How Elastic Is the World's Oil Supply?

The Interagency Task Force on Commodity Markets has released its Interim Report on Crude Oil. This publication addresses the role of "speculators" in the oil futures market. I am still wading through the report but I found an apparent contradiction between two points that the task force made.

On page 18, the report said:

"The current short-run demand for oil is relatively price inelastic, meaning the quantity demanded does not change much relative to price changes (it takes a very large price increase to reduce the quantity demanded significantly). In the short run, the supply of oil is inelastic as well: the quantity supplied is not responsive to changes in market price, due to low spare capacity, the inability to bring new supplies online quickly, and relatively low inventories to draw down."

On page 28, the report said:

"Crude oil inventories can also shed light on whether the price run-up depicted in Figure 13 reflects mostly fundamental supply and demand factors. Artificially high prices will create an imbalance between supply and demand that should lead to inventory accumulation. However, as shown in Figure 14, inventories of crude oil and petroleum products in the United States and in OECD countries have generally declined over the past year. Based on these inventory figures, current prices, although high, are not prompting the inventory accumulation that would be associated with artificially high prices."

Well you can't have it both ways. On page 18, they correctly stated that both oil supply and demand is inelastic in the short term. On page 28, they said that if prices were "artificially high" meaning propped up by speculators, then demand would fall or supply would increase, leading to an inventory accumulation.

Are they making a distinction between the impact of "artificially high" prices and just "high" prices? Or is the distinction between long and short term impacts? If it is the latter, then I don't think that they have given enough time for this inventory accumulation to appear.

Comments

[LilBob:]

I agree with you about needing more time to see the buildup of supplies appear. Right now we're not seeing prices at the pump falling at the same rate that prices are falling in the commodities markets, and that's having an ongoing negative impact on gasoline demand. Personally, I feel that the "threshold of elasticity," for 89 octane unleaded is 3.85 USD, and we should consider measures of inventory accumulation from the point in time where pump prices exceeded $3.85/gallon. I'm confident that by this time next year petrol reserves will be significantly larger than they are now-provided oil producers don't get into the habit of (very publicly) closing down points of production to scare market prices higher.

2008 Jul 31 03:42 PM

[carbonates:]

Thanks for the link to the report. As someone on the supply side of the business, maybe I have some insight. Maybe.

"Based on these inventory figures, current prices, although high, are not prompting the
inventory accumulation that would be associated with artificially high prices."

I think the problem they are alluding to is that while market demand has dropped, it appears that market supply has fallen as well. In this business, falling supply is not necessarily related to market forces. There are lots of areas the world-around that are in declining production mode and even more that are politically-impeded. There are very few that are actually increasing their production, and this is not due to the market, it is mostly due to geology and engineering.

It takes time find new oil reservoirs and to drill new wells and add production using the newly justified economics of higher prices. Most oil companies (wisely) refuse to have faith in current market prices to predict economics of drilling new prospects, and whatever benchmark price they use (often only 50% of current prices) can determine whether or not a well gets drilled.

There are very few producers that have the ability to turn on the taps and produce oil at a higher rate just because prices are rising. The market impetus is there, but geology and engineering limitations do not always respond to market forces. Often, increasing production rates can damage a field and reduce long-term production. One of the few short-term responses in the market supply is often the oil moving in tankers, which can be diverted to different ports depending on prices while still in transit.

The problem is not the speculators, it is declining production and the failure of many producers to replace reserves- pointing to long-term problems and thus changing the market character from backwardation to contango. The speculators have merely reacted to the inability of the supply side to respond to the demand side in a timely manner.

For everyone who thinks the oil market is somehow a perfect market (and that speculators are the control), I like to use the analogy of the corn market. If you can predict the weather a year ahead, you can master the corn market. Oil is no different- except there are probably just about as many factors as those that affect the weather, and they are just as complex.

As for the previous comment on how prices of gasoline are not falling as fast as the price of oil -be very very glad. Gasoline prices never got up to an equivalent price of oil and were lagging behind strongly. Oil was selling for $3.45 a gallon at $145 per barrel, and a barrel of oil does not make 42 gallons of gasoline- it only makes about 25 gallons, meaning wholesale gasoline could have reached well above US$4.00 per gallon (that would have put retail above US$5/gallon)!!!

2008 Jul 31 04:47 PM

[whidbey:]

Tell us about speculators. Do speculators really affect price levels and supplies? Do a thought problem: how would it work step by step? As an economist (and CFA) I worked through the several legs of this game, and I concluded that unless one takes delivery the capacity to affect price level or supply is nil. I did not consider naked shorts (which is a real issue in the real world), but I think that is not an issue on most energy markets. What worries me is that we do not understand that governments and oil firms, and others do take deliveries,or choose not to produce or deliver. The room for abuse by major players (governments, and businesses) seems massive, but why would anyone bother to coordinate such a massive manipulation? Does not pencil out since it invites cheating. I think the markets are so complex that conspiracy is virtually impossible or terribly inefficient. What is not impossible is governments/ and participants lie about supply and demand to manipulate prices. More to the point the stories about demand destruction are simply unverifiable and when one asks he gets Visa data, no oil company data, and little highway data. I think there is no supply glut out there, which is easily, cheaply refined crude, nor do I think demand has been greatly reduced by price. In short, I believe we are being played with. Have the global heating folks taken control? I wonder.

2008 Jul 31 06:46 PM

[ether:]

The statements are contradictory at first glance, but the second statement is merely poorly worded. What they meant to say was, if prices were artificially inflated, you would see stockpiles of inventories start to build. But so far oil appears to be worth whatever we're willing to pay. And we ARE paying because demand is so inelastic.

2008 Jul 31 07:07 PM

[oiler1930:]

I watch the EIA weekly petroleum reports, and have been tracking them for over five years. One key that I use is the number of days' supply, the quotient of crude inventory over daily inputs to refineries. This value ranges from ~.17 to 24 days. In the last year, crude oil prices doubled, while the days dropped from 22 to 19. The reduction in inventory total cost was several billion dollars! Management usually has two discretionary costs, maintenance and inventory. The carrying cost of the current inventories can be tied to whatever return on money you wish, say 4% long bonds, or prime rate; doubled inventory cost carriage can be carried a little more easily by the lowering of inventory quantity by 15%. Reduction of maintenance costs brings piper paying time closer, but is often done to stay our of chapters 11 or 7.

As a corrolary, should prices drop the addition of cheaper inventory quantities lowers the average cost. With a twenty day nominal inventory, turnover is swift, and a larger inventory at a better comfort level is affordable.

2008 Jul 31 11:05 PM

[fireball:]

do you not think that the destruction of u.s. production has an artificial effect? i know this field or that field will not cure the problem but when you combine those different projects it should be a good start. it seems to me much of the rising price can be blamed on our own non-representatives. anyone heard schumer with his little piss-ant dirty harry sound bite on killing domestic production? if we destroy our cheapest energy source or make it expensive enough the inefficient alternatives become more attractive.

2008 Aug 01 10:55 AM

[mkreisel:]

ANWR, NPRA, and Continental Shelves are our ultimate strategic petroleum reserve.

Oil companies always wanted to drill there, even back then when crude oil was at $10, $25, $35, $50, $70, $80....

Fortunately, Congress remained stubborn and didn't flinch. Let's at least wait until the Saudis can't pump more.

2008 Aug 03 12:52 PM

[Ali Aissaoui:]

"Fundamentals or Speculation? A Critical Review of CFTC’S Interagency Task Force ‎Report on Crude Oil Markets"

In defying conventional expectations, crude oil markets and ‎‎prices have puzzled and polarized oil analysts, ‎economists and ‎‎policy advisors alike. As the controversy has stimulated further ‎‎research, valuable papers have ‎recently been produced that ‎‎deserve our attention and appreciation. CFTC’s interagency task ‎force report ‎is no less ‎worthy of interest. The authors have shared ‎rare professional ‎skills and insights that will greatly ‎enhance our ‎understanding ‎of ‎structurally changing and volatile markets. ‎

Obviously, it is not the intention of our review to ‎weigh for or against ITF’s assertion that ‎speculation has not ‎systematically driven changes in oil prices. The review, however, ‎highlights ‎significant ‎omissions and ambiguities, which do ‎not appear to stem from the report’s interim nature only. The ‎‎most obvious are the effects of ‎US policy-related factors on ‎market fundamentals, the ‎implications of futures ‎market ‎backwardation for both low ‎inventory levels and soaring ‎speculation, and the absence of ‎explicit ‎affirmation or negation of ‎a speculative bubble. As work continues, CFTC and the interagency ‎task force should ‎broaden their analysis and target a wider ‎audience in order to validate and legitimize their conclusions.‎

To get the review contact

2008 Aug 07 04:38 AM