A reader writes:
I would like to see you do an article about the current oil prices. I am no economist but have a basic question. If oil production is about the same as three years ago and oil refineries are running at about the same capacity (maybe less due to Katrina, political unrest, etc.) , why is the price of oil more than double from three years ago? I know that the demand for gasoline is probably up which would certainly explain higher gas prices but it would seem that a relatively fixed refinery capacity breaks that relationship between oil and gas prices.
Three reasons:
1) Rising world demand Rising incomes in Asia are pushing up demand for oil to power transportation and industry.
2) Supply worries When investors worry that future oil prices will be high due to a supply disruption, they bid up the price now and stockpile. No one's quite sure how much this speculative aspect plays a role. But security worries in Iraq and Iran, civil unrest in Nigeria, Saudi Arabia's simmering problems, and Hugo Chavez's populist antics with PDVSA, the Venezolano state-owned oil company, all have people worried.
3) Supply inelasticity Pretty much every country on earth is pumping as much oil as they can except Saudi Arabia, and it's very unclear how big even their cushion is--certainly no more than a couple of million barrels a day in a world thirsting for the hundred million mark.
We don't know whether these worries are permanent or short term. One argument says that OPEC nations have been grotesquely exaggerating their reserves in order to raise their OPEC quotas, and that therefore we are at or near the natural limit of the oil that can be economically pumped. Another argument says that countries, especially OPEC nations, are simply slow to ramp up their capacity because they are still haunted by the memory of the price collapses in the 1980s and 1990s, which devastated their economies and politically threatened many oil regimes. It's worth noting, however, that one of the main oil supply bulls is now predicting that oil will hit $150 a barrel.
In the short term in the US, the main constraint is refinery capacity, especially in small regions with their own boutique mixes, such as Chicago. Over the longer term, the constraint is willingness of various places to build processing plants for our gasoline, port capacity to handle transshipment, and of course, how much we're willing to pay for the oil that goes into our gasoline.
Either way, I'd look for prices to stay high for a while. Of course, bubbles always look most solid right before they pop, so take that for what it's worth.
Don't forget the devalued dollar. Obviously, there's a chicken-egg relationship as to which is causing which, but it's still a factor.
Not disagreeing with you, but you've forgotten reason 4. Oil is priced in dollars and the dollar has gone a massive devaluation over last few years. That translates into inflation of oil prices.
Not sure where I read it, but the figures struck me so much they stayed with me:
Since 2006, the price of oil has risen 80 percent when priced in Euros, but 136 percent when priced in dollars.
So, yes, the devaluation of the dollar certainly has been a factor, as has the concomitant bid-up in commodities as a result.
How much of the "worry premium" is owed to me, as a consumer? Just asking.
Meanwhile, how about we squeeze out some of the non-physical demand for oil and see what happens, just for the heck of it, he?
Megan,
you could be of further service if you'd care to report to on, the many, continuing, large, oil discoveries like:
http://clusty.com/search?v%3afile=viv_970%4018%3aKwDTkE&v%3aframe=list&v%3astate=root%7cN526&id=N526&action=list&sw=%7cBakken%20Oil%20Formation%7cBakken%20Formation%20oil%20field%20has%20up%20to%204.3%20billion%7c&sec=1210289000&
as well as, report on the huge swaths of our own Contiental Shelf that has put 'Off Limits' to any exploration whatsoever..
this, of course, says nothing of Brazil's massive new finds, et al., etc..
Simply, we live on Bountiful Earth--including Oil.
Can we include the effects of those hedging against the dollar by investing in commodities?
These aren't attacks, but just questions
Re: #2 - I have heard this proposition a lot lately. To explain this, wouldn't someone, somewhere need to be literally stockpiling oil somewhere? Or, are people just bidding up the price on tomorrow's deliveries?
Also, how can we reconcile #2 and #3? If it was thought that oil prices are going to be higher in the future, doesn't that incent[ivize] producers to slow down their production? The cheapest way to stockpile a barrel of oil is to keep it in the ground to begin with isn't it? Assuming a single owner for a given deposit, it only makes sense to produce as fast as possible if the owner thought that prices would drop in the future. Otherwise, the producer either produces at a rate with the lowest cost per barrel or produces at a rate sufficient to cover costs with the plan of jacking production once prices spike.
I have a good business model. I will drill for and sell oil, and then use the profits from that oil to bid up oil futures which raises the prices I get from that oil. If enough of my friends do the same thing, we can keep prices up indefinitely
To explain this, wouldn't someone, somewhere need to be literally stockpiling oil somewhere?
I've always wanted to call up a commodities broker and tell him I wanted a bushel of wheat and one pork belly, to be delivered to my door.
Seriously, I think most commodities prices as traded on the open markets and reported in the press are futures: i.e., you're buying a future delivery. So speculators don't need big tank farms, they can just buy up rights to future deliveries and then later sell that right in a private, non-exchange-listed, not-reported-in-WSJ sale to somebody who actually wants unrefined crude.
But I could easily be wrong.
I taught economics some years ago, so here goes ...
Supply is the quantity supplied AT A GIVEN PRICE
that last bit tripped up some percentage of the students and always seems to
We also have increased demand as Megan has described
MM's descriptions of the oil market and the tax incidence of gas tax were pretty sound but the points are lost on people who don't (or won't) grasp the concept of supply (or demand)
There's a hell of a lot of oil undergound but it won't be "supplied" unless the price is right and the factors of production (Rigs, workers, pipelines, etc.) are in place
"I have a good business model. I will drill for and sell oil, and then use the profits from that oil to bid up oil futures which raises the prices I get from that oil. If enough of my friends do the same thing, we can keep prices up indefinitely."
Nice plan other than you'd be buying oil at the higher price on the futures' delivery date. Or you can unload those futures and drive the prices back down again.
Jozef: your post seems to be a bit of a non-sequitur.
proposition #3 was that currently oil wells are at peak capacity and regardless of price, cannot produce more oil (with the exception of Saudia Arabia). Price is set by demand, which is much more elastic than supply.
proposition #2 was that oil wells are producing more oil than is actually being consumed, because some oil is being diverted to stockpiles, thus artificially reducing the supply and increasing price.
These two are difficult to reconcile with each other. If there is stockpiling, where is this occuring? We would be talking about a lot of oil. The most logical place would be underground, but then why is it being produced in the first place? Which brings me to the second point, if it makes sense to stockpile oil, then it would make sense for the oil field owners to reduce production rates. But that would mean the oil fields are not at peak production.
My guess is that one of these propositions is wrong, or that I am missing something that would reconcile the two.
I think you misunderstood the question. Perhaps a corollary question I've wondered about would clarify the issue: why does the price of oil spike on news that a gasoline refinery is unexpectedly shutting down (due to a maintenance issue or some such)? Shouldn't this lower demand for oil, not increase it, especially since refineries have been running at 100% effective capacity for years? BTW, your answer was excellent to the question that you thought was asked.
Let's not forget that most of the oil on the planet is being pumped by inefficient state-run companies (PDVSA, PEMEX, Saudi Aramco, Gazprom, Petronas, Petrobras).
Privatize them, and they might be able to raise production more rapidly.
#3 - Not all Opec Countries are interested in keeping prices high indefinitely. Sure the ones with smaller reserves want to sell their stuff in as big a quantity and for as much as they can. While there is little change people can make in the short run, in the long run, the collapse in the oil price was in part due to changes in behavior that were not going to be unchanged. For example homes became better insulated, industrial processes became more energy efficient, and more energy efficient cars came on the market. Worst for Opec's case, non-opec drilling and exploration occurred and global supply increased and opec market share decreased. In the long run alternatives will come on the market and other demand factors will change.
Rob,
You are welcome to get wheat and/or pork bellies delivered. First, you buy the futures contract. Second, you don't sell it. That means you take delivery. The "delivery" is usually to some standard place (for wheat, Chicago and Kansas City are pretty common - I have no idea about pork bellies). Then you have the choice of having it shipped to your doorstep or paying rent to have it held in the warehouse where it currently resides.
The selling is no more secret than the buying. In fact, they are exactly symmetric. You cannot buy a bushel of wheat (whether now or for delivery in December) unless someone else is willing to sell that bushel of wheat. The number of bushels contracted is known as "open interest" and is published by the exchanges daily (you can get it in real-time if you pay for it).
You can, of course, make as many secret, unreported deals as you like off the exchanges. Those are called "forwards" not "futures". The prices are generally more-or-less equivalent at the time the deal is made but the contracts are VERY difficult to get out of (as delivery nears, one side or the other has probably made a significant profit and will not be willing to back out) and the quantities are VERY large (an oil company is not going to deal in mere 50,000 barrel quantities, although the futures market does).
The Iranians are stockpiling oil in ships offshore, about 20 million barrels right now. The US is stockpiling about 70,000 barrels per day into our reserves. No doubt others are doing the same.
The people stockpiling it (underground, mostly) are not the same people who are pumping it.
Hope that helps.
Rob,
You are welcome to get wheat and/or pork bellies delivered. First, you buy the futures contract. Second, you don't sell it. That means you take delivery. The "delivery" is usually to some standard place (for wheat, Chicago and Kansas City are pretty common - I have no idea about pork bellies). Then you have the choice of having it shipped to your doorstep or paying rent to have it held in the warehouse where it currently resides.
The selling is no more secret than the buying. In fact, they are exactly symmetric. You cannot buy a bushel of wheat (whether now or for delivery in December) unless someone else is willing to sell that bushel of wheat. The number of bushels contracted is known as "open interest" and is published by the exchanges daily (you can get it in real-time if you pay for it).
You can, of course, make as many secret, unreported deals as you like off the exchanges. Those are called "forwards" not "futures". The prices are generally more-or-less equivalent at the time the deal is made but the contracts are VERY difficult to get out of (as delivery nears, one side or the other has probably made a significant profit and will not be willing to back out) and the quantities are VERY large (an oil company is not going to deal in mere 50,000 barrel quantities, although the futures market does).
The Iranians are stockpiling oil in ships offshore, about 20 million barrels right now. The US is stockpiling about 70,000 barrels per day into our reserves. No doubt others are doing the same.
The people stockpiling it (underground, mostly) are not the same people who are pumping it.
Hope that helps.
Iranians are "stockpiling" only to the extent that there are constraints on refining the foul oil they produce, it is sitting in tankers because of refinery constraints...
Rob, your post is a bit of a non sequitur. (Did the ancient romans use hypens?) You can bid up the price of oil without buying (taking physical possession) via a futures market as others have noted.
Iranians are "stockpiling" only to the extent that there are constraints on refining the foul oil they produce, it is sitting in tankers because of refinery constraints...
Rob, your post is a bit of a non sequitur. (Did the ancient romans use hypens?) You can bid up the price of oil without buying (taking physical possession) via a futures market as others have noted.
The 100% year-over-year move in oil prices is mostly the result of a speculative bubble. Global demand is only up about 2% year-over-year, according to the International Energy Agency, and global supply is up by a similar amount.
The U.S. government should stop filling the strategic oil reserve for a few months and should start selling into this crude rally -- we've got 280 million barrels of sweet crude, so why not sell 28 million of them over the summer? The cash proceeds can be used to replace the oil after prices pull back.
From listening to the Q1 conference call from a domestic refiner this week (Frontier Oil Co.), it doesn't seem like refining capacity is an issue this time; the issue is the cost of crude. Frontier's CEO said they are going to transition their production even more to diesel (where FTO's margin's approach $30 per barrel) from gasoline, where their margins are only about $4 per gallon. Bear in mind that those ~$4 margins are despite using cheaper heavy, sour crude. Refiners who can only process the light, sweet stuff probably have negative margins.
Does anyone, liberal, conservative, or libertarian really want the government to start dealing in oil on the open market?
Liberals will be afraid of a new Teapot Dome Scandal.
Conservatives will assume the government will be incompetent and lose money.
Libertarians will be afraid the government will be competent and become self funding allowing the government to grow unchecked by the power of the purse.
One of the problems with the present (ie post-Katrina) run up in futures prices is the extent of the margin trades. In the 20's a large run up in the stock market was, I think, to no small extent fueled by a low margin highly speculative market. When the market did drop the margin calls broke people and started a major run on the cash markets.
Much the same is happening in the commodities futures via the ENRON loophole on the electronic exchanges. I have read that margins on oil futures are in the neighborhood of 3-5%. That's a very thin margin and if the trader's guess is correct on price moves, there is fabulous money to be made. On the other hand, once the speculative run-up ends, those left holding the futures contracts in a falling market will be forced to meet the margins on paper they cannot sell or accept delivery on. In this financial musical chairs, the music will eventually stop and when it does, those with out a seat will lose..big time.
The solution for the speculators: rumor mongering, fud (fear, uncertainty, doubt) generation on supply issues to maintain an ever increasing spiral. Analyzing the net crude/refined inventories shows a steady increase in inventories in the post-Katrina timeframe.
The solution for the rest of us, before we all go down? Raise the trading margins to something reasonable like 50-70% from 3-5%. I have no problem with an honest profit from honest labor and trading, but margin trading as it existed in the '20s and today in commodities futures is Las Vegas writ large, and benefits no one except those gamblers with large purses, while leaving the black jack tables to the "poor people."
Looking a little more broadly, people are continuing to finance the run up in gas prices, but there is also subtantially increased credit spending, another bill which eventually must be paid, either through gains in income/productivity or by not buying other items or by bankruptcy. This is a very frightening picture as I'm sure the Bear Sterns people have come to realize.
The present price run up curve over the past number of years has the form of an e^x shape and we are on the steeply rising part of the exponential curve. It will only be a matter of time before this curve approaches its maximum and the music stops.
Jon,
The government is already buying oil on the open market, and has sold oil from the SPR in the past (e.g., during the aftermath of Katrina). None of the concerns you mention are particularly strong. Since the average cost of the oil in the SPR is about $28 per barrel, it would be impossible for the government to lose money selling a small percentage of it. And even if all 700 million barrels in the SPR were sold, at current market prices that would only cover about 2.8% of the costs of the federal budget. The libertarians have nothing to fear.
mrsizer, thank you for a most informative post.
Why hasn't the sustained high price of oil triggered a world wide recession?
RATHER BUY SASOL, SOUTH AFRICA, COAL TO OIL!
On the 8 April the company had a comprehensive investor day in New York. Timing of these investor "show and tell" days are always important and with crude prices at new highs, Sasol times this to perfection.
The date also coincided with Sasol’s 5 year anniversary of its listing on the New York stock exchange main board.
The investor day was designed to update analysts of the company’s strategic, operations and financial progress as well as an update to opportunities.
Sasol is the world’s leading provider of synthetic fuels and chemicals. As the price of fuel trends sharply up, Sasol’s technology taps into coal and natural gas in order to convert this to clean diesel, petrol and jet fuel.
Sasol has a powerful business model with 50 years of technological innovation, operating and continuously improving its large synfuels and chemical plants all using its proprietary technology to the Fischer Tropsch process.
They have 206 PhD’s on their staff.
Sasol’s SA operations remain the biggest contributor to earnings at 86%.
Internationally the business units are Sasol Synfuels International (SSI), Sasol Chevron and 50/50 Joint venture and Sasol Petroleum International (SPI)
Their presentation revealed some interesting statistics:
o 80% of world oil in 9 countries, representing just 5% of world population and 5% of GDP.
o 80% of world coal in 6 countries representing 45% of world population and 46% of GDP
o 80% of world gas in 13 countries, representing 12% of world population and 26% of GDP.
Sasol has a large pipeline of projects at various stages. Shorter term is the Oryx operation in Qatar, gas to liquid (GTL) in Nigeria.
Medium term is China coal to liquid (CTL), an increase of the Qatar footprint
Longer term is possible projects in US and India (CTL) and Australia (GTL)
Sasol Technology is at the heart of Sasol. Its here where Sasol employs 100 PhD’s, 2000 technical and support personnel and has filed about 590 patentable innovations of which more than 300 are in force in many countries around the world.
Staffing up is a big project in it own right, given in the war for talent.
In addition Sasol has recently announced the Sasol Inzalo black economic empowerment deal, which will effectively see 10% of Sasol owned by various groupings, in a total transaction valued at R25,9 billion.
4% will be at the employee share ownership level, where in the broad scheme 24 500 staff will benefit with an indicative value of R310 000 per person. 235 senior black management will receive 0,3% of Sasol with an indicative value per participant of between R2m and R9,8m.
The company’s year capex plan is R50 billion with financial 2008 estimated at R12 billion.
The cash generated by operations in the first half was up just 4% to R14,1 billion.
Sasol has indicated some sensitivities, which are useful to note:
o Should crude oil price increase by US$1/bbl then Sasol’s earnings before interest and tax (EBIT) will improve by R300m
o Should the rand weaken by 10c against the US$, then Sasol’s EBIT will improve by R600m.
Rob, your post is a bit of a non sequitur. (Did the ancient romans use hypens?) You can bid up the price of oil without buying (taking physical possession) via a futures market as others have noted.
But buying in the futures market only bids up the price of oil for that futures contract. Oil spot prices have also been high, and I don't see how you can bid up the spot price of oil without actually having to take delivery of the oil, or finding a buyer who wants the physical oil. (And if that buyer wants the physical oil, they have a rather strong incentive to find the person you're buying the oil from and buy from them directly, cutting you out).
I'm with Rob on this. The argument that spot oil prices are high because of financial speculators doesn't make sense. And if spot prices are high, then it's unsurprising that futures prices are high.
I've bolded the word spot just to make it clear that I am talking about spot prices, where the oil does show up in large quantities when you purchase it, as opposed to futures or forwards contracts.
Crude oil is an intermediate good, i.e., there is no final demand for crude oil, only for refined product. Consequently, the only people who buy crude oil are the refiners. So please explain to me how inadequate refining capacity causes the price of crude oil to rise. Yes, I understand there can be imbalances among the various grades and types of oil, but that is not really a significant factor in the overall price of oil.
So again, can someone please explain how a lack of refining capacity causes the price of crude oil to go up. Doesn't that violate the premise of supply-demand analysis?
You like to use graphs, how about presenting a set of charts demonstrating how a lack of refining capacity causes the price of oil to go up.
"I'm with Rob on this. The argument that spot oil prices are high because of financial speculators doesn't make sense. And if spot prices are high, then it's unsurprising that futures prices are high."
Exactly, it is very hard to make a specutlative argument with spot prices high. Every NYMEX contract has the option to deliver oil so at expiry the future=spot. And as many traders know fundamentals rule in the cash market. The only way a speculator could be bidding the spot price up would be by buy spot, pumping it into the ground and selling for future delivery. I have not seen evidence of this type of activity.
Of course if you mean "Speculating" by national governments or oil companies by not pumping everything out of the ground now betting prices will be higher in the future, then this might make sense. But this is not the type of activity most people think about when they talk about speculating, most people think of a bunch of Wall Street/Houston traders pushing around the price.
To the question of why a refinery going down pushes up the price. This used to puzzle me as well, until I had an oil guy explain it to me.
The reason has to do with the grades of Crude. Light Sweet Crude is traded on the NYMEX and it is the highest quality crude and easiest to refine all refiners can handle it. Some refiners can also handle heavier more sour crudes. When one of these goes down the output difference must be made up by the greater number of refiners that use Light Sweet Crudes, increasing the demand for that grade. What really gets pushed up is the basis between high and low quality crudes, but since NYMEX crude is light sweet it looks like and increase in the NYMEX contract.
Fred,
It was a poor attempt at a joke. I was attempting to make fun of the typical fears of each group regarding the federal government. I guess I should have been more hyperbolic.
'The solution for the rest of us, before we all go down? Raise the trading margins to something reasonable like 50-70% from 3-5%. I have no problem with an honest profit from honest labor and trading, but margin trading as it existed in the '20s and today in commodities futures is Las Vegas writ large, and benefits no one except those gamblers with large purses, while leaving the black jack tables to the "poor people." "
This would just push all oil trading overseas. It is a world market. The Brent Crude Contract is already traded in London on the Intercontinental Exchange and has been gainng ground vs the NYMEX contract for a while. Higher margin requirments in the US would effectively put a bullet in the NYMEX contract without affecting oil speculation.
Also if they did the same thing to the NYMEX Natural Gas contract, Natural Gas would spike overnight. The Non-Commercials "Speculators" are way net short Natural Gas so they are serving to HOLD DOWN prices not push them up. People forget that speculating works both ways.
Someone agrees with my suggestion that we should sell oil from the SPR: "How to Use the Strategic Petroleum Reserve", WSJ Op/Ed by Lincoln Anderson.
"But security worries in Iraq and Iran, civil unrest in Nigeria, Saudi Arabia's simmering problems, and Hugo Chavez's populist antics with PDVSA, the Venezolano state-owned oil company, all have people worried."
Pardon me while I pick myself up off the floor. I can't help laughing at the sheer ignorance of all this.
What Megan isn't saying, but SOMEBODY should, is that all those "security worries", "civil unrest" and, my personal favorite, "populist antics" are the direct result of US imperialism, nothing more.
And so, for that matter, is the artificially high price of oil. Big Oil, which is largely headquartered in the US, UK and Holland, found out it could make a killing by capitalizing on all of the above (with the exception of the excellent public policy here denigrated as "populist antics", which they hate like poison because that cuts into their profits and lets too much money trickle down to those uppity Injuns, darkies, etc.)
Think about it: What better way to artificially hike the price of a commodity than to claim "too much risk"? Too much risk to treat Iran, Iraq, Arabia, etc., on the level--gotta rob them. Make excuses ("so-and-so is an evil tyrant") and then make war. Oops! Now the risk is really high. Damn! Gotta hike that price a bit more. Plus the Military and Mercenary Industrial Complexes are all demanding THEIR cut of the flesh. Oh crap, time for another hike. The pinstriped suits are chortling all the way to the bank.
Incidentally, this strategy works the same anywhere Big Oil has sunk its tentacles. Except now that Venezuela is setting a good example, which the others are all in grave danger of emulating because it actually lifts a country out of backwardness, and it doesn't make Big Oil's shareholders happy.
You get the picture now, I hope. Have a nice, INFORMED day.
You get the picture now, I hope. Have a nice, INFORMED day.
I'll try; the 'nice' part should come easy enough, but the 'informed' will be more difficult seeing as you just set everyone's intelligence back by about 95 years of history.
Re: What Megan isn't saying, but SOMEBODY should, is that all those "security worries", "civil unrest" and, my personal favorite, "populist antics" are the direct result of US imperialism, nothing more.
"All" is an exaggeration. We have a lot to do with trouble in the Middle East, and yes, a big piece of the "security premium" needs to be paid at our door. But we have next to nothing to do with troubles in Nigeria, or with the Byzantine manipulations of Tsar Vladimir of the house of Putin. As for Hugo Chavez' bufoonery-- he's brought most of his trouble on himself. (Bush and Chavez probably deserve one another-- both must be founding members of Asses Anonymous. But neither the US not Venezuela deserve being saddled with them in charge)
What better way to artificially hike the price of a commodity than to claim "too much risk"? Too much risk to treat Iran, Iraq, Arabia, etc., on the level--gotta rob them
A) If you are artificially hiking the price of oil, you are not robbing Iran, Iraq, Arabia, etc. These countries are oil producers. You are paying them more for their oil. If you think this is robbing, you are welcome to rob me by paying me $2000 an hour. Ah what the heck, how about you be really really nasty and pay me $4000 an hour? I'm tough, I can take it.
Plus the Military and Mercenary Industrial Complexes are all demanding THEIR cut of the flesh.
Yeah, the military and the mercenary industrial complex never use oil themselves. They would have absolutely no interest in finding a cheaper source of oil. To say nothing of the transport industries, the power industry, the Chinese government. All these people are willing to pay billions in extra dollars just so the oil companies can pay extra billions to Iran, Iraq, Venezula, etc.
One maxim economists need to never lose sight of is Korzybski's "the map is not the territory." I think the more complex the question, the easier it is to lose oneself in those very abstractions that were created to handle said complexity. Oil market prognostication and string theory are two good examples of the above (glib proclamation).