Searching Oil Inventories for a Bubble

I've suspected for a while that we were in a speculative bubble with respect to oil prices. Paul Krugman offers a good insight into the question. (When he's not preoccupied with left-wing rants, he's a pretty good economist.) He says (full article here):

... there are only two things you can do with the world’s oil production: consume it, or store it.

If the price is above the level at which the demand from end-users is equal to production, there’s an excess supply — and that supply has to be going into inventories. End of story. If oil isn’t building up in inventories, there can’t be a bubble in the spot price.

So I looked into oil inventories:

We don't seem to have much increase in inventories. Maybe it's building up outside of OECD countries, where we don't have good data, but if I were going to store millions of dollars of oil in some tank farm, I'd want it in a stable country with secure property rights. So the oil is probably not hidden in Somalia or Zimbabwe.

What about futures markets? Let's say that we are in equilibrium (current supply equals current demand) and then speculators bid up the price of oil in futures markets. If today's spot price does not rise, then I can buy a barrel of oil today, store it for a few months, and deliver it to fulfill my futures contract. This arbitrage will bid up today's price. But if today's price is bid up by speculators in the futures market, we end up with more supply and less demand--which means inventories have to build up.

Think about past bubbles. In the housing bubble, the inventory of vacant houses, condos and apartments rose (as I've noted frequently in this blog). In the tech bubble, the inventory of shares of stock mushroomed. In the tulip bubble, people hoarded tulips for investment purposes (I think).

Tyler Cowen over at Marginal Revolution notes that inventories could be building up underground, as producers choose to not maximize their current pumping. Seems unlikely, though possible, to me.

So the high prices are most likely due to strong demand and long time lags in exploration and development.

Comments

[BookValue:]

How about the supply/demand and inventory of oil futures contracts? Since 2003, the number of open futures contracts has shot up over 200%, and the daily number of contracts traded is up over 300%.

The truth of the matter is that prior to this big jump in oil futures contracts and trading, there was a 75% correlation of the year over year price change in oil to the year over year change in oil inventories (higher inventory, lower price, and vice versa). Now, that correlation has fallen to ZERO. When the price of anything disconnects from fundamentals and trades on momentum and sentiment, you can be assured it is speculation that pushes the price into bubble territory.

ICE's power outage last week demonstrated this. While their electronic exchange was down, the price of oil started to collapse on other exchanges. Then as soon as ICE was back on line, oil pared its losses to close flat for the day.

$120 oil is unsustainable for any extended period of time, because anywhere above $80 gives the US the largest oil reserves in the world in the oil shale wastelands of Utah, Wyoming, and Colorado.

2008 May 18 08:47 AM

[mpkirby:]

If there was a truly fundamental disconnect between speculators and real consumers for the price of oil, I'd expect at least some of them to acquire the oil they need on the spot market. Why buy expensive long-term contracts when you can get cheap spot-price oil now.

Since the spot price isn't heavily discounted relative to futures, I suspect the smart money (that is the money that actually wants to purchase the product) believes the price is relatively fair.

Regarding oil shale. the old $80 figure was based on energy costs during $30 dollar oil being used to extract $80 dollar or higher shale oil.

Now that energy prices are $130, the break-even point isn't $80, it's considerably higher.

Further it is a very water intensive process.

And finally, the kind of oil it produces is difficult to process. There aren't a lot of refineries that can process that kind of oil. If we produce it in large numbers it isn't clear that we could do much with it.

Mike

2008 May 18 09:15 AM

[David Lentz:]

I'd certainly like to see a table of the monthly amounts of oil being:

*) consumed (by nation would be nice)
*) pumped out of the ground (again, by nation would be nice)
*) pumped into the SPR
*) in transit in tankers
*) in transit in pipelines
*) in storage in various commercial tank farms

At least then we would have some numbers to back up all this nice theory. Without the data, it's just mindless blathering.

2008 May 18 11:06 AM

[Jack Yetiv:]

Who believes that, given their comments in the past few months, OPEC will not CUT production if oil goes back toward $100?

Remember, in terms of goods and services, OPEC is not getting 4 times as much for its $120 oil as it was getting for its $30 oil 4 years ago.

Given the devaluation of the dollar and the cost of materials needed to build infrastructure (steel, concrete, labor, etc), OPEC is getting at most twice as much as it was 4 years ago, and not even 1.5X as much goods and services as it was getting 30 years ago, per barrell.

Jack

2008 May 18 12:25 PM

[Norman Lepo...:]

Excellent article and comments. Thanks.

2008 May 18 01:09 PM

[Paul Killinger:]

Since courtesy of the U.S. Congress we're headed toward $200 per barrel oil (...what's that, about $7 a gallon at the pump...?), we're going to learn about the real economics of all forms of energy and which alternatives are most viable.

2008 May 18 01:10 PM

[JimG:]

Jack is right on. Short term prices may decline as the dollar stengthens, but only if producers accept lower margins. In the face of increasing demand in Asia & the much higher cost of new supply( ie.tar sands, deep water production) prices are much more apt to increase significantly.

2008 May 18 01:20 PM

[NOWHEREMAN:]

Any one look at a long term chart of the US Currency?

Going back from the present say 10+ years, 80 was long term support which died in a hurry. The current dollars stability is an illusion which could possibly hit 80 again (retest of the point of breakdown) but the prospect of a move to 40 looms...just my interpretation of that particular chart.

2008 May 19 02:08 AM