Spot oil prices climbed to new highs last week even as the price of the December 2011
futures contract fell, steepening the backwardation I commented on here and here. A look
back at what happened in the early 1980’s may give some insights into what the market may be
expecting next.
Last week’s news was not encouraging. British Petroleum announced
that U.K. oil production was down 10% over the last year, suggesting that the decline in production that began in 1999
as North Sea fields are depleted may be accelerating. Concerns about possible turmoil in
Nigeria may have also worried markets. But the most important factor continues to be strong
world oil demand.
Why didn’t the longer term futures prices, like that of the December 2011 contract, move up
with spot prices in response to the news? Some insight into this may come from looking back at
what happened to oil markets in the late 1970’s and early 1980’s. The graph at the right
displays the price of oil over the last half century quoted in current dollars, calculated by
dividing the price of West Texas Intermediate crude by the U.S. consumer price index. The
1970’s were a turbulent decade in which the OAPEC embargo, Iranian revolution, and Iran-Iraq war
resulted in supply shocks that more than quadrupled the real price of oil, driving it to a peak
in 1980 that would correspond to $95 dollars a barrel today.
World oil production fell over 10 million barrels a day between 1979 and 1982. But the
interesting thing to note is what happened to oil demand after these events, as oil use stayed
below 55 million barrels a day until 1985.
In part the drop in world petroleum demand was caused by the twin recessions of 1980 and
1982, which I’m
still hoping won’t be repeated this time. But even after the economic recovery from these
recessions was well under way, oil use remained low well into the decade.
This episode illustrates one of the key features of the petroleum market, which helps us
understand both the current turbulence of the market and one source of potential longer run
stability. The short run demand curve is quite inelastic– huge price increases are necessary
if you want to cut oil use significantly over the next few months. When, as in the current
environment, there is limited excess capacity, supply is quite inelastic as well. The result is
that spot oil prices are going to be extremely volatile in response to any disturbances on
either the supply or demand side.
Given more time, however, as new vehicles and equipment get replaced, there are lots of
things that businesses and consumers can do to reduce oil use. Most of the demand response to
today’s high oil prices will not be seen until several years down the road. Whether the price
increases so far will be sufficient to restore a longer run stability to oil markets without a
global recession is the big question we’re all pondering at the moment.
Someone was claiming on one of the message boards last week that at that moment the oil futures were in full contango, with each forward year higher than the spot price. I think one factor is that the spot prices tend to be more volatile than the longer term futures (which also lack liquidity). When we have a couple of big up days, like the last few, there will be a greater trend towards backwardization. Whereas if we have a down day or two, the long term prices won’t move down as much or as fast, and we can get into a more even price structure or perhaps even contango.
$60 a barrel oil
Oil prices surged almost 10% last week and are widely expected to top $60 a barrel this week. The recent price gains show a sharp turn in the short term market since only a month ago, when reports of steady…
Interesting analysis. There is one big difference though – areas of decline in demand. In the ’80’s most of the fall in use (at least in the US) was in industrial demand and electricity generation. Industrial contraction over the past two decades would indicate that the decline in use won’t be as large as back then; electricity generation moved heavily into nat gas and more coal, to the same effect. Transportation did not decline significantly, as usage stabilized. So, where is this decline to come in the US?
If we are to presume that Chinese usage (e.g., mobile electric generation, powered by diesel) will contract, we don’t get much in the way of decline, as Chinese usage in total is less than 7mbd.
Where is the predicted decline to come overseas? (Lacking massive economic disruption, that is.)
Thanks for the fair assessment, but I would like sombebody to explain what is so magic about the December/January breakpoint, where futures rise until that point and then begin to decline. Is it due to some sort of calendar-year reporting cycle of investment funds? Is somebody expecting a recession to begin? Is somebody expecting a geopolitical event in the Fall? Or, is it simply a classic six-month specuative trading horizon?
Finally, one admonition: Please take the word “hope” or “hoping” out of your vocabulary. Economists only have value to the extent that they can make strictly rational asessments and tell us what is real and what the likely outcomes are, based on objective analysis, not “hope”. Thank you.
— Jack Krupansky
Fatbear – You are certainly right that there are few prospects for oil demand reduction outside of transportation, particularly in the US. So the answer, from our standpoint at least is that is where it will come from, if price signals are strong enough.
China is a major oil consumer and responsible for a high percentage of the demand growth that has been (partially?) pushing prices up. Seven mbd is small compared to the US, but may be the second largest consumer in the world, up from the back of the pack a few years ago. My guess is that the use of oil for power generation and, more so, as a part of a boom in automobile use is price sensitive and elastic.
So my answer is that if oil supply is a major factor in price increases (which I thnk it is), prices will eventually rise high enough to shave off some of the marginal transportation use in the US and China.
OK – I’ll buy that Chinese demand can go down.
But, let’s say that China steps up to the plate and revalues (long overdue per many economists) by an effective 20% – if the Chinese economy can stand it. If it can, then oil is now 20% cheaper there – so needs a 25% rise to equate to US pricing.
I’m sorry, but as long as oil is in dollars and other economies have the opportunity to revalue (and in the case of China, need to), then I don’t see $-based demand reduction being enough.
The Euro area already is less price sensitive, due to the fact that high energy taxes already reduce the price damage (percentage basis). The only economies sensitive enough (outside the US) are either third world (and thus not heavy users, or heavy users but also producers at lower, non-market prices for internal use) or capable of revaluing away from the worst damage (Japan and China mainly).
Obviously the revaluation path may have negative impacts on the economies of those nations, and that may cause demand contraction. But my point is that the dollar price may not be enough to immediately constrain demand.
Energy Market Correction: Catalyst
I continue to look foward to that almost ‘single’ item of information that hits the market and expectations of investors that leads to an inevitable correction in energy prices. There are at least three reasons for this point of view:
1. Energy equity markets have soaked up a high percentage of equity capital that has continued to lead to a self-fulfilling prophesy of continued stock price growth due to a high degree of liquidity in that sector;
2. Outside the energy sector, other stock sectors have ‘slowly’ been creeping up in price. In particular, I view the technology sector as a market segment poised for excess stock returns going forward due to high expected growth in the semiconductor industry, as recently commented about by the Semiconductor Industry Association (SIA), but it will be an albeit volatile upward path. What’s more, please view the daily data for technolgy stock price jumps when the price of crude has dropped by more than US$2/boe lately on a given day; and
3. With rising short-term lending rates and also the emergence of higher medium to longer term bond yields as well, the last thing the global macroeconomy needs at the moment is an unexpected contraction in real gdp 3 – 5 quarters from now.
Thus, for selfish global growth reasons and also for a more balanced allocation of equity capital in other non-energy stock sectors, I look forward to a correction in the energy sector. The billion dollar question(in terms of by what dollar amount energy market capitalizations across the sector may drop) is, however, what will be the catalyst? Perhaps:
1. Saudi Arabia making a credible statement that affirms that there are no supply problems on hand and that the capacity back up in the US can be alleviated through a substitution effect for other sources of energy at present?
2. Financial markets realizing that their buying is already into 2007 and that energy stock prices are in fact way ahead of themselves?
3. Or, perhaps a slowing of global growth and growth in emerging market economies such as China as Chinese Offical investment restrictions demonstrate their lagged effects on economic growth in China?
My personal bias is to expect that the catalyst for an energy sell off will be something very simple such as the imbalance between the growth rate in demand and supply BUT this relationship will show up first in the expectations of financial market participants as they react to information that has been out in the market for some time but has been ignored.
Sound familiar? It should, as in my view, the energy price excesses in the commodity and equity markets are simply another example of excess speculation driven by good fundamentals in a sector that have turned into spectacular fundamentals in the minds of many, which will be checked by the market in time in a typical cyclical manner….
The oil-price bubble
It doesn’t seem like two months ago that I wrote this: In many ways today’s oil market reminds me of the dot-com insanity, what with analysts like Goldman Sachs’ Arjun Murti channeling Henry Blodget, predicting $105-a-barrel “super spikes,” a…
Kirby –
In theory you’re on to something – except, in this case there is a slight problem in that the supply of oil is a limit on the drop in price, and by that I mean the total supply, not daily production. Forgetting whether the peak is this year, next year, or 2015 – it will happen, and oil has financial value due to its scarcity in the future. Please remember what happened in the first oil crisis – even after production was back to full levels, the price never returned to the previous $1-2 range – according to your analysis, it should have.
6/27/05 Carnival of the Capitalists
Welcome to the Carnival of the Capitalists, your source for the best business blogging of the past week. This week’s carnival was done with the help of Brian Gongol’s template. I also labeled a few of my favorite posts with…
6/27/05 Carnival of the Capitalists
Welcome to the Carnival of the Capitalists, your source for the best business blogging of the past week. This week’s carnival was done with the help of Brian Gongol’s template. I also labeled a few of my favorite posts with…
This Week’s Carnival Of The Capitalists
This week’s Carnival of the Capitalists is up at BusinessBlogCast. While your tastes may differ, here are my “picks of the litter”:
The Best Advice I Can Give from FreeMoneyFinance. He’s been putting together a collection of “best advice” from per…
The oil-price bubble
It doesn’t seem like two months ago that I wrote this: In many ways today’s oil market reminds me of the dot-com insanity, what with analysts like Goldman Sachs’ Arjun Murti channeling Henry Blodget, predicting $105-a-barrel “super spikes,” a…