Oil's Supply and Demand

In recent weeks, there has been widespread speculation on the reason for the most recent incredible rise in the price of oil.  Speculation by hedge funds is one reason given while buying by index funds is another possible reason.  Finally, some people believe that there are fundamental supply and demand factors driving the rise in the oil price.  While I do believe that the energy markets have been pushed around to a degree by their participants, as I discussed here, I wanted to make it clear that I believe that there is currently a significant demand/supply imbalance. 

To begin, I will say that speculation likely does have an impact on prices in the short term but over a long period of time speculators will make or lose money depending on how fundamental supply and demand factors play out.  Speculators may frequently overestimate or underestimate where prices should be causing increased volatility but in the long term the impact on prices caused by speculators should be negligible.  

While we all want to pay less at the pump, higher prices in the short run are beneficial to long term supplies as they help to close the gap between supply and demand that exists at lower prices.  Higher prices cause people to reduce their consumption of oil which saves more oil for the future when supplies are expected to be insufficient.  Higher prices also entice producers to make the investments needed to expand production.  If prices are too low for too long, a shortage will undoubtedly develop, throwing a terrible wrench into the world's economy. 

The reason that the price of oil is rising and will continue to rise in the long term is simple.  The market expects that there will not be enough oil available in the future if prices are anywhere significantly below current levels.  The price level that is needed to bring supply and demand into balance will continue to change and could drop if enough supply comes online in the future. 

Of course, the world will eventually run out of oil since oil is not a renewable resource.  However, for right now it appears that only the most low cost oil reserves have been exploited and that most of these low cost reserves are as a result beginning to decline.  There are many areas worldwide that can still be drilled or mined to produce more oil.  

Most of these areas are however in hostile environments or require expensive recovery techniques that make the processes unviable at lower prices.  Given some time and consistently higher prices, we can expect more high cost oil production to come online.  However, it will take years before a large amount of high cost reserves can provide significant production to help relieve the current supply demand imbalance in world oil markets. 

Worldwide oil production has barely risen since the middle of 2004.  Meanwhile oil demand seems to be rising at an increasing rate as developing countries such as China and India rapidly increase their consumption.  If the slowdown in the U.S. economy does not affect China and India significantly there is really no way for oil to move significantly down over the longer term.  

The first part of the puzzle is that worldwide oil production has barely risen since the middle of 2004.  This is because the number of low cost oil deposits that are found that can be profitably developed at low oil prices is decreasing dramatically with each passing year.  There is a limited amount of oil in the world and there are geological limitations to our ability to produce oil. 

Even when oil is found that can be produced economically it can take years to build the necessary infrastructure to get that oil to market.  It will likely take years before the majority of the new high cost oil will enter the production phase of its life cycle.  The current high level of oil industry profits is without a doubt needed to finance the development of new oil reserves so that more oil can be brought to market in the future.

Meanwhile global oil demand is rising at an increasing rate as developing countries such as China and India require increasingly large amounts of oil to continue their industrialization.  While the drop in oil consumption in the US last quarter is important, the fact that the oil markets did not react to the news suggests that U.S. consumption habits are no longer driving the market. 

The main driving factor of the rising price of oil is clearly the ever increasing demand in the developing world, with the situation being exasperated by the lack of increased production.   For years the worldwide demand for oil has been in excess of the supply of new oil.  As worldwide oil inventories have slowly declined the price of oil has climbed.

The imbalance looks small while the rise in the price of oil has been huge.  But it is important to remember two things.  First, oil demand is very inelastic in the short term.  Longer term oil demand is more elastic as people may choose to buy more fuel efficient vehicles or to conserve in other ways.  

Second, looking at past oil supply and demand figures is missing the biggest reason for the oil price climb.  As the primary reason for the surge in oil prices has been the rapidly increasing demand from China and India which is not reflected in past data.                                                     

Currently, Chinese oil consumption is around 7 mb/d, but by 2030 Chinese oil demand is expected to exceed the current level of US oil demand.  Similarly huge increases in consumption are expected in other developing countries. 

The reason oil prices are skyrocketing is not because there isn’t enough oil to satisfy demand right now but because the market expects that significantly more supply is going to be needed in the future to make up for new demand coming online from the developing world.  These new oil supplies cannot be economically produced without significantly higher oil prices to make production economical and higher oil prices are also needed for consumers to cut back on their own consumption of oil.

Another important factor is that the production in many oil-exporting nations has been in decline due to under investment in new drilling and infrastructure by state run oil companies.  Venezuela and Iran are two countries that fit into this category.  Production in Venezuela and Iran is declining due to years of under investment as oil profits have been funneled into social programs designed to keep each country’s ruling party in power.  Recent political instability in the Middle East has also contributed to the oil price rise. 

When the chances of significant supply disruption increase, the market responds by raising the oil price.  While these geopolitical issues have also driven up the price of oil, the falling dollar has exacerbated the situation.  The price of oil is dollar denominated, so as the dollar drops, the price of oil climbs even if oil stays constant in terms of other currencies.  But, of course, the price of oil has been climbing in terms of all currencies.

Markets never work perfectly and in rare circumstances can work quite poorly. However, markets almost always work very well over the long term.  Blaming the most recent rise purely on speculation is missing the big picture as one would then be failing to give the required credence to the macro story. 

I think the best piece of evidence to support my fundamental supply and demand theory is that the price of oil is not the only commodity price that is skyrocketing.  Food prices, metal prices and all energy prices in general are skyrocketing because the developing world is rapidly increasing its consumption of all commodities. 

High oil prices are here to stay and the entire economy needs to adapt to a higher price level.  Oil will remain expensive, and to avoid long-term shortages, the global economy needs higher prices to force people to make more efficient use of energy and to help finance the development of new oil reserves.  Eventually, geological limitations will limit the ability of the world to increase oil production beyond some point, regardless of price.  I do not think the world has yet reached this point, but it will eventually. 

I think the price of oil will never again drop to the levels we have become accustomed to in the last several decades, and while it may decline in the short term, the price of oil will clearly rise over the longer term.  

Comments

[GORILLA800]

On point.

[jcrash]

Supply demand imbalance does not explain Nat Gas's rise. We are coming off the highest gas storage levels on record last year.

It is all a game. When the music stops, don't be caught without a chair or you might be OUT.

[ChrisB]

OOPs, problem is your whole article is an explanation of why the current spike (which has occurred over a short term) is in fact caused by speculation. Take a look at the volatility to see it is all speculation driven.

[Jerlad]

I recently started positions in commodity (USO, GLD, DBB) and clean energy (PBW) ETFs. Your article is the best that I have seen on the "oil speculation bubble vs. supply/demand" argument. I'm very grateful that you spent the time to help us poor novices out there sort through this mess.

Every once in a while Seeking Alpha receives these clear instructional posts, which is why I check SA every day.

Keep the the good work !!! Who needs CNBC with posts like these?

[BlackBarn]

I agree with the supply/demand analysis as far as long-term price appreciation goes. But in the short-term, what role do subsidies play in the projections for Chinese, Indian, etc. demand? We hear about their unquenchable thirst for oil, but their governments are paying the same spot price as the rest of us, and that cannot be sustainable. As emerging markets are forced to cut subsidies, as the Chinese gov't announced today, won't prices come down in the short-term, perhaps shaking out some speculators in the process?

I'm thinking that oil will come down to $100/barrel before the end of the year due to the cutting of subsidies and pursuant to the old adage that high prices are the cure for high prices. I just opened a long position in DUG for that reason.

I agree with Jerlad that these message boards are a billion times more thoughtful than the talking heads on CNBC. I look forward to hearing your thoughts.

[maximax]

highly simplistic analysis, nothing new. for those who really want to know about the oil markets, get hold of the argus or energy intelligence newsletters.

[mdmrjsds]

85 million barrels of oil/day at $140/barrel is $11.9 billion/day.
Hedge funds have $1,700 billion dollars.
Sovereign wealth funds have $1,700 billion dollars.
Both have an economic incentive to manipulate the oil market. And the means to do it for months of production. Like shooting fish in a barrel.

So while your analysis of demand is true in an overall sense, I think there is a lot of speculation contribution to price as well.

The end result will be to drive the developed world into alternatives, thus reducing dependence on oil. A good result from market manipulation.

[jcrash]

You are hopelessly naive if you think that US demand is going to increase at a linear rate with the past given the current prices. Look back to the late 1980's to see what happens to demand when the price spikes. US demand in two years will probably be 15 to 20% LOWER than where it is today.

[Kimbo Slice]

Buy DUG now for when the bubble bursts. It will sooner or later. Most likely once the Fed starts hiking rates and strengthening the dollar.

[cyberfly]

Oil's physical supply and demand are not the only inputs that influence the price of crude. For instance, Saudis news of increasing capacity in months ahead saw crude drop from $140 - The market expects Saudi's capacity to rise. China's overnight decision to raise retail prices 18% to help curb its oil demand saw crude drop $4 overnight to $132 - The market expects China's demand will drop.

Last nights drop did not come about due to a sudden increase in oil inventories (not physical text book supply and demand) but a drop due to oil trading speculators sentiment and their electronic selling and buying ratios changing due to China's announcement.

Oil's wild swings/exaggerations in price are a reflection of the market's sentiment and their buy/sell trades in a very liquid market trying to second guess perceived supply and demand issues and levels of oil inventories.

Last night, the Market expects/second guess supply is more likely to meet a slowing demand.

[AEB]

jcrash doesn't understand that we have also reached the limits of global natural gas supply. Read my blog: petroleumtruthreport.b.../ or the summary version in this month's World Oil magazine: worldoil.com/Magazine/...

[Dan Walker]

It doesn't look as if anyone has added that China's economy is headed to the outhouse. Half of their invested capital has evaporated in the last 9 months, their inflation rate is running around 7-8% and they are in better shape than most of their neighbors. Sadly enough, they are sitting on a pile of our currency, which, if they revalue the Renminbi, will drive our currency down even more. You also obviously posted this before they removed their latest oil price supports. It ain't looking pretty here no matter which way it goes.

[oil baron]

The Daily Oil Consumption chart in your article seems to show that by 2020 the combined consumption of the US and China will amount to approximately 42mmbopd. Based on current consumption the rest of the world consumes an additional 60mmbopd. By 2020 I would estimate the rest of the world will consume closer to 80mmbopd. Adding the 42mmbopd and the 80mmbopd you arrive at total world consumption of approximately 122mmbopd within 12 years.
There is no chance that production will ever exceed 100mmbopd within that time frame.
Oil will surge well past $200bo and in all probability create economic chaos and even armed conflicts to control the world's declining oil supplies.
I am not optimistic that our government, whether now or in the future, has a clue what lies in store for us. What we need is a Manhattan Project to develop viable alternative sources of energy.

[john s. gordon]

one reason finding new oil supplies worldwide is constrained is that the territory is controlled by hostile and/or criminally irrational governments.
> jack

[Saffie]

Ok guys I am a neophyte so please tell me whether I am correct. If one want's to find out what the speculators are doing then one looks at the CBOE and specifically the CRUDE OIL open interest. Now if one finds that most speculators s are long we can then blame them BUT what if most speculators are short? If they indeed are SHORT then we cant blame the specs or am I daft?

[riwilliams]

Working in the oil/gas engineering environment we see a significant portion of retirees returning to support the ongoing industry expansion efforts. Where there was no investments there is now a significant backlog of work which cannot be supported by the available engineering talent. Major refinery expansion projects are progressing through various phases and will be onstream by 2009 and 2010.
An Alaskan gas pipeline, a potential reality after 30 years, will cost up to 30 billion dollars and could be in service by 2015. Ultradeep well drilling and deep sea production with supporting FPSO involve similar mega billion investments and time frames.
These very high oil prices are paying for these future investments and the beneficiaries are the oil companies, oil/gas services companies and us oil/gas engineers of all disciplines.

[BullishOnOil!]

Hey, riwilliams: You need any c#.NET, ASP.NET, and T-SQL computer developers?

[thedozer]

well put...
and if you want real news I wouldn't go to CNBC... that is if you care about the truth

[bill d]

Very good except your conclusion that:
"I think the best piece of evidence to support my fundamental supply and demand theory is that the price of oil is not the only commodity price that is skyrocketing. Food prices, metal prices and all energy prices in general are skyrocketing because the developing world is rapidly increasing its consumption of all commodities. "

The cost "price" of oil is the driving force that is directly or indirectly responsible for the other increases. Cause & effect.
Does the price of the other commodities determine the price of oil ?
e.g. If the price of rice goes up does that result in the oil price to increase ?

[kcube99]

why flog the developing world if they r trying to catch up. is it bcz they shld remain in dark ages ever

[KingOfCoolies!]

We (our leadership and consumership) need to wake up and start functioning in a frame of mind as if we DO NOT have an OIL- dependancy. Like waking up after the death of a spouse, or a divorce, and moving forward, otherwise, we (as a global nation) will find ourselves in similar situations over the next generation. Do we minimize, carpool, demand alternative energy, choose energy-efficient products? Solar, wind, geo-thermal, hydro-electric, kinetic, bio-fuel, photosynthesis, and even nuclear energy...when mass produced the "invisible-hand&q... will see markets' demand for these products/technology increase. People WANT to use alternative energy; the abundance, availability, and price of said alternatives are the problem! It is time for the Global market to respond to the overwhelming comsumer-demand!