Oil prices above $70 ... don't go Peak Oiling just yet

From the WSJ (Stocks slide ... $$$):

Stocks slid as oil prices shot above $70 a barrel amid concerns that prices might push higher still, sapping global economic expansion. ... Investors have largely shrugged off high oil prices during the past several months, recently pushing major market measures to multiyear highs. But with concerns about Iran's nuclear program mounting and demand from places such as China and India increasing, the persistent upward creep in oil is eroding confidence among investors. ... Oil for May delivery rose $1.08 a barrel to $70.40 on the New York Mercantile Exchange, the highest closing price for oil since the contract was begun in 1983. On an inflation-adjusted basis, oil remains below its record of $97.21, in current dollars, set in 1980.

And a page 1 WSJ column explains that $70 is more than basic supply and demand (Oil settles above $70 ... $$$):

Crude oil closed above $70 a barrel for the first time, highlighting a phenomenon reshaping the petroleum world: Investment flows into oil futures are supplanting nitty-gritty supply-and-demand data as prime drivers of prices.

In contrast to past bull markets in crude, this year's run-up has occurred even though oil inventories in the U.S., the world's largest market, have swelled to their highest levels in nearly eight years.

Of course, supply and demand is still working here. The only difference is we've added a speculative financial market layer to the commodities market.

The answer to the puzzle posed by rising prices and inventories, industry analysts say, lies not only in supply constraints such as the war in Iraq and civil unrest in Nigeria and the broad upswing in demand caused by the industrialization of China and India. Increasingly, they say, prices also are being guided by a continuing rush of investor funds into oil markets. Institutional money managers are holding between $100 billion and $120 billion in commodities investments, at least double the amount three years ago and up from $6 billion in 1999, says Barclays Capital, the securities unit of Barclays PLC.

The flow of money into oil, analysts say, has been prompted by a spreading belief that demand for oil will continue to rise with global economic activity as supply tightens under the influence of several factors -- among them, the West's escalating nuclear standoff with Iran; growing political violence in oil-rich Nigeria; and more broadly, steadily growing global economic activity. The three-year bull run in oil has been underpinned by strong global demand for fuel coupled with a prolonged shortage of spare capacity to pump and refine crude.

In other words, investors are buying futures contracts for oil at today's low prices and hoping to sell at some higher price in the future. In the process, today's low price becomes tomorrow's high price today. Got it?

Since early 2005, the crude-oil market is in what traders call "contango," meaning futures contracts for a given product are priced higher than that same good for near-term delivery. The price of oil to be delivered four months from now is about $3 more than oil to be delivered next month.

In short, it pays for refiners and other oil-market players to buy and hold oil now to sell it down the road. Making that trading opportunity possible, says Colorado-based oil analyst Philip K. Verleger, is the huge volume of new buyers on the other side: investors who he estimates have put more than $60 billion into U.S. crude-oil futures since 2004.

Cool word for the day: Contango!

During their meeting in Vienna last month, officials from the Organization of Petroleum Exporting Countries expressed concern about rising inventories and the growing role of financial players. Their fear: Money flows could reverse on the proverbial dime, while any move by the cartel to reduce supply would take months to affect markets.

OPEC also fears a return to "backwardation" -- the opposite of contango -- with near-term prices higher than long-term contracts. Such a flip-flop could prompt speculative buyers to dump inventories; prices could quickly drop $20 a barrel or more, OPEC officials said.

"More and more people are going to recognize that the fundamentals just aren't there to support these prices," said John Gault, an adviser to the energy industry with Geneva-based firm Nalcosa.

So, don't go Peak Oiling just yet. Today's high price isn't unambiguous evidence of oil scarcity.

Comments

[odograph]

I would think it was rare that a commodity price was ever an unambiguous evidence of anything.

It does strike me that the fundimental geology and engineering issues beneath the "peak oil" moniker do set the stage for tighter supply and demand scenarios, and more erratic geopolitical influences.

Basically, it is natural for oil companies to pursue the cheapest and easiest oil reserves first. They did. Those were also the supplies that could be brought to market most rapidly in response to demands. If you start to see increasing quantities demanded, as available reserves are more difficult, expensive, or time-consuming to bring on-line ...

[odograph]

Put another way, when all you had to drive a truck to a new place in Texas and drill a hole, response on the supply side was pretty quick. Now, when you have to build an umpty-ump billion dollar tar sands plant, or an umpty-ump billion dollar deep water drilling infrastructure ...

[joshua corning]

But the DoD has contigancy plans for peak oil and they are not purtty....how could the DoD be wrong?

[John Whitehead]

Odo,

How's this?

Peak oil problems lead to high prices but high prices are not necessarily evidence of peak oil problems.

John

[Scott Peterson]

Best explanation of contango I've seen. Clearly a price bubble exists here; due to investors "seeking yield". It seems that OPEC has completely lost control of the oil market. Interesting how times change...

[odograph]

John, sure. What we get to see next is if increased investment yields a bounty of supply ... or if it simply costs more to produce smaller returns.

[Duncan Brown]

Friends, I remember the last "peak oil" scare, in the seventies. I'm betting on this one being a cyclical bubble too. Sell oil companies. Buy users of oil (such as airlines) and companies that develop and sell energy-efficiency technologies and greenhouse gas controls. Because once the current corrupt Congress is swept away (this November I hope), we may see some more sane policy.

For me that policy would be abadoning all of the nickel-and-dime subsidies for ethanol and hyrbid cars, nuclear fission, and solar whatever, and putting on just a big fat tax on carbon dioxide emissions (and other greenhouse gases). Economists have a pretty good idea of how big a tax it would take to reduce carbon emissions by a given amount (see studies at Resources for the Future etc.)

The peak oil ideologues seem to be unaware of the notion of "price elasticity of demand." Go to Widipedia if you're fuzzy on it.

Another excellent benefit is that my tax return would become way simipler, since all of those little credits would disappear.

[odograph]

The interesting thing about the '70s was that US oil production did peak and decline, as predicted. We just moved to increasing imports.

It is fairly straightforward that those fields outside the US would also peak and decline, someday. The only interesting question is when.

Say, when I recommended (nay, demanded) that the hosts read "A Thousand Barrels a Second" by Peter Tertzakian, did they comply?

If now, I'm afraid these posts are like doing your assignments without first doing your readings ;-)

[odograph]

"if now" should be "if not"

[Duncan Brown]

The underlying geology doesn't matter Odo. It's a universal law of human behavior.

For those, like Odo, who didn't take my hint about the Wikipedia:

Generally as the price of something (such as gasoline) rises, the demand for it goes down. Economists calculate this effect and call it the "Price elasticity of demand." For example, if, in response to a 10% fall in the price of a good, the quantity demanded increases by 20%, the price elasticity of demand would be 20%/(− 10%) = −2.

So if gasoline prices rise people will find ways to use less of it (and they will find other substitutes too).

Read all about it at: http://en.wikipedia.org/wiki/Price_elasticity_of_demand

[odograph]

The underlying geology doesn't matter, until they become the limiting factor.

Show me that US domestic production has grown, in response to price changes.

I think figure 4 on this DOE page shows otherwise:

http://www.eia.doe.gov/neic/brochure/aeo2004/aeo2004.htm

(short of that your wiki link is so much wind)

[odograph]

Let me make a more genearl comment. Absent any data to the contrary, the answer to the question:

Q: are we running out of oil?

is best answered it a general:

A: no.

Why? Because we only run out once, and (again, absent any data) there is no reason to leap to the low probability that the end is now.

The problem is, we have data. People who offer blythe "the peak is not now" arguments are, in my experience, those who do not familiarize themselves with the data.

A good moderate read (and not a polemic at all) on this is "A Thousand Barrels a Second" by Peter Tertzakian. He's a working petrolium economist and gathers a good set of historical data, along with current trends.

[John Whitehead]

Odo,

In answer to your question, I've yet to read "A Thousand Barrels a Second."

John

[Duncan Brown]

It sobers me to realize that 'm the only one on this site to remember a time before oil futures markets made all of these interesting invesments possible. Until the 1970s, the price of oil was stable, and production was controlled largely by the big American and European oil companies.

The 1970s threw this tidy oligarchic world into confusion. The Arab oil embargo in 1973 signaled the rise of OPEC. (I remember standing in gasoline lines, due to misallocation of supplies by the companies!)

For producers and users of oil, price volatility became serious problems. They needed a way to hedge the voltatility in Short term physical markets. A group of energy and futures companies founded the IPE in 1980 and launched the first futures contract, on Gas Oil, the following year. In June 1988, the IPE launched Brent Crude futures.

I dare say that if we were still doing it the old fashioned way, we might have blundered into a war in the Middle East over access to oil--Oh, wait ... Never Mind! The Wikipedia entry on the IPE:

http://en.wikipedia.org/wiki/International_Petroleum_Exchange