Oil Prices (2)

The factors I described in the last post have been working in both directions over the last few years. World-wide economic growth over the past decade created an enormous demand for oil. This demand reached peak in July, as China stockpiled oil for security during the Olympic Games. Productive capacity was unable to match this peak in demand, so the price rocketed up to $150 a barrel.

During the latter part of 2008, the world economy stropped growing and many western countries moved into recession. This caused a sharp decrease in the demand for oil. The politicians who control oil production have refused to reduce production, so the oil price has plummeted, as supply exceeds demand.

Motorists are really appreciating the drop in prices at the pump. However, we should not become complacent in response to the decline in fuel prices, because the high oil prices last year are a warning of what could happen in the future, if strong demand comes up against limited supply. When the world economy moves back to full speed, strong demand for oil will once again push hard against limited production capacity. The problem is that most of the easy oil has now been found. Production is declining at several of the largest oil fields. Many more oil discoveries will be made, but they will be much more expensive to bring on line, so much higher prices will be needed to make them economic.

The current low price of oil is probably temporary. Enjoy it while it lasts, but this is not the time to buy a bigger better gas guzzler.

Oil Prices (1)

Back in July 2008, the price of oil peaked at nearly $150 a barrel. By November the price had dropped under $50. This is an amazing change in prices over a short period.

The usual pattern for most goods and services is that prices rise and fall to clear the market. If demand increases, the prices rise and supply increases to meet the new demand. If demand declines, the price will fall slightly, causing the supply to fall.

If either the supply or demand for a good does not respond quickly to small changes in price, bigger price changes may be needed to clear the market. This is the situation with oil. (Economists describe this as inelasticity with respect to price, but you can forget that if you are not an economist).

The reason for the recent sharp fluctuation in the price of oil is that production does not respond quickly to changes in price. Prospecting for oil is a hit and miss affair that takes time. Bringing a new oil field into production takes several years. When there is no spare capacity, an increase in price does not lead to increased production, because producers cannot bring new fields into production quickly.

The other reason is that most of the large oil fields in the world are owned by government authorities. Politicians do not like reducing their spending. So when prices fall, state-controlled oil companies do not cut production, because the politicians do not want to reduce their spending.

This problem has been evident over the last few months. OPEC agrees that the logical response to the falling price of oil would be to cut production to maintain the price at least $80, but they have been unable to take action, because none of the OPEC member states are willing to cut production. The politicians avoid economically sensible actions, because they have a short-term focus that makes them unwilling to think further ahead than the next election, or the next coup.

The complexity of the production process and the complicity of the political process prevents oil production from responding quickly to changes in price. This means that changes in demand can produce sharp fluctuations in price.

The Economic Situation (10) - Balancing Oil

An economic model that can accurately assess and weight all these factors together to determine the future price of oil does not exist. We simply do not know how severe some of these effects will be. However, we can be sure that all these factors will come together in the oil market to decide the price. I am happy to leave this question to the market to decide.

I do not have any revelation about the direction that prices will go. In the short term, I expect that ail prices will continue to go down as the weakness in the American economy bites and as consumers respond to high gasoline prices.

On a more cautionary note, I have been amazed out how easily we have coped with oil prices above $100 a barrel. We have grumbled a lot and carried on doing most things that depend on oil. Air travel had not declined dramatically. I once thought that prices at that level would cripple the world economy, but the events of the last few months have proved that this is not the case. The credit crunch has had greater impact than high oil prices. I am sure that OPEC have noticed this too. They do not have the ability to control oil prices, but given that they have had some extremely good years, they will be able to bring significant cuts in production to prevent oil prices from falling to far. Therefore, I suspect that we are unlikely to see prices go much below $100 per barrel. That is not a problem as the world economy will be able to cope.

Wise observers will be aware that market prices sometimes overshoot. We have probably just seen oil prices overshoot on the way up. They may also overshoot on the way down.

In the longer term, the pressures on oil prices are mostly upwards. How fast and how far they will go up will depend on how quickly new supplies can be pumped and how quickly the world can reduce dependence on oil. No one knows the answer to that except God.

The Economic Situation (9) - Bad News about Oil

1. Although Americans have cut back on their gasoline consumption, it is not clear that this can be sustained. The American suburban lifestyle cannot function without cheap gasoline. Americans may not be able to change their lifestyles sufficiently to bring about a permanent drop in dependence on oil. If gasoline prices drop a little, they will probably hit the hammer again.
2. The weakening of the American economy is reducing demand for oil. The problem is that this could be temporary. When the economy returns to full health, most of this demand for oil will be restored, putting upward pressure on prices. If the recession is short, the demand for oil will recover quickly.
3. Oil production has slowed over the past few years. I am not sure if we are anywhere near peak oil, but there is no doubt that the easy oil has already been pumped.
4. A serious problem is that no one knows the size of Saudi Arabian oil reserves. When the Americans were kicked out of Aramco in 1979, the Saudis had proven oil reserves of 50 billion barrels. Since then the Saudis have increased their reserves to 260 billion, despite not find a single new oil field. In the past ten years, they have pumped at least 50 billion barrels of oil, but their reserves are never adjusted down. The problem is that the Saudis do not allow any outsider to monitor their production or authenticate their reserves. Their reserves may be much smaller than they claim. When the truth emerges, the world might be oil shocked.
5. Nigeria has become an important oil producer, but the political situation in the oil producing areas is increasingly unstable. Oil workers have been kidnapped and oil pipelines have been destroyed.
6. Iran is an important oil and gas producer. Any military action against Iran would disrupt Iranian oil production. Iran might retaliate by closing the Straits of Hormuz through which half of OPEC oil must pass. This would blow out the price of oil.
   
   The problem is that Prime Minister Ehud Olmert of Israel, President George W Bush of the United States and President Mahmoud Ahmadinejad of Iran are all weak political leaders with declining domestic political support. They are all shoring up their weak political positions by pointing to foreign enemies. Despite the current posturing by the leaders of Israel, the United States and Iran, I expect wiser heads to prevail. I do not believe military action against Iran is likely in the next decade, but every time that war is threatened the price of oil will go up.
7. The United States has already pumped all the easy oil. Even if the law is changed to off-shore drilling, the new oil will be more expensive to extract.
8. The North Sea fields operated by Norway and the UK are being depleted quickly.
9. Russia has immense reserves of oil in Siberia, but they may not have the technical capability to extract and deliver this oil to market.
10. Central Asia has large reserves of oil and gas, but transport is difficult.
11. The big unknown is Asia. Will the Chinese economy turn down? This is the key question, but no one knows the answer. The developed world will certainly import fewer goods from Asia. However the new Chinese middle class are starting to spend and consume in a serious way. The growing demand from Asia may compensate for the declining demand from the west.
12. In the long term, demand for oil from China and India will be huge, if they continue to develop at current rates.

The Economic Situation (8) - Good News about Oil

1. The best cure for high prices is high prices. People respond to high prices by reducing consumption. Producers respond to high prices by increasing production. This is already happening. Consumption in the west is declining
2. The United States is no longer as dependent on oil as it was during the first Oil Shock in 1973. Part of the reason is that much of the oil intensive manufacturing has moved to China.
3. High prices encourage oil exploration. However, increasing production is not easy in the short term. A new oil field can take several years to bring into production. If the fuel is in a remote hostile environment, it may take even longer to bring into production.
4. Rising oil prices make processes that extract oil from sand and shale economic. This will increase production.
5. If oil prices remain high, new energy technologies will emerge to reduce dependency on oil.
6. Despite OPEC’s efforts, the market for oil is relatively free. If prices remain high, consumption will reduce and production will increase, which will bring prices down.

The Economic Situation (7) - Unknown Oil

The big fly in the ointment is the price of oil. It has doubled in the last few years. Opinions differ as to what will happen next. Some say that the fundamentals mean that the price will drop to $US20 a barrel. Others say that it will increase to $400.

The truth is that no one knows. It is impossible to look at the fundamentals of any good and decide what the price should be. The Soviet Union proved this to be true. They tried to look at the fundamentals and decide what the price of good should be, but they always got it wrong. They set the price of bread to low, so there were always shortages and people had to queue. Other prices were set too high, producing a glut of goods that nobody wanted. The truth is that no person or organisation has sufficient knowledge to determine what the price of any good should be. The benefit of markets is that prices go up and down to ensure that supply matches demand.

I smile when people say that based on fundamentals, they know what the price of oil should be. These fundamentalists do not understand markets.

There are several factors that make the price of oil particularly hard to forecast. Some are positive and others are negative. I will look at them tomorrow.

Oil Proof

The sight of George W pleading with the Crown Prince of Saudi Arabi to pump more oil was pitiful. I bet they had a great laugh in the palace afterwards.

Recent events have proved that the world can cope with oil at $100 a barrel. We can be certain of one thing. OPEC will not let the price go below that level again. If I were the Saudi Arabian oil minister, I would reduce production, as soon as the price went below that level. They can afford to reduce production, because they have earned enough while the price was at $130 to last them for quite a while.

Actually the best thing that could happen for my great great great great great great grand children would be for the price of oil to go above $200 a barrel. That way there might be some oil left for them. I think they will appreciate having some oil, because it is so useful.

Oil Futures

Some commentators are accusing speculators of pushing up the price of oil. Before getting to worked up about this we should do some clear thinking. There are three ways that speculators came make money from a commodity like oil.

1. Speculators can buy shares in the companies that produce the commodity. This is happening with oil companies. There shares have increased dramatically, but this does not change the price of oil.
2. Speculators can invest in commodity future. They are guessing what the future price of the commodity will be in the future. Future prices do not feed into current prices. Unless they close out the contract before the settlement date, the parties to a contract must settle on that date. If the market price has diverged from the contract price, one of the parties will make a loss.
   
   The futures market must face reality when the future meets the market in the present. This means that the market price eventually dominates the futures price. Speculators may be pushing up the future price of oil, but if they are wrong, they will eventually take a bath.
3. The only way that speculators can influence the current price of a commodity is to buy the commodity and storing it. This reduces supply while leaving demand unchanged, which should cause the current price to move up. Buying and storing is quite easy for many commodities. Gold coins can be purchased and stored in a vault or under the bed. Wheat can be purchased and store in a silo. The problem with purchasing oil for speculative purpose is that it is not that easy to store. The oil has to be stored in tank or a tanker, which is costly. Current reports indicate that the volume of oil in storage has not increased significantly, so it is unlikely that speculators are storing large volumes of oil to get a better price in the future.
   
   Buying a commodity for speculation only makes sense, if the price is going to go higher in the future. Most of those who own oil at the moment, will be selling it as quick as they can to get $130+ a barrel.

People like having someone to blame. Speculators are always an easy target. The real reason for high market prices is that the supply of oil exceeds demand. If the American economy goes into recession or American’s get out if their cars and walk, prices might fall again, but I am not holding my breath. The American economy still looks fairly strong and the American pedestrian is overweight, so I do not see either happening soon.

Waste Oil

The chief executive of BP has released a Statistical Review for 2008. He says that in the last century, the world has used a trillion barrels of oil. He says that oil companies know about another trillion barrels of oil and could possibly find another trillion with better technology.

What strikes me about this is that we have lived through a very selfish century. Three generations have consumed a third of all the oil that exists on earth. One generation will consume the next third.

Oil has a tremendous range of uses. It is one of the most useful resources in the earth. Burning oil in cars is really poor use of such a precious resource, yet about half of that oil produced so far has been consumed in cars.

The strange thing is that most of this oil has been used up by countries with a strong Christian influence. Paul taught that people without faith live for the present.

Let us eat and drink, for tomorrow we die (1 Cor 15:33).

He expected Christians to be future orientated.
When it comes to oil, Christians have outdone the pagans of Paul’s time. Our philosophy seems to be,

Drive and burn, because Jesus is returning next week.

Using up the total supply of oil on earth in the earth in one and a half centuries would be fine, if we are near the end of history. However, if life is going to go on for another couple of thousand years, as I expect it will, our descendents will look back and regret the way that we have wasted oil.

Oil

Over half of all the oil in the world has been used up in less than a century. This natural resource has been used up at an amazing speed with little thought for the future. And it has been sold amazingly cheaply. I am always amazed that a litre of petrol is still cheaper than a litre of bottled water.

I wonder if part of the reason is that most of the oil fields in the world are effectively owned by the state. Politicians have very short time horizons. They only look as far as the next election. Dictators only look to the end of their reign. Therefore, politicians want to see as much oil pumped as soon as quickly as possible. They have not interest in conserving their asset for later generations.

Maybe it would have been different if the oil fields were owned by families. I suspect that they want to keep more of their oil as an asset for their familes future. Maybe the price of oil would have been higher and this resource not used so quickly, if it were not in the hands of politicians.