventories are currently well above normal, suggesting that, particularly given the recent production gains, a lower price would likely be consistent with the quantity consumed being equal to the quantity produced.
I believe that events in Libya had been a key driver of the price of oil over the last few months. The country produced about 2% of total world supplies last fall. If one assumes a short-run price elasticity of demand of 0.1, that would warrant a 20% price increase if those supplies were knocked out and no one else had the excess capacity to replace them. Not all of Libyan production has been lost, but on the other hand, I have heard some analysts claim that Libya accounted for 15% of current light sweet production, where the real crunch has been recently.
The political currents recently manifest in North Africa could still easily spread to other key oil-producing countries. But if that does not happen, then with the likely response of consumers to the still-high price, and the promising near-term production gains, it is possible that this week's dramatic oil price declines are only the beginning.
In terms of what this means for American consumers, each $1/barrel change in the price of oil usually translates into 2.5 cents per gallon of gasoline at the pump. With the price of oil now down $16 from its peak, that might mean a drop of 40 cents per gallon in the retail price of gasoline.
Posted by James Hamilton at May 8, 2011 10:09 AMdigg this | reddit
Over the long run market prices will reflect the risk of a supply disruption that will overwhelm spare capacity and the ability of producers to bring on new production to make up any shortfall. The problem is that with no new supply solution in the cards the only way for prices to decline is to have a price increase force marginal users out of the market and create economic contractions. This means that until a new source of cheap energy is found we cannot have a healthy economy without very high oil prices. It also means that the predictions made by CERA, EIA, and IEA a decade ago are totally discredited and any assumptions that they make need to be supported with logic and actual evidence.
Posted by: Vangel at May 8, 2011 10:58 AM
Are not here to stay.
Posted by: Ivars at May 8, 2011 12:40 PM
Regarding short term oil prices versus average annual oil prices, I frequently use the example of a salesman, who makes a living off commissions. He had a good month in January, with a $50,000 commission check, but his average monthly commission for the entire year was $20,000. What is a better indication of his annual income, the $50,000 peak or the $20,000 monthly average?
In a similar fashion, I think that average annual oil prices and production give us the best indication of fundamental supply & demand factors.
Here is a chart of annual US spot crude oil prices:
And here are the annual spot crude oil prices and year over year exponential rates of change for 1998 to 2010:
1998: $14 (-41%/year)
1999: $19 (+31%/year)
2000: $30 (+46%/year)
2001: $26 (-14%/year)
2002: $26 (0)
2003: $31 (+18%/year)
2004: $42 (+30%/year)
2005: $57 (+31%/year)
2006: $66 (+15%/year)
2007: $72 (+9%/year)
2008: $100 (+33%/year)
2009: $62 (-49%/year)
2010: $79 (+24%/year)
We have nine years showing positive year over year rates of change, and the median is +24%/year, within a range from +9%/year to +46%/year.
Assuming that 2011 does show a year over year increase over 2010, based on these numbers, we would expect to see an average annual price for 2011 between $86 and $125, with a median expectation of about $100, which is the approximate average to date for 2011.
And following are what we show for global net oil exports for 2002 to 2009 (oil exporters with net oil exports of 100,000 bpd or more in 2005, which account for 99% plus of global net oil exports).
Note that global net oil exports increased at about 5%/year from 2002 to 2005, and then we had flat to declining global net oil exports. I suspect that this inflection point was quite a shock to oil importing countries, especially developed oil importing countries.
Also shown are Chindia's combined net oil imports. The difference between the two is what I define as Available Net Oil Exports (ANE), i.e., global net oil exports not consumed by Chindia.
As you can see, ANE fell from 40.8 mbpd in 2005 to 35.7 mbpd in 2009. A plausible estimate is that ANE could be down to about 27 - 30 mbpd by 2015.
Global Net Oil Exports Less Chindia’s Combined Net Oil Imports = ANE
(BP + Minor EIA data, mbpd, total petroleum liquids):
2002: 39 - 3.5* = 35.5 (ANE)
2003: 42 - 4.0 = 37.4
2004: 45 - 5.1 = 39.9
2005: 46 - 5.2 = 40.8
2006: 46 - 5.5 = 40.5
2007: 45 - 6.1 = 38.9
2008: 45 - 6.6 = 38.4
2009: 43 - 7.3 = 35.7
*Chindia's combined net oil imports
This table shows the detailed data for 2005 to 2009: http://i1095.photobucket.com/albums/i475/westexas/Slide3-1.jpg
For more info, do a Google Search for: Peak Oil Versus Peak Exports.
Posted by: Jeffrey J. Brown at May 8, 2011 02:59 PM
Regarding US crude oil inventories, I am reminded of the old joke about the drunk looking for his keys, under a streetlight, late at night. He lost his keys down the street, but the light was better under the streetlight.
In a similar fashion, we (presumably) have great oil data in the US, but that is not where consumption is increasing. Weak demand in the US is not a new story, since our oil consumption probably peaked for good in 2005.
As I have previously noted, our work suggests that the US is well on its way to "freedom" from our dependence on foreign sources of oil, as we are outbid by developing countries for access to declining volumes of global net oil exports.
Posted by: Jeffrey J. Brown at May 8, 2011 03:13 PM
EIA STEO last three months 2012 vs last three months 2010:
US: -0.7 mbpd (collapse of the Gulf)
China: +0.2 (very mature producer)
Canada: +0.2 (declining convention vs increasing oil sands)
Other non-OECD: +0.6
OPEC: up 2.9 mbpd
of which, NGLs: +0.9 mbpd
Angola is producing less than it did in 2008.
Brazil has a steady growth policy. They could do more, but that 0.2 mbpd / year is about what can be expected under current government policy. Iraq could over-perform, +300 kpbd this year compared to recent expectations (Mission Accomplished!).
If you're looking for production growth, in the eyes of the EIA, it's all OPEC, all the time. Nevertheless, without Saudi Arabia, it's hard to see where the production growth comes from.
On the other hand, the carrying capacity of the US is around $90; China, about $105 / barrel. So if Brent's at $125, it's not clear prices are sustainable.
But we're missing a piece of theory here concerning how prices depart from fundamentals. We can say there's no speculation, and maybe there's not. But how then do prices exceed the carrying capacity of China, the price setter on the demand side? In theory, that shouldn't be possible. And yet it is, to all appearances.
Posted by: Steven Kopits at May 8, 2011 07:15 PM
>>the carrying capacity of the US is around $90; China, about $105 / barrel.
Are both of these numbers your calculation of 4% of GDP? Or something else?
Posted by: New Deal democrat at May 9, 2011 03:33 AM
I think that you misplaced a tense in the sentence "it looks as if we're finally lifting above the five-year plateau". It should read "we were"!
Obviously with the bulk of Libyan production, and more crucially, exports, knocked out for the time being, this is no longer operative.
Posted by: dan at May 9, 2011 03:36 AM
Please tell me how and why the oil commodity price today affects the gas price today.
Posted by: Gaelan Clark at May 9, 2011 04:48 AM
Gaelan Clark: The effect is not immediate, but may take several weeks. It occurs because crude oil is the most important factor in the cost of gasoline. Look at a plot or any statistical analysis of the two series and you will see why I make the statement I do.
Posted by: JDH at May 9, 2011 06:11 AM
dan: Production between Nov 2010 and Jan 2011 is enough above 2005 levels that you can subtract out all of Libya and still come out ahead.
Posted by: JDH at May 9, 2011 06:14 AM
With the death of Usama bin Laden and a decline in foreign involvement in Lybia much of the global risk premium has been removed from the price of oil.
The real question is whether the rise in the price of gold confirming the higher oil price is a lasting rise. Gold is reacting to the end of QEII and appears to be anticipating the FED will have to enter into some kind of policy that to keep interest rates down. The worst thing that could happen to the deficit is for interest rates to return to normal, but then there is the inflation factor. That is being confirmed by both the decline in the dollar against the euro and the price of gold.
Once again we see that the FED has painted itself into a corner. Bad policy can do that. The FED sees only two options, both bad: return to QE and risk greater stagflation, or reduce QE and watch interest rates destroy the federal budget.
Through all of this congress is getting a pass. Congress is the key and could solve the whole problem tomorrow, but they are more interested in saving Cowboy Poetry or if the Republicans are ever going to cut Social Security or Medicare, or anything for that matter.
Our government is flailing like a dying fish when the solution is simple and obvious ... that is to anyone but mainstream economists and politicians (is there a difference?)
Posted by: Ricardo at May 9, 2011 06:25 AM
Note the discussion of Chinese inventories:
JPMorgan raises oil price forecasts to US$120 a barrel
JPMorgan Chase & Co raised its oil price forecasts because Organisation of Petroleum Exporting Countries (Opec) and other producers aren't matching rising demand and consumers will take time to react to higher prices. . .
While the bank lowered its estimate of world demand by 100,000 barrels a day, in part because of the earthquake-led disruptions in Japan, it raised its forecast for Chinese consumption, saying data implies China's crude-oil inventories have been “drawn heavily” in the past six months . . .
“We continue to believe that the oil supply-demand fundamentals will tighten further over the course of this year, and likely reach critically tight levels by early next year should Libyan oil supplies remain off the market,” it said.
Posted by: Jeffrey J. Brown at May 9, 2011 06:47 AM
Question: Do we have any idea at what oil price thresholds either Europe or some emerging economies are likely to go into recession?
Steve Kopitis: What you mean by saying the 'carrying capacity' for China occurs when oil sells at $105/bbl?
Posted by: westslope at May 9, 2011 07:09 AM
You cannot look at the events of last Friday, and the price of oil over the last 2 years and not conclude that speculation has been the primary driver.
Why is it so hard for an economics professor to start with the basics of supply and demand. Supply is determined by the marginal cost of production.
Good god man this is economics 101. Hell, maybe it's econ 1. And yet in all of these posts there has not been one attempt to estimate what the MC for oil actually is.
Frankly it's almost comical.
The assumption that in the short run supply is fixed is questionable at best in this market given inventory supplies and the ability of many players to adjust production quickly.
So we see the market for oil go from 157 to 35 to 110 and then decline to 100 in ONE DAY, and the professor still hasn't asked about the marginal cost of production. In fact, it is pretty clear that the marginal cost of production hasn't changed a dime in all of this.
To be usefull, economics must start by asking if the assumptions on which it is based can be confirmed in the real world. Its failure over the last 4 years are manifest to everyone.
And I would argue that this post is another example of that.
Posted by: Fladem at May 9, 2011 08:42 AM
New Deal, Westslope -
Yes, US carrying capacity is as determined by the 4% Rule, which gives about $90.
For China, the carrying capacity appears to be in the 5-6% of GDP range, equaling around $100-105. I would note that there is considerable volatility in the Chinese ratio, but the differential to the US ($10-15) is reasonably consistent with earlier estimates from Francisco Blanch of BoA/ML.
Consequently, at $125, I would expect Chinese consumption to stagnate at a minimum. That number should also be sufficient, based on the 4% Rule, to put the US into recession outright.
Posted by: Steven Kopits at May 9, 2011 09:49 AM
Fladem: You're exactly right that the issue is marginal, not average cost. By marginal cost, what we mean is, what is the additional expenditure necessary to bring an additional barrel of oil to a Gulf Coast oil refinery. This is very different from the cost of existing production, but is instead the cost of getting an extra, say million barrels per day of production beyond what is currently being produced delivered where it is needed. I would describe the marginal producer today as Canadian oil sands-- a bigger daily production flow is clearly possible there, but it will cost you something to get it. Additional production means getting additional labor, capital, and transportation infrastructure. My impression is that producers are facing quite steeply upward-sloping cost schedules for all three at the moment.
So the critical question is, what exactly do the marginal cost numbers you wish to cite refer to, and how exactly are they calculated?
Posted by: JDH at May 9, 2011 10:23 AM
So, it turns out that the Saudis were right after all that there is a lot of oil sloshing around out there and were justified in their production cut. Maybe it was not because of production limits being hit after all.
Posted by: Barkley Rosser at May 9, 2011 10:47 AM
If you take the 4% Rule (6% for China), then oil prices at $125 will lead to excess supply due to falling demand.
If you cut production into this price scenario, as Saudi claimed to have done, then you are attempting to maintain prices through supply restriction leading to demand destruction--you are acting as a defacto monopolist, which, in terms of global spare capacity, Saudi Arabia is.
But I think the interpretation is still more likely political than anything else. It's not business, it's personal.
Posted by: Steven Kopits at May 9, 2011 11:06 AM
Just another reminder that we now into the sixth year of Saudi production and net export cuts, relative to their 2005 production and net export rates, because of a persistent inability to find buyers for all of their oil:
Saudi Net Oil Exports Versus US Oil Prices2002-2010 (EIA, Total Petroleum Liquids)
2002: 7.1 mbpd & $26
2003: 8.3 mbpd & $31
2004: 8.6 mbpd & $42
2005: 9.1 mbpd & $57
2006: 8.4 mbpd & $66
2007: 8.0 mbpd & $72
2008: 8.4 mbpd & $100
2009: 7.3 mbpd & $62
2010: 7.6* mbpd & $79*
As I previously noted, in a similar fashion in my opinion, Texas started "having problems finding buyers" in 1973.
Posted by: Jeffrey J. Brown at May 9, 2011 11:46 AM
You are assuming an immediate impact on prices of any announced supply changes. Bringing on or shutting in extra supply make take weeks. Even then, it may take months or for consumers to full absorb price changes and change behaviour. The Saudis could be forecasting an oversupplied market and are starting to prepare for that event. Lags between policy decisions and price impacts (if any) could be significant.
Or the message could be a unique way of cheap-talking the market into bidding oil prices lower because regardless of how much extra oil capacity Saudi Arabia truly possesses, it unlikely possesses enough capacity to offset the shock to perceived scarcity experienced following the Arab Spring/Awakening/Civil revolt.
Referring to Saudi Arabia's alleged pricing power as monopoly power is simply wrong. Recent history has amply demonstrated to what extent the Saudis have failed to determine the price of oil. At best the Saudis have had a moderating influence on the price of oil over the years. Note that the Saudi can only discipline fellow OPEC members by increasing supply and punishing them with lower oil prices.
Or maybe Saudi leaders wish not to lose face and reveal just how few extra barrels exist? That news could send oil prices flying much higher.
In the meantime, domestic policy reform can help accelerate the process of reducing the total social cost of energy use by tacking on high taxes: excise and carbon. Finger-pointing Saudi Arabia is counter-productive. Besides they buy lots of US-made weapon systems.
In short order the swing-producer will become Russia.
Posted by: westslope at May 9, 2011 12:39 PM
JDH - So at least you are attempting to answer the question.
But you avoiding two salient facts:
1. When oil was 35 there was plenty of production.
2. You assume that the Saudi's marginal cost is higher than the Canadian Tar sands.
Do you have any evidence for you assumption?
Posted by: fladem at May 9, 2011 01:37 PM
fladem at May 9, 2011 01:37 PM:
You're still missing the point. There was a big rightward shift of the demand curve between 2005 and 2011, but little increased production. If supply intersected demand at $35/barrel in 2004, there is no way you can logically argue that supply should still intersect demand at $35/barrel in 2011.
I don't know the Saudis' marginal cost of bringing more production online. Econbrowser has discussed what's really going on there at length before, e.g., , , . As you'll see from that analysis, while it may at one time have been appropriate to view Saudi Arabia as the marginal producer in the sense that that is where the next 1 mb/d would come from, I'm quite persuaded that's not the correct assumption to make at the moment. I repeat, if you want to talk about the marginal barrel of oil, the best particular to have in mind is increasing the daily output from Canadian oil sands.
Posted by: JDH at May 9, 2011 01:51 PM
Canada to the rescue?
Canadian & Venezuelan net oil exports, 1998 to 2009, and their combined net oil exports (BP, Total Petroleum Liquids):
We would have needed the net export increase of more than three Canadas, from 2005 to 2009, just to meet the 2005 to 2009 increase in domestic consumption in Saudi Arabia.
Posted by: Jeffrey J. Brown at May 9, 2011 01:58 PM
Jeffrey J. Brown at May 9, 2011 11:46 AM: That's exactly my point. Canadian production could increase, but at a sharply rising marginal cost per barrel, particularly if you want to get several million b/d increase.
Posted by: JDH at May 9, 2011 02:02 PM
I think production has been slow to come on for fear that Saudi could produce much more than it does. At what price would Saudi look for additional productivity (ie, look for new fields) to make up for revenue shortfalls?
Posted by: aaron at May 9, 2011 02:06 PM
So far, slowly rising unconventional production, e.g., from Canada, has not been sufficient to offset the decline in conventional production, post-2005, resulting in global annual crude oil production for 2006 to 2010 inclusive being at or below the 74 mbpd (C+C) rate that we saw in 2005.
And of course, as shown above, we have seen measurable declines in global net oil exports (total petroleum liquids), post-2005.
Posted by: Jeffrey J. Brown at May 9, 2011 02:14 PM
Aaron - I am in the oil business every day: there is no fear of Saudi.
Fladem - Yes, there was plenty of oil at $35. There isn't now. It's what we call 'peak oil'.
Saudis marginal cost of oil is still probably in the $20-40 range. (Maybe Jeffrey's going to disagree with that...) But will they produce it? Doesn't look so right now; nor is it clear they will pump it at a reasonable price (from the consumer's point of view) without the pressure of competition.
Oil sands are probably good at $65. Most everything is. That's not the problem. The problem is that these things take a long time to bring online, and they're not coming on fast enough to displace natural declines. So right now, the oil industry is more or less just staying even. See the scariest slide I ever drafted here (slide 11): http://ourfiniteworld.com/2011/03/03/steven-kopits-oil-the-economy-and-policy/
And Russia will not become the swing producer. What do you think that Rosneft / BP stuff is all about? It's about going to the Arctic. Why do you think they have to go there? Maybe because the western Siberian fields are mature?
So there's nothing really clever going on. We just have enormous demand, primarily from the emerging economies; and limited supply. Or as a former boss of mine said: "It's all supply and demand. Economics has nothing to do with it."
Posted by: Steven Kopits at May 9, 2011 03:42 PM
fladem: From memory, the cost of a Canadian oilsands barrel on the margin exceeds $75/barrel. The Saudis can lift light sweet for under $10/bbl and the heavier stuff for closer to $20/bbl if memory serves though I'm guessing that true marginal costs of both Saudi light and heavy crude are much higherl unless the Kingdom is deliberately keeping barrels in the ground. The Saudis may still be nominally the 'swing producer' but barrels on the margin live in the Canadian oilsands as JDH suggests as well as in the massive heavy oil belts found in South America and elsewhere. In situ extraction as well as heat dispersal techniques and horizontal drilling promise to lower those marginal costs by increasing expected ultimate recovery (EUR) rates.
JDH: To quibble and hopefully clarify: as it stands and in response to business plans determined with lower oil price forecasts, oilsands production has been increasing and will continue to increase as business plans are implemented.
Much higher oil prices could very well lead to an increase in the rate of production growth. Except, in the specific case of the Canadian bitumen, other factors than simply forecast operating costs are starting to intervene and constrain the pace of expansion: tight labour markets, environmental costs, zoning restrictions, land set-asides. Some of these constraints are increasingly binding, and not easy to substitute.
Higher oil prices should noticeably accelerate the pace of heavy oil exploration and development in places like the Venezuela-Colombia-Ecaduor-Peru heavy oil belt where property rights regimes are relatively stable but infrastructure and access difficulties contribute to high costs.
Posted by: westslope at May 9, 2011 04:43 PM
Once conventional oil production peaks in a given region, in most cases there may not be an oil price that can keep conventional oil production on an upward slope.
The Texas & North Sea peaks (1972 and 1999 respectively), with production on the horizontal axes and oil prices on the vertical axes:
Posted by: Jeffrey J. Brown at May 10, 2011 01:24 PM
Tell me, is the speculator the buyer or the seller?
Is he the oil producer selling an oil futures contract or the buyer of the contract?
Is he the farmer selling the wheat futures contract or the buyer of that contract?
Posted by: Ricardo at May 11, 2011 06:10 AM
That's good to hear, I think. It should mean accelerated production everywhere.
What would happen if Saud discovered another large reserve? How quickly would capacity come online?
Posted by: aaron at May 11, 2011 10:28 AM
You are correct that China's oil consumption has increased, while since 2005 the US and other countries have had a decrease in oil consumption.
What you are not aware of? Two things:
1) The US and global European industrial countries have EPA or state environmental laws that demand environmental pollution controls. And this causes a decrease in consumption.
In other parts of the world, that might mean nuclear plant increased capacity on-line, for highest and best use.
2)In the USA, we have substitution with another form of energy, called natural gas. According to OGJ.org, if you have been reading for the last seven years, you would have known that natural gas has increased in US power plants for cleaner energy, causing oil use to decrease, with less air pollution cost equipment because of EPA laws.
Another factor you have not discussed in the overall oil prices and consumption and dollar exchange rates? Arab oil is purchased in dollars. And of course, they have to raise the price of oil to compensate for our dollar exchange rate. Your figures from the IEA global oil and gas demand and usage figures are only as good as the reporting to that global institution for accuracy.In 2005-6. W Bush would not release figures to the IEA, but had Director Sam Bodman of our DOE was producing his own! (The GAO had a 2005-6 report about this infighting for figures.)
By the way, oil prices might not be tied to the dollar if Chavez (Venezuela) and the Saudis get their way. These oil producers want a dual basket, or the EURO as an additional currency with which to buy and sell oil with. Thatb would alter the demand for the dollar, you think?!
Posted by: theloneconsumer at July 4, 2011 01:16 PM