Does Crude's Price Reflect Reality? 15 comments
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While the crude oil market has sharply corrected from its bubble heights, there is reason to believe that it still does not truly reflect the underlying demand and supply equation at the heart of price discovery.
Here’s a chart showing OPEC’s spare capacity in millions of barrels over the past 8+ years:
Source: Bloomberg
We are right back to where we were at the beginning of the year in 2000 and 2002. Since this isn’t relative (to total production or demand) it is difficult to look at this data series over time. But assuming that 9 years isn’t that long, it is still valuable.
Of course, there are many variables that go into determining the price of a barrel: total capacity of production, how much oil is flowing from OPEC, how much demand there is from the global economy, as well as the demand from institutions not for use but for investment.
This last rationale has been the driving force in recent years as ‘animal spirits’ have taken hold. While last year’s crude oil bubble returned to normalcy, it looks like it is reflating right back up again. And the same basic script is being used as large institutions and hedge funds plow money back into this market.
Considering the extreme economic downturn, crude oil should have fallen to $20 - previous support from 2002. That’s just my own guess. Or it could have not gone up so much in the first place. Instead of acting as a ballast to rescue the global economy when it most needs it, it has instead been acting like an anchor, dragging it down further.
Here’s a chart of crude oil futures for the same time period showing each time that spare capacity reached above 6 million barrels:
Looking at these two charts together makes one wonder if the crude oil market is ignoring the excess spare capacity or whether it successfully discounts it. For example, most recently by falling from $147 in 2008 to less than $40 in early 2009 as spare capacity shot up to multi-year highs.
It is impossible to speak on behalf of a collective such as the market but my hunch is that, for the past few years, the oil market has been driven by tectonic shifts in asset allocation more than that which can be explained by fundamental analysis (such as supply and demand variables).
While we’re at this discussion, here’s an intriguing thought experiment. Imagine if instead of crude oil, we had to rely on a cartel such as OPEC in setting the price of a ubiquitous commodity like say, water. How would the price of water be set? would we just go along? or would we simply refuse to allow a cabal to dictate the price of water by turning their spigots on or off?
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Tectonic shifts? Is that a euphemism for the black hand of 'hot money' speculators? (Crooks manipulating the market, in other words.)
Very interesting article. I'm hoping some readers can explain how higher production and lower demand can result in such a sustained spectacular rise in price.
I love thought experiments.
Who is "we?" Our actions would depend on how thirsty we were. It would also depend on our ability to project power, a real need but one "we've" taken for granted.
You know, against a basket of major foreign currencies (excluding USD), the price of oil is actually closer to 2004 levels. Since 2002, the USD has lost more than 30% of its purchasing power. 30%!!!!!
So, just on the basis of a weaker US dollar, of course oil is a lot more expensive to buy. It's not only supply and demand forces at work here, folks! Your dollar is not buying as much as it used to.
If one were to look at OPEC production capacity, one would quickly see that it is: 1) not verified (reporting agencies just accept what OPEC countries report); 2) is suspect (e.g., several years ago, the reported reserves of several OPEC countries suddenly doubled in the same year, and have not changed since, even with continuing production - highly unlikely in reality but probably done to get around self imposed production targets based upon reserves - so how can we believe reported spare capacity); and 3) likely to be much higher than reality (several countries - Nigeria, Venzuela to name but two - still have reported production capacities in excess of prior peak capacities when they are now only able to produce less than half of that peak capacity - so they obviously have no spare capacity).
Spare production capacity is defined as that capacity that can be brought on line within 30 days and sustained for at least 90 days. If one looks more closely at the data, the reported spare production capacity is highly suspect and certainly not something that I would base any conclusions upon.
But don't worry because the Fed are currently printing a lot more to make up for this!
Long term, this is a one way story.
Probably won't happen in the next 10 years....but in our lifetimes? Maybe....
The laws of supply and demand work slightly differently for non-renewable resources. Short term, the laws act like any other....but over the medium and long term, prices will always go up. This is even more so for oil. Not only is the supply limited, but it is becoming increasingly harder (and more expensive) to source. And despite the push for greener sources, the demand will always increase. China's consumption of oil is only just beginning. There are reasons why China is actively signing deals with and acquiring energy and oil companies....
To Mr. Big - In studying the movement of OIL and RBOB daily for the last two years...the value of the dollar relative to Oil Prices is very overrated. This, too, was a "handy urban myth" that was used to divert the 'real gaming' going on last year and again this year...
Last June (2008) the value of the dollar was, according to the IMF testimony in Congress, accountable for about $10 premium, max, on the price of crude - that takes it from $80 to $9- at the most...not teh $147 it was heading too...
Today, Oil should be $58 - $61 and RBOB, which is not really an international commodity, $1.55-60 max. Yet, you'd think that the dollar effected this price by $.50.
I've noticed that global supplies have been getting tight from time to time. I noticed OPEC countries simultaneously double their estimated reserves and I wrote that off as cheating on quotas. I think their reserves are declining just like mine are.
I've also noticed that nobody has found any large new pools of oil for decades, and all the new oil being found is hard to get at and expensive to produce. New oil is so expensive, in fact, that it is now economic to produce it from tarsands; and the deepwater Brazil discovery is actually being considered recoverable even though the technology to get at that oil does not yet exist and it would be cheaper to send Americans to Mars than to get the first barrel of that oil out of the ground.
You have seen all these facts too, and you also see continuing strong demand for your refined products. You and I both know that the economy of the world is driven by oil-based fuels and it would take a multi decade concerted effort to convert to another fuel source for transportation, if any such alternative fuel existed, which it doesn't. So you are resigned to buying and refining oil at market prices and I am happy to offer it to you for sale at those prices.
My cost structure is much lower than tarsands oil, but they represent the marginal suppliers. That is, the next new barrel of oil is going to be produced and sold at high cost or it will not be produced at all. Neither you nor I expect any new cheap oil to be discovered or any technological miracle that replaces oil.
If you, the refiner, ever run out of crude oil feedstock, you have to do a plant shutdown then a restart when you get supply again. This will cost you many millions of dollars in addition to your lost earnings during your shutdown. You and I both know this.
For all these reasons oil is a seller's market. I can hold out for a price that reflects the high cost of new marginal supply even though my own cost is a fraction of that. For decades Venezuela has been currying favor in Latin American countries by selling them oil below world price. They can do this because their cost structure is below the cost of new marginal supply, so they still make good profit selling oil below market price. I could do this too but I want the money, not the political power, so I hold out for maximum price. (Chavez' political fortunes depend on social spending of Venezuela's oil earnings, so in that sense Venezuela's 'cost structure' is now determined by Chavez' spending commitments rather than the cost of getting oil out of the ground.)
Neither you nor I nor anyone else knows for sure how much spare capacity exists in global oil supplies, nor do we know how much recoverable oil remains in the ground. We are aware of the potential for politically originated supply disruptions (i.e. wars) in places from Nigeria to the Middle East. We both know that in the short term oil is price inelastic: the world cannot stop moving itself with oil-based fuels just because the price goes up. You and I are both sensitive to the possibility of price spikes for these reasons.
I will certainly stay alert because if the opportunity arises to ramp up my prices I'll jump on it, and you know you will have to pay. You also know you can pass on the increase to your end consumers because they need your fuels for their trucks and buses and cars and ships and planes and they can't just stop doing business and going to work. In the short term they will simply suffer the higher prices you are charging.
We believe peak oil is true: there will be no more cheap oil to discover and produce. We know that I, the oil producer, must continuously find and produce new oil to compensate for the decline rates of my currently producing fields, and we both know this has been getting costlier for me. So you do not feel that I am screwing you on price even though I am making windfall profits during price spikes because you know I will have to pump much of my gains into finding and producing oil next year and the year after that.
That's the end of this thought experiment. So now, what "should" the price of oil be? My answer is that it should be whatever the market says it should be, and this includes fear (of supply disruptions) and greed (cashing in on price spikes) as well as objective economic analysis of the shifting supply and demand equation.
And, I'm not sure whether it is funny, more strange that so many "smart people" fail to take various vital factors, into their considerations?
Additionally, the justifiable global loss of confidence in paper assets generally, and in USD-denominated paper in particular, means that physical commodities are unlikely to return to depressed prices of the past.
1) The Federal Reserve has trashed the dollar in the last 9-10 years, meaning "the" price of oil denominated in worthless dollars is going to be much higher
2) OPEC has 2000-2002 levels of surplus capacity, but non-OPEC suppliers have little if any surplus capacity. If the author would stop parroting Congress and read about the North Sea fields or Cantarell in Mexico, he would know this. The author clearly doesn't follow even the oil headlines in mainstream news much less oil industry publications
3) Even in a recession, oil demand is higher world wide than it was in 2000. More of the demand at the margin is coming from emerging markets
4) The entire discussion of "the" price of oil betrays total ignorance -- there isn't one price for oil because oil is not a commodity, there are many different grades and location is important.
"The" price quoted by the author is for West Texas Intermediate crude oil passing through Cushing, OK. So when a refinery in Cushing has a major accident and has to dump its inventory-- WTI futures prices collapsed to the mid-high $30s. When that refinery came back on line, there was a "sudden new source" of demand that forced the futures price back up. Ignorant authors and members of Congress would know this if they simply read the weekly report from the Dept of Energy.... Heck, Congress members from Oklahoma couls actually visit their state once in a while... But rational thinking doesn't get any TV time in a country dominated by fools.
WTI is light, sweet crude that is very easy and cheap to refine. Saudi oil is heavier and more sour -- making it more difficult and costly to refine. WTI (and Brent crude from the North Sea) make up a much smaller percentage of the total crude in world markets than 10yrs ago. Refineries are bidding up the price of WTI and mixing it with the heavy sour crude to create a mix that is easier for them to refine.
Many emerging economies understand the subtleties of crude oil, but the US does not. Our education system has failed us; decision making is increasingly based on ignorance and hysteria; and any honest assessment would have to mention that "leadership" in the US has become an oxymoron (Bush, Obama, Pelosi, Franks, Paulson, Geithner, or any CEO you can name -- they are all the same)
Peak oil is here and as soon as the economy recovers, oil is going as high as it can until it puts the economy back into recession.
My EV's get 250 and 600mpg equivalent which shows a better way to go. If I need unlimited range, a small DC generator does the job at over 100mpg. If Detroit wanted to they could do the same.
I don't object to making a profit from my oil stocks, but before I put any money into battery stocks, I'd like to know that those batteries are going to get me to my new grandchild, 800 miles away, without requiring a week of driving each way.
There is no doubt that tightness of surplus capacity is an important component of contract crude price. But even at the July 2008 high of $134, the global surplus capacity of a mere 2mbd was only an $18/barrel forcing. Currency debasement played a far greater role ($30/barrel), while tight inventories ($6/barrel) were a factor as well.
2008 was a perfect storm - one that affected virtually all commodities. Attempting to seek a basis for these mega movements based on fundamentals is futile. At least that's what the last ten years of observation reveals: trendlines.ca/monthlyr...