Some Qualified Good News on the Oil Front

Nick Butler, in “The falling oil price is a lull in the storm,” argues that the break in oil prices is likely to persist for a bit due to improvements on the supply side, but that falling into complacency would be a mistake.

The bad thing about the volatility in oil prices is that it is an impediment to moving to new sources. The Financial Times, in an editorial last year, stressed the importance of having a stable price for carbon to facilitate the transition to cleaner sources. But as much as the runup of oil to nearly $150 a barrel led to conservation in advanced economies (which is far and away the biggest opportunity over the short to intermediate term), the sudden drop to almost $110 leaves open the possibility that it might retreat further (which this article contends will happen later in the year), which would call the viability of alternative energy into question and may also lead to more consumer use (at a minimum, airlines may be able to lower prices and add flights although their nickel and diming is no doubt here to stay). But governments seem loath to design tax regimes designed to achieve a certain end price.

From the Financial Times:

The explanation for the change in sentiment [on oil prices] lies in a combination of factors that between them are transforming the level of spare production capacity – a measure that over the past two years has become the leading indicator of world oil prices and a signal to speculators.

First, demand levels have slipped back and look set to end the year more than 500,000 barrels a day below the initial projections. Demand, especially for petrol , is down in the US and Europe as high prices work through to the pumps and as the economic slowdown takes hold. The Japanese economy, the second-largest single source of energy demand in the world – at 4.5m b/d – shrank by more than 2 per cent in the second quarter.

Almost all the remaining growth in oil consumption is now coming from the emerging markets – especially China and India. Even there the rate of increase in demand has slowed in the past six months. In a market that is sensitive to every change, even the Chinese constraints on car use in advance of the Olympics have had an impact.

More important is the other side of the equation. High prices have encouraged producers to expand output and a series of new development projects around the world, such as the delayed Khursaniyah project in Saudi Arabia and new offshore fields in Nigeria and Angola, are due to come on stream over the next six months.

The net result of these changes is that the level of spare capacity, which dropped at one point to little more than 1m b/d, has crept up to about 1.8m b/d and could rise to 3m b/d by next spring. Three million b/d was the historic level of spare capacity in place throughout the 1990s – a comfortable margin of security against problems anywhere in the world. If such levels are restored the stage is set for a reduction of prices through the autumn and winter. Prices could break through the symbolic $100 a barrel level – only this time they will be heading downwards.

Those brave enough to predict oil prices are usually wrong, but the perception that the fundamentals have changed has begun to affect the trading market and behaviour of speculators. That is why the Russian invasion of Georgia had so little impact. Speculators in particular are pulling out of oil – with a few beginning to bet on a further substantial fall. In the words of one London trader: when prices have risen by more than 100 per cent in 12 months the chances are that the next move will be downwards.

None of this resolves the long-term challenges facing energy policymakers. The world is still dependent on hydrocarbons for more than 80 per cent of daily energy needs. A year of rising prices has only served to shift demand to coal. As a result carbon emissions continue to rise. The dependence of the world’s consumers on Saudi Arabia, Russia and a few other producers remains high. Imports are set to rise in the US, Europe, China and Japan.

The big oil companies are losing market share and seem unable to secure significant access to the few new discoveries being made in areas such as Brazil. The bulk of supplies are controlled by state companies. With Russia and the core of the Middle East closed off, big oil groups face a fundamental challenge to their raison d’être. Falling prices will relieve some of the pressure on consumers but complacency would be misplaced. This is a lull in the storm not a reversion to normality. The need for a transition to a more diversified, lower-carbon energy economy is as urgent as ever.

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  1. Anonymous

    There is another viewpoint in today’s Washington Post, describing the results of the CFTC investigation. The article is entitled: “A Few Speculators Dominate Vast Market for Oil Trading”.

  2. odograph

    I think we have to be careful when we say “moving to new sources.”

    There are few ready for prime time, especially in the private transportation field.

    The opportunity we have now is for efficiency, especially with the Civic and Prius class hybrids on the market.

    The auto-buying public seems to know that, a bit, but I imagine some are out there just wishing on a star … for “new sources.”

  3. Dean

    I think it would be prudent to address the oil issue from the supplier side as well. Having “tasted” a $145/pbl price for a finite resource, why would you (in the long run) accept something less?

    In order to get to the truth about future petro prices, we must understand the whole dynamic of no new large oilfield discoveries and a world oil consumption rate on the ascendancy.

  4. Anonymous

    The developed countries must increase the amount of their capital allocations into further expansion of emerging energy technologies via multi-phased strategy.

    For instance, if every G7 govt purchases hybrid and hydrogen fuel cell vehicles for their fleet (that is no small potatoes by the way) starting ASAP, this would send a strong indication to the rest of the world, including OPEC, on the path to come.

  5. halbhh

    It’s fascinating how the “price” of oil is really determined by a worldwide *discussion and speculation process* (speculation not only in the influential futures market, but in many other ways — choosing to explore or hoard, etc, all all forms of speculation of course).

    So for instance, if someone could convince enough people Saudi Oil will run out soon, they could then achieve $300/barrel oil (from their speculations). If someone could convince enough people a new energy source will replace gasoline very soon in a big way, they could then achieve $40/barrel oil.

    It’s all a game of beliefs and voting with capital and choices.

    The model of producers and consumers as very simple short term traders looking for immediate profits/savings has only the occasional realism, barely adequate to occasionally be the important factor — but less often than not!

    Hal Horvath

  6. mxq

    “The bad thing about the volatility in oil prices is that it is an impediment to moving to new sources.”

    Exactly…the whole point of the futures market is so producers and consumers can allocate capital without having to worry about 50% moves in their primary product/feedstock.

    imo, the gov’t needs to subsidize alternatives to eliminate the uncertainty associated with substitution effect if carbon would plummet. i think that’s a no-brainer, yet its been next to impossible to do.

    Anon 6:41

    Thanks for pointing that out.

    Most interesting was the quote “The CFTC…now reports that financial firms speculating for their clients or for themselves account for about 81 percent of the oil contracts on NYMEX”

    Wasn’t that amount 49%, like, less than a last week ago? And even less than that back in July, right before the Senate voted?

    Keep in mind…this is the regulated Nymex they’re talking about…not the UN-regulated ice…

  7. Anonymous

    dean @ 9:42 AM is right on target. Everyone discusses oil
    1) as if the producers have nothing to say in the discussion,
    2) while ignoring the absence of any new large discoveries,
    3) and ignoring the growing demand from Chine, India, and others.

    Good luck with your blind forecasts!

  8. S

    On LEH…

    FT is reporting that the price LEH was seeking was absurd 50% above BV. One anonomyous banker is quoted as saying Fuld still thinks he is playing with a full hand. Then comes the word that the Fed is calling CS and asking if they were pulling a credit line? One has to ask, why has Dick Fuld who has a serious conlfict of interest still on the board of the NY FED? Why has he not recused himself and resigned from this post? Why is he still at Lehman. He has erased all the profits the firm has made since 1998 the last time he presided over a near death. This makes Enron look like child’s play.

  9. Anonymous

    I’m a bit non-plussed by the notion that oil falling from $150 to $120 per barrel creates a risk for complacency.

    The current infrastructure – car fleet, etc. – is based on the $15 to $30 price range that pretty much prevailed from 1985 to 2003.

    Well, it doesn’t matter if a barrel goes for $90 or $120 or $150 or $200. In any case, it’s not going back in the old price range. Period.

    So, no worry there. Oil consumers will adjust. They have to. Their pocket book is being hit hard and it’s not going to change. Beyond that, it’s just a nuance of how hard.

  10. mickslam

    The volatility of oil prices is such a huge part of this story.

    Look at the price action since 1998 in oil, that is, over the last decade. You can clearly see that this appears to be a highly managed product that is going to be depleted. How can I make such a bold claim?

    The price path that we have is the close to an optimal path if you were attempting to extract as much money for as long as possible of a resource that will run out very soon. First, you delay research on alternatives by artificially lowering the price for a few years. Then, when price increases are unavoidable, increase the volatility to give the impression that it could in fact go down to a low price again.

    I read a report by Bear in 2001 that made this exact prediction. I am astonished that it hasn’t been more widely circulated.

    Plug the recent volatility into a price forecast and you get high percentages we will see prices in the $40-50 range. Most alternative energies can’t compete at this level.

  11. Anonymous

    Those eight short paragraphs grease all the likely avenues of explanation
    but fail to mention united snake POTUS
    beauty contest that requires cheap gas
    round election time.

    A sense of forgiveness is now the pitch; bought off blather drone SOB’s
    including blog land and otherwise competent observers fell for it: What is it about the removal of public voice that always sails above, over, and beyond American’s heads? Without so much as a squawk. (whimper).
    Business as usual though not yet a mantra, is fast overtaking gloom and doom. Does anyone else see our public mafia pulling this shit off? Or has everyone signed on?: “Just give me my piece of the pie.” I think the later.

    What is to be done? Especially from a perspective of ‘how to structure one’s time’ now that investment, financial adviser,consultants, fund managers, conger up notions of ‘is someone placing a bulls eye on the back of my head?’
    ‘Art is long and time is fleeting
    and our hearts though stout and brave
    still like muffleded drums go beating
    funeral marches to the grave.’

    Two well traveled gents enjoyed food and drink at an inn during one of Europe’s bloody wars. The conversation drifted to one’s philosophy of life. “Its like there are two armies joined always in battle, allegiance change often, and with death, famine, pestilence and natural tragedy comes a giant with seven league boots who rampages the countryside indiscriminately killing people.

    My philosophy is to enjoy life, help my fellow man, and occasionally pitch a pail of grease under those boots.”

  12. mxq

    just to follow up, the cftc issued a statement saying that the 81% figure the wapo used assumed swaps dealers were 100% specs. That, of course, is not true, as swaps dealers do act as agent for commercials and producers. CFTC reiterated 50% were non-commercials.

    That said, it is still dubious as to how much swaps dealers speculate. The CFTC assumes swaps dealers are 100% commercial (non-spec) — when that is also probably not true.

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