"Oil Prices and Economic Fundamentals"

Jim Hamilton looks at the question of whether changes in oil prices have been driven by fundamentals:

Oil prices and economic fundamentals, by Jim Hamilton: Oil was selling for $123 a barrel on May 7, and that's where it closed this week. Sounds like a calm and rational market, except for the fact that just last week it was going for $145. ...

Which price was right, $123, $145, or something else? Before you let anybody give you an answer to that question, try to get them to comment first on the following two facts. (1) According to the Energy Information Administration, China consumed 7.6 million barrels of petroleum each day of 2007, which is 860,000 barrels/day more than in 2005. (2) EIA also reports that the world as a whole produced 84.6 million barrels of oil per day in 2007, which is 30 thousand barrels per day less than 2005. ...

Now, how could it be that China is burning 860,000 b/d more than it used to, but no more is being produced? Well, it could be that there are errors in the consumption or production numbers, and both will likely be revised. Or it could be that we're drawing down global inventories. But the most natural inference is that somebody else in the world must have been persuaded to reduce their consumption of oil between 2005 and 2007 to free the barrels now being used in China. And indeed, according to preliminary EIA estimates, petroleum consumption in the U.S., Japan, and those countries in Europe for which data are now available fell by 760,000 b/d between 2005 and 2007.

Here's the framework I would propose for answering the question of how much the price of oil should have risen since 2005-- the price of oil needed to go up by whatever it took to persuade places like the U.S., Europe, and Japan to reduce their consumption by the amount that China, the newly industrialized countries, and oil-producing countries were increasing theirs.

And how big a price increase would that be, exactly? Somebody who claims to know that would need to have more confidence in their estimate of the price-elasticity of oil demand than I have in mine. But if your answer is that a much smaller price increase than the one we observed would have been sufficient to produce the requisite decline in quantity demanded, that would seem to imply that, since price went up by much more than you believe was needed to reduce demand, the quantity demanded must have fallen by much more than was called for. One place that might have been expected to show up is in the form of an accumulation of inventories. The black line in the figure below shows the average seasonal behavior of U.S. crude oil inventories. The red line demonstrates that current inventories are if anything below normal. On what basis, then, could one insist that the quantity of oil consumed has fallen more than was necessary?

OK, suppose you believed that the price increase we actually saw-- from $42/barrel in January 2005 to $96 in December 2007-- was just the right amount to accomplish the task of balancing global demand and supply for 2007. Should the price have held steady from there in 2008? Figures reported by Rigzone imply that China imported an additional 8.97 million tons of crude and 2.96 million tons of refined product in the first half of 2008 compared with 2007:H1, which converts to a 480,000 barrel/day increase. Where's that supposed to come from? A U.S. recession, which many of us were anticipating in January, certainly would have brought demand down. But current U.S. GDP growth is likely to come in higher than many of us had predicted earlier, meaning if you gave one answer for the correct price of oil in January, you should be giving a higher value for that number today. On the other hand, the data coming in the last two weeks have raised the probability of a recession in Europe. If that occurs, it will bring a reduction in the quantity demanded from those areas even if the price begins to fall. Whatever the correct price of oil was two weeks ago, I think it's a lower value today.

What about the delayed response of quantity demanded to the price increases already in place? If that proves to be substantial (and I'm of the opinion that it will), U.S. petroleum consumption should continue to decline during 2008 even with no further price increases and no recession. There's also been some increase in global production this year, and more is expected. Won't that be enough to satisfy those new and thirsty Chinese vehicles? If so, $123/barrel may be way too high a price.

But don't forget, while you're doing these calculations, you'll need to meet Chinese demand for 2009, and 2010, and 2011.... Which, if you project the current trend and tried to satisfy entirely by cuts in U.S. consumption, would have us down to consuming zero barrels of oil in the United States in about 17 years.

Is the price of oil today too high given the fundamentals? Could be. Is it too low? Could be. But one thing I'm sure that's too high is the confidence on the part of those who insist they know the answer.

In that case, I'm glad my last comment on this topic was "I'm absolutely certain I could be wrong."

Comments

says...

Yes, the price of oil is too high, given the fundamentals.

I sit and watch Goldman Sachs earn their vig by "trading" and shake my head, in vain, as my common sense screams.

All markets are rigged by an abundance of well fed porker banks. The economists cling to their failed models and proclaim all sorts of ridiculous scenarios. They have been wrong for seven straight years.

Meanwhile, Rome burns.

[John V]

Is the price of oil today too high given the fundamentals? Could be. Is it too low? Could be. But one thing I'm sure that's too high is the confidence on the part of those who insist they know the answer.

Indeed. I may grumble and say lots of things about the price of oil.

Is it higher than I would like? Yes.
Is it "too high" for America's taste? Yes.
Is it too high to live like we have 'til recently? Maybe
Is it "TOO HIGH"? How the heck should I know.

All I know is that many independent people, estimates and decisions are complexly involved in what sets our price. Is it right? Again, who knows?

BUT, is it the best number we have to go on going forward? Absolutely.

This is the good part of what speculation does....trying to determine future demand based on projected supplies and profiting (or losing your shirt) from it.

Personally, I'm not even sure the recent drops mean anything...YET.

Consider the ponderous Tyler Cowen. This one will leave you with steam coming from your ears and perhaps glad that you aren't a commodity a trader.

[Two Factors]

The price of oil, and other imported commodities, has two components. World demand for oil, and world demand for dollars. About half of the recent increase in oil has been due to increased world demand for oil, and half from declining world demand for dollars. As inflationary expectations become unanchored, foreign demand for dollars tends to decline. We pay more dollars per barrel.

[BJ Feng]

The price of gasoline was cheap for most of the past half century. So cheap that gasoline cost less than the same quantity of milk. Less than $2 a gallon for gasoline vs. $2+ a gallon for milk. Yet oil has to be discovered, drilled and taken out of the ground. That oil then has to be shipped to a refiner, processed, then shipped to a gasoline station where you purchase it for under $2 a gallon. It seems incredibly cheap to me. Compare that to even water, which costs $0.99 a gallon for distilled tap at your supermarket, or a gallon of Coke, which will cost around $2.80 or so, per gallon.

[Michael McKinlay]

Mark Thoma has indeed stated the case for peak oil:

"EIA also reports that the world as a whole produced 84.6 million barrels of oil per day in 2007, which is 30 thousand barrels per day less than 2005. ..."

And we know that the price of oil was increasing the whole way, yet more net barrels did not come to market. We know that old wells were brought back into production and every drilling rig in the world is currently leased and drilling. There is only one answer and that is that depletion is now beginning to outrun production. Peak Oil my friends ...

And with Peak Oil comes other peaks such as peak credit, peak money and peak worldwide GDP.

What we see going forward is lower highs and lower lows for world GDP while at some point the leveraged debt based fractional banking system will implode with bad debt and fewer new loans.

[Eric Dewey]

Mark, thanks for the best post I've seen on this subject...