July 3, 2008

What will oil do in the short-term?

There are many dynamics operating in oil markets, including geological limits, capital expenditure lag-time, geopolitics, currency valuations, technology, consumer psychology, institutional resistance to change, and speculation. It is reasonably accurate to say that supply and demand got us to $100 oil in the last year. This is well explained at Econbrowser.

$100 oil was sufficient to flatten out oil consumption (the US DOE calls this "demand", though this word usage drives economists crazy) for the last several years, despite the overwhelming media message that high prices were temporary. Lately supply (and consumption) has increased slightly, which should have helped keep prices at the same level. Instead, prices are jumping - from the viewpoint of supply and demand, it makes no sense. For instance, David O'Reilly, chief of Chevron, is baffled by the extremely high oil prices seen recently. "We're surprised. We can see how you can get to $100," he says. "At $140, I just don't know how to explain it." (NYT 7/5/08) .

Could speculation raise oil prices beyond $100?

Sure. Fundamentally, futures markets are a marketplace to order commodities for future delivery at a fixed price (even if they're used as a casino). If many new participants place new orders, we have new demand, and prices will go up, so there's no question that speculators can raise prices by "going long" - in other words, betting that prices will rise. Of course, they can also lower prices by going short. In the most benign scenario, speculators provide a socially productive service by "price-finding": pushing prices up (or down) until supply and demand are balanced. If speculators see a looming shortage, they bring that shortage forward to the present, and accelerate the necessary economic adjustment. This is good, though the process is by trial and error, and can easily overshoot and oscillate around the ideal price, causing unpleasant volatility. On the other hand, it is common for speculators to "herd" - IOW they mostly choose one side or the other of such a bet (this is often what is called a "momentum play", aka "the greater fool" theory), and this can create a much larger and very unpleasant overshoot, and an excessive adjustment afterwards, such as we are seeing in the housing market.

An analysis at Econbrowser suggests that a small bubble is possible. Some people say that the effect has to be temporary, as eventually delivery must be taken or the contracts sold, but new paper bidders (speculators) can surely raise futures prices temporarily (IOW, create a bubble), and spot prices will rise in tandem due to arbitrage. Even if it is only temporary, most futures contracts are measured in years, so why can't we see a bubble for a year or even more? Further, if existing investors roll over their bets, and new investors continue to arrive ("greater fools") the bubble can grow for a significant time.

So, are we creating a bubble?

It seems to me that, that fundamental supply and demand are the problem, but there's no question that there's a lot of speculative money in the market. Even though price-finding is probably a healthy thing from an economic viewpoint, that can easily overshoot. Further, there's a lot of money that is herding (mostly, apparently, in the form of Exchange Traded Funds), so a bubble due to momentum-play speculation is also reasonably likely, and these investors seem to be mostly going long.

I suspect that current prices are unsustainable: higher prices stop consumption, even in China. We see that China had to cave in, and raise price controls, even before the olympics, which is very likely something that they really didn't want to do. Despite a constant linkage in media reports of Chinese and Indian consumption, India's consumption has been flat for several years. Brazil has become an exporter, due to increasing oil production (with a greatly exaggerated assist from sugar cane ethanol). The highest prices are being seen by the US, and countries whose currencies are tied to the dollar, including China and Japan.

Short-term demand elasticity is much smaller than long-term. In other words, people don't reduce consumption if they think high prices are temporary, and reductions are much easier over time, as people make routine capital expenditures such as car purchases. It's a serious mistake to think that people and businesses don't respond to oil prices. Overall global demand is unsustainable at this price level, and will fall until prices decline substantially. The level at which demand matches the current plateau of oil production is probably around $100-$120. I expect to see more stories like this describing a short-term decline to more sustainable prices.

Wouldn't we see accumulating oil storage in the form of rising inventories?

First, that assumes increasing production or falling demand. Oil export show no sign of responding strongly to prices (outside of a small increase from Saudi Arabia), and it would take some months for declining demand to have a strong effect (there are a number of sources of delays, including the time required for oil product distributors in China and India to run out of money because of price controls, the time required for pundits in oil-consuming countries to admit to the public that prices are going to stay high, and the delay in reporting production and consumption statistics), so a bubble measured in months wouldn't have a visible effect. Second, the speculators don't have to store it (and refiners currently consider oil far too expensive to store - they're minimizing inventories just to save money). The logical place for storage is by the sellers who have promised future delivery. AFAIK we have little info about National Oil Company storage, and in the final analysis NOC's can store oil in the ground. The King of Saudi Arabia has recently talked publicly about doing just that ("saving our oil for future generations").

Are NOC's (like Saudi Arabia) manipulating prices?

They certainly could - they have more than enough money. I think that Saudi Arabia is smart enough not to do that, as it would hurt them in the long-run. Sadly, not all oil exporters are as smart as Saudi Arabia. The leading regulator thinks manipulation is possible : "The acting CFTC chairman told the panel that it is imperative that strong enforcement actions be taken in order to prevent illegal manipulation of the commodities markets, noting that the markets are "ripe" for such manipulation. "

Do we know for sure?

No, there's inadequate data on trading and and inventories outside the US. We have to rely on our analysis of fundamentals, and read the entrails of snippets of information about the activities of traders. Here is a good discussion of how little we know.

Note: I remember seeing the heads of the commodities exchanges quoted as saying that oil speculation is a productive price-finding process, in effect bringing future shortages to the present. I can't find a reference - has anyone seen that?

1 comment:

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