More Theories on Oil Prices and (Declining) Prospects

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It’s remarkable how certain words elicit knee-jerk reactions. Take “speculation”. I’ve questioned the prevailing view that an price increase of nearly 50% in six months in crude oil prices is entirely a function of demand (meaning immediate consumption, the kind most economists think of when they draw demand curves) and supply. That is partly because I think it’s more useful to test conventional wisdom that accept it, and in part because most of the time when you get sudden adoption of a new thesis, it’s generally overdone.

In fact, one of the writers featured today points out the widely overlooked fact that Goldman’s touted “oil is going to $150 to $200 a barrel” report predicts that after a “super-spike” the price of oil will fall in 2012 to $75 a barrel normalized.

Mind you, saying the run up may not be entirely a function of supply and demand seems to be misread as a statement that the increase is due entirely to speculation. And this blog was bringing up Peak Oil before it was fashionable, so we are not Peak Oil deniers.

Today we have a variety of alternate views on the oil price phenomenon, some provided by readers. On one end of the spectrum, we have John Dizard of the Financial Times. One of Dizard’s endearing features is that he is attached to no particular view about anything, save deep cynicism of the workings of the world of markets. I put the provocative part in bold. From the Financial Times:

The political reaction to high prices is most likely to lead to legislated changes in commodities markets regulation in the US and elsewhere. I am fairly certain that the changes will take effect after the coming decline in commodities prices.

I say decline because there always is one, and the late-stage political reaction suggests it is coming soon….

In the oil market, specifically, the CFTC stated: “… there is no evidence that position changes by speculators precede price changes for crude oil futures contracts . . . Commercial trader group positions are those found to significantly precede crude oil futures price changes.”

Furthermore, the Commission’s staff found: “The recent crude oil price increases have occurred with no significant change in net speculative positions.”

This is not to say, in my view, and of others, that today’s oil prices reflect the economics of marginal supply and demand. There are people out there who have bought physical oil and stored it so as to sell it in the future. But the real commodities buying frenzy has been defensive buying by consumers, government stockpilers, and processors trying to protect themselves from the adverse effects of future price increases.

Eugen Weinberg, a commodities specialist with Commerzbank, who thinks we are in the late stages of a bubble, says: “At the moment we have big inventories worldwide, about 3.5bn barrels in the OECD countries, which does not include China. That is enough so that if Saudi Arabia stopped exporting, the world could run at its present level of demand for a year and a half with no increases in production from other countries.”

You don’t have to buy the evil-specs-caused-all-this argument to believe there are problems with the way parts of the commodities markets work. As Mr Weinberg points out: “The West Texas Intermediate oil contract, based on delivery in Cushing, Oklahoma, is good for 300,000-400,000 barrels per day. The storage capacity in Cushing is about 20.5m barrels. The trading volume on which that is based is between 500m and 600m barrels per day. If you are going to manipulate the price, you would think about doing that in Cushing.”

This claim makes John Mauldin’s report from George Friedman of Stratfor that tankers are full of crude in a gamble on further price rises seem, well, trivial.

Reader Rajiv sent a link to the testimony of Philip Verlegger, a well regarded energy consultant and visiting fellow at the Institute of International Economics before the Senate Committees on Homeland Security and Energy and Natural Resources last December. Verlegger’s remarks ran to 20 pages. The two parts that diverged most from conventional thinking was that the the Strategic Petroleum Reserve’s purchases were having a marked impact on oil prices and most observers were completely misreading the significance of inventory rises and falls. First, a summary of his argument on the Strategic Oil Reserve:

…the rise in light sweet crude prices to almost $100 per barrel in November came about because the U.S. Department of Energy has been removing a significant share of the daily volume of this type of crude from the market for storage in the Strategic Petroleum Reserve. The volumes have amounted to as much as 0.3 percent of the global supply of light sweet crude available. DOE’s actions may have added as much as 10 percent to the light sweet crude price, given the very low estimated price elasticity of demand for crude and the likely even lower price elasticity of demand for light sweet crude. This conclusion is supported by the fact that producers of sour crude oils such as Saudi Arabia have had to institute price cuts of as much as $10 per barrel for sour crude.

Verlegger presents his case in considerable detail: how tightened environmental standards have increased demand for light, sweet crude and how it therefore has much lower demand elasticity than crude in general. Thus comparatively small change in demand can produce large price moves. He also thought demand from India and China did not contribute to the price rise.

Consider this statement, which although now six months old, was after a price increase in WTI from $70 in the late summer to $100 in early December, seems to support the Saudi claim that they don’t see enough demand to warrant lifting more oil:

Each month the Saudi oil company, Aramco, announces a differential to WTI for firms buying Saudi crude for delivery to the United States in that month. For example, buyers lifting Arab Light Crude from Saudi Arabia this month will pay the WTI price that prevails 50 days from now less $11.65. (The delay allows for the oil’s transit time from Saudi Arabia to the United States.) Aramco adjusts this differential every month to reflect changes in market conditions.

As can be seen from Figure 3 (page 5), the differential set by Saudi Arabia for oil loaded in August was $2.15 per barrel. Five months later, the Saudis boosted the discount to $11.65. As every shopper knows, discounts do not deepen when supplies are tight. Rather, they increase when goods do not sell. Apparently, Saudi Arabia has been having trouble selling its oil.

The Saudis dropped prices when WTI prices were rising.

What I found most intriguing was his view of inventories:

[U.S. Energy Secretary]Bodman’s statement makes it sound as if commercial inventories will increase if OPEC boosts production. But doesn’t something else have to happen for this to occur? Don’t companies have to agree to buy the oil Suppose, given the current financial crisis, that companies choose not to buy the oil? What happens then?

The data demonstrate that companies accumulate incremental stocks oil only if it is profitable to do so. Since May, it has not been profitable. Since May, companies have been dumping stocks….

Returns to storage will be a new concept here because, to my knowledge, neither the Energy Information Administration nor
any other organization follows the idea. However, the concept goes back to John Maynard Keynes, who, whatever his other vices, was one of the world’s great commodity traders. Returns to storage measure the financial return earned by purchasing a physical unit of a commodity, selling a future for delivery at a later date, and storing the commodity. If, for example, one buys crude for $50 per barrel and sells a future for delivery a year hence at $100 per barrel, one earns a return of 100 percent. The trade, referred to as cash and carry, can be very profitable…..

Figure 8 shows that returns to storage for crude oil were positive through the second half of 2006 and the first half of 2007. Since the end of May 2007, though, returns have been negative. Logically, one would expect stocks to have accumulated during the second half of 2006 and the first half of 2007 and then be liquidated from June 2007 forward. The data on inventory accumulation and liquidation confirm this hypothesis. Figure 9 shows that stocks tend to rise with positive returns and decline when returns are negative…..

The explanation for this effect is quite simple. Financial officers of firms holding oil stocks have a wide number of options. They can invest their cash in commercial paper, Treasury bills, or inventories. They can even borrow to acquire additional stocks. Their decisions are driven by the returns offered by various instruments. This finding, while intuitively obvious, seems to have escaped many who follow the oil market. Recently, though, the financial market’s effect on oil and the rest of the economy has become painfully apparent. In particular, the subprime crisis has caused many lenders to withdraw from the commercial paper market. In turn, the cost of borrowing has increased, raising the cost of holding oil stocks. At the same time, buyers who had lifted forward prices to a premium over cash prices have liquidated positions, in part to obtain cash. This has made it expensive to hold inventories and so stocks have dropped.

This view runs the polar opposite of prevailing thought that inventories are a function of supply and demand. This view instead says they reflect the cost of money and alternate investment opportunities. And with the cost of money high, holding inventories is expensive. Hence, low inventories.

Now to a sighting from Daniel Yergin in the Financial Times, “Oil has reached a turning point.” Interestingly, Yergin contends that the immediate supply problems have more to do with political instability and long investment lead times and higher general development costs due to scarcity of talent and supplies than played-out oil fields:

What is now unfolding is an oil shock. The fact that the world could take $80 in its stride in the context of strong economic growth does not mean that a price that is 60 per cent higher at a time of a credit crunch will be so easily assimilated. The economic toll is mounting….

Oil supply, one might think, should be responding. Yet there are three obstacles. The first is time. These high prices have not been around all that long and development of new supplies takes many years. The second is access to new resources. And the third factor is what is happening to costs. The public focuses on the price at the pump, but the oil industry is preoccupied, and indeed somewhat stymied, by how rapidly their own costs are rising – far exceeding the rate of general inflation. The latest IHS/Cambridge Energy Research Associates (Cera) Upstream Capital Cost Index – the consumer price index for the oilfield – shows that costs for developing a new oil or natural gas field have more than doubled in four years. Some costs have risen even more: a deep-water drill ship might have cost $125,000 per day to rent four years ago. Today it goes for more than $600,000 per day – if you can find one.

Everything is in short supply – people, equipment, engineering skills…… This competition for people and equipment has driven up costs dramatically….

Demand is already responding to the new prices except in those parts of the world where retail fuel prices are controlled or subsidised. What can be done to improve the supply picture? The International Energy Agency’s work on future supply is getting attention. But the IEA’s message is not that the resources are not there. Rather it is the likely risk that the required investment will be “deferred” – will not take place in a timely way – because of these rising costs and because governments restrict access or postpone decisions….

That answer is already unfolding – in terms of public policy, technology, consumer response and corporate strategies. At the end of 2007, as oil was heading towards $100 for the first time, the US Congress passed the first bill requiring an increase in automobile fuel efficiency in 32 years. Consumers now want to buy fuel efficiency not sport utility vehicles. Hybrids are going from fringe to mainstream and a concerted assault has been launched on the problems of battery technology….

The break point is already here. Oil is in the process of losing its almost total domination in ground transport. It is not going to fade away soon – such is the scale of its use and convenience, it will retain a dominant position for many years. But it will share the transport market with other sources as never before, reinforced by a new drive for fuel efficiency.

A more provocative version of Yergin’s “oil is on its way out as fuel” view come from “The New Peak Oil: Peak Demand” at The Inquisitive Mind (hat tip Felix Salmon):

Today’s rally came in spite of news that IEA had again cuts its forecast for demand for crude-oil (to 1.03 million bpd); the current estimates for growth of oil demand are more than 50% less than the forecast put out in July, 2007 (2.2 million bpd). The IEA expects a further reduction in the forecast as high crude prices, and a slowdown in the developed economies are likely to cut demand further. There is even talk of reduced demand projections in the non-OECD oil importing countries (emerging economies), since the cost of subsidies is sky-rocketing and can no longer be sustained by their respective governments.

Even in oil exporting countries, where gas often sells for less than a $1/gallon, the government is bearing the cost of lost export revenues at prices which are almost an order of magnitude higher. Iran, OPEC’s second largest oil producer, imports 40% of its gasoline…..

Lost in the bullish talk of $200 oil was Goldman’s notes about demand destruction. The same report which predicted the super-spike also said that by 2012 the price of crude oil would fall to $75 normalized. Goldman expects the current euphoria to lead to a spike in crude oil prices, which will spur new supply development and also lead to permanent demand destruction.

OPEC has been using volatility in the oil market as a tool to limit the development of new oil fields. Volatile oil prices discourage investments in new oil fields if the cost of extracting the oil is significantly more than the current fields. Volatility keeps the average price of crude reasonably high, but the sharp dips in oil price make big investments in more expensive fields risky.

However, with oil projected to remain close to the $100 mark, a lot of these undeveloped fields will now become financially viable. Advances in technology also mean that oil sources like oil sands, shale oil and deep-sea oil, which were once considered too risky can now be harvested at a competitive cost.

In this article I shed some light on how high oil prices are resulting in a dramatic change in the energy industry and politics. High oil prices are accelerating the adoption of alternative energy resources and may signal the emergence of a new kind of peak oil fever: Peak Demand.

It continues here.

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  1. mlnberger

    Ms. Smith: Could there be a connection between Verlegger’s comments about storage and James Hamilton’s contention that the spike in commodities is a function of low interest rates?

  2. Yves Smith

    The points do seem in conflict, since Hamilton argued low interest rates could contribute to demand for commodities as a place to put dough (that was his chart showing for at least the first 3-4 months of the year moving in lockstep) versus Verlegger’s point about borrowing costs.

    However, the people doing the borrowing (those looking at oil storage as a use for cash) are not the same people as institutional investors and retail players. In a credit crunch, anyone but the best credits usually faces a higher spread over risk free rates than in more settled times, even if the risk free rate goes down. You also see the syndrome that even if the rates in theory on offer from your bank may not be that bad, the bank may be reluctant to lend (as in they won’t give you the dough or will give you less than you’d like).

    Thus the reduction of inventories (per Verlegger) may not just have been a function of rates, but conservatism about risk. Better to be safe, and be more liquid (in the having more cash on hand and being less indebted) until things look more settled.

  3. Richard Kline

    Verlegger’s comments regarding light sweet crude as a price chokepoint highlight something much on my mind. If there is a forward options collar bunching up prices, it needn’t be on oil supplies as a whole. Some varieties of oil, and some locations of storage as mentioned are much more constrained than the market as a whole, and at the same time have far more impact on prices as a whole. There are chokepoints which allow disproportionate price impacts by speculation. Pricing is nominally marginal but in fact aggregate supply and demand are not determinative.

  4. Anonymous

    The highlighted comment by the Commerzbank analyst is true insofar as the rest world could get by without Saudi Oil for a year IF it burned every last drop of its strategic reserves AND the declines in non-OPEC production magically stopped. I believe most OECD countries are committed to holding something like 57 days’ supply in reserve. I bet a few people doing a drive-by read of the FT piece read it as saying there’s a year’s worth of oil in storage.

    As for the tankers, I believe they are holding Iranian heavy crude that nobody wants to refine at the moment, not lashings of black gold racked up by heartless speculators. Heavy sour crude is all that Saudi Arabia has in its fabled spigot, so that won’t come to the rescue of a world that only runs properly on copious amounts of cheap light crude.

    As for deep sea oil, it may be economic now but in terms of its potential for staving off Peak Oil, it’s like asking a weir on the upper Thames to fill in for the Hoover Dam. It’s demand destruction, Jim, but not as we know it.

  5. mxq

    Anonymous…the heavy crude vs. the WTI is an interesting debate.

    But the fact that there is inventory of “Iranian heavy crude that nobody wants to refine at the moment” cannot be dismissed. Why doesn’t anyone want to refine it?

    My guess is the value of the products that refiners produce from the sour barrel would be insufficient to cover costs (“crack spreads”). But then, how can that be?

    I’m guessing (again) that rbob and distillate markets are more regulated and therefore aren’t participating in the shift of capital into this asset class.

    For instance, according to yesterday’s Schork Report (its a pdf via a subsription…so unfortunately, i can’t post a link…but they offer a free three week sub…worth a look imo) non-commercials held almost 10 long rbob contracts to each short, “the longest position in the 25-year history of NYMEX gasoline trading.” I have a feeling “commercials” in this market are indeed real commercials…whereas the crude mkt has those jumbled (big time) as Yves points out.

    If indeed that is true, my bet is crude gets regulated before rbob gets “de-regulated”…eventually facillitating the consumption of sour by refiners– away from the benchmark WTI — as cracks would recover.

  6. VoiceFromTheWilderness

    As someone who in not an economist, but who has to make investment decisions based in part on understanding what is going with oil, I have been devoting some effort to this issue. Particularly after Krugmann’s essay claiming supply and demand is the only possible explanation, I tried hard to understand if he was right because my bias is to think he isn’t.

    Since I don’t have the theoretical expertise, after a while, due to my science training perhaps, it occured to me to use the data. smart huh?

    So… if the price of oil is purely reflective of supply and demand, then it necessarily follows that when the price of oil dropped precipitously immediately prior to the 2006 election, a drop that was a bigger delta than across the entire 2001 recession period, (in a matter of weeks, not years), it follows that this must have been entirely due to supply and demand. uh, no. No way, sorry not buying it. The idea that supply in 2001 was tighter than in 2006, or that demand in 2006 with the economy booming, was less than than demand at the bottom of a recession, and that moreove this change happened in a couple of weeks, instead of a couple of years is… absurd.

    It is in fact, beyond absurd, it is manipulative to even propose it. That price drop in 2006 clearly demonstrated that oil prices are affected by things other than supply and demand. You may choose to believe that it was a nefarious manipulation of price or that it was a surprise consequence of Goldman Sachs for some reason choosing to make a change, but you cannot argue that supply and demand together swung by that amount in that short of a period of time with little or no macro cause, or consequence interestingly enough.

    The whole thing is absurd, and for any economist to devote more than one word of theorizing about why it isn’t a consequence of the financial market structure, is for them to be engaged in foolish sophistry, at best or outright duplicity at worst

  7. Juan


    Pardon if you already know this but the modern oil price regime is one of formula pricing. The various oils are priced +/- in reference to a few benchmark crudes such as WTI and Brent, while discovery of benchmark prices takes place within what are financial markets.

    Physical production of benchmarks has been in long decline, (i.e. the physical markets for these have become progressively thinner), which evidently has had the effect of making price formation increasingly dependent on the non-physical.

    Not to say this just began but has been a multi-decade process that rose from OPEC’s mid-1980s loss of ability to manage price(s), an ability that itself had developed out of earlier contradictions between OPEC members and the major integrated oilcos, and these latters’ loss of control.

    As you say, aggregate [global] supply and demand are not determinant.

    A twist to the above would be inclusion of transfer pricing and cross-subsidizing between upstream and refiners within the same vertically integrated organizations.

    In the real world, the light sweet v. heavy sour question is not simply availability of the former but refiners ability to throughput the latter grades, and the spreads. To a point, ‘standard’ refineries can be upgraded to handle the latter and, purely recollection, both India and China have been building heavy sour dedicated refineries.

  8. binaryoptions

    When John Dizard of the Financial Times quotes Eugen Weinberg — commodities specialist with Commerzbank –about the “[belief in]…problems with the way parts of the [oil] commodities markets work”. He describes the WTI contract based upon a 300k-400k BPD delivery. Then he quotes him as saying: “The trading volume on which that is based is between 500m and 600m barrels per day”. So, total oil futures trading volume for WFI delivery are trading in quantities exceeding the physical delivery capacity in Cushing? Wouldn’t this spike up the spot price automatically? If so, then arbs are buying spot right now, storing it, anytime this structrual phenomena occurs. If so, then are the the contracts outstanding (known to not be insufficent in quantity delivery)are theese contracts then settled in cash? And why are companies buying oil futures based upon this blatant undercapity? (unless they are buying near term and recognizing far term contracts as being overvalued) I’m sorry I’m confused over this and hope someone here can clarify the implications this problem identified by Weinberg. I read something similar recently that corn futures, too, have exceeded the physical spot delivery quanitities.

  9. Anonymous

    Yergin says, “And the third factor is what is happening to costs. The public focuses on the price at the pump, but the oil industry is preoccupied, and indeed somewhat stymied, by how rapidly their own costs are rising – far exceeding the rate of general inflation.” And, “Everything is in short supply – people, equipment, engineering skills…… This competition for people and equipment has driven up costs dramatically….”

    But oil companies are still making record profits.

  10. Richard Kline

    So Juan, I have been dimly aware of formula pricing in oil, but had not given the issue substantive thought until attempting, like others now, to unravel the “Is it a bubble?” conundrum. Your follow on comment above explained the context far better than I, for which thanks. Yves’ points in the earlier post on ‘black speculation’ OTC, which I hadn’t yet read whit I put up the above comment, highlight the small source/large price leverage issue dissect the chokepoint multiplier effects far more comprehensively also.

    I’ve felt that the inventory build/non-build argument for present oil price trajectories missed the real ‘black spec’ drivers for the price spike, so I’m glad to have this all gone over here in detail—and now we’re even getting probable inventory builds! Mamma mia, this a-ones gonna end in tears.

  11. mxq

    AP – “Oil prices fluctuated Thursday after the Energy Department reported sharp and unexpected declines in crude oil and gasoline supplies last week, but said the drop in crude inventories was due to temporary delays in unloading oil tankers along the Gulf Coast.

    I love it…”temporary delays”

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