Oil price fundamentals

I’ve been offering reasons for believing that the flow of funds into commodity investing has contributed to the recent oil price highs. Although I believe this speculation has gotten ahead of fundamentals in the last few months, there is no question in my mind that market fundamentals are the main reason for the broader 5-year move up in oil prices. Here I review those fundamental factors.

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The developed economies consume a disproportionate share of the world’s energy, with North America and Europe accounting for about half of the total oil use in 2006. However, it is the newly industrialized countries and oil producers that account for the recent rapid growth in demand, with Asia and the Middle East accounting for 60% of the increase in petroleum use between 2003 and 2006. North America and Europe contributed only 1/5 of the growth.

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Particularly dramatic in this growth has been China, whose petroleum consumption between 1990 and 2006 increased at a 7.2% annual compound rate. It’s always amusing to project these impressive exponential growth rates. If that rate of growth were to continue, China would be using 20 million barrels a day by 2020, about as much as the U.S. is today. By 2030, China would be up to 40 mb/d, twice the current U.S. consumption.

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Are such projections plausible from the point of view of potential demand? During 2006, China used about 2 barrels of oil per person. For comparison, Mexico used 6.6– Chinese oil consumption could triple and they’d still be using less per person than Mexico is today. The U.S. used almost 25 barrels per person. According to the data collected for a new research paper by Max Auffhammer and Richard Carson, there were 3.3 passenger vehicles per 100 Chinese residents in 2006, compared with 77 in the United States. Yes, I would say that these astonishing numbers for potential future Chinese oil demand are not at all inconceivable.

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Are such projections plausible from the point of view of potential supply? Not remotely. I do think there are prospects for a significant boost to world petroleum production this year, thanks to a number of big new projects scheduled to begin production. The Wikipedia database reports 7 mb/d in eventual gross new production capacity eventually expected from projects that are supposed to begin producing during the current calendar year. Before you get too excited about that number, however, several cautions are in order. First, 7 mb/d refers to the eventual peak production, not the amount that can be produced this year. Second, there is inevitably some slippage and delays. For example, the list includes 250,000 b/d from Thunder Horse, BP’s Gulf of Mexico project that was initially hoped to start giving us oil in 2005, but is still undergoing repair work. Third, the above tabulation refers to gross new capacity, much of which is needed to replace declining production currently being observed in the world’s mature producing fields. At any point in time, some of the world’s producing fields are well into decline, some are at plateau production, and others are on the way up. It is not clear what average decline rate is appropriate to apply to aggregate global production, but a plausible ballpark number might be 4%. That would mean that in the absence of new projects, global production would decline by 3.4 mb/d each year. To put it another way, a new producing area equivalent to current annual production from Iran (OPEC’s second biggest producer) needs to be brought on line every year just to keep global production from falling. Of the 7mb/d in gross new capacity from the projects tabulated above, projects in Saudi Arabia, Russia, and Mexico account for about a third of this gross increase. Data currently available for the first two months of 2008 show actual production in Saudi Arabia down 350,000 b/d from its average 2005 value, though the latest news suggests that Saudi production may be close to returning to 2005 levels. Mexican production is currently down 400,000 b/d from 2005, and Russian production is down 100,000 b/d from its average level in the second half of 2007.To summarize, I think we will see some net production gains this year, and expect this to bring some relief for oil prices. But I cannot imagine that the projected path for China above will ever become a reality. Oil prices have to rise to whatever value it takes to prevent that from happening.So yes, I do believe that speculation has played a role in the oil price increases, particularly what we’ve observed the last few months. But it’s a big mistake to conclude that speculation is the most important part of the longer run trend we’ve been seeing.


Originally published at Econobrowser and reproduced here with the author’s permission.

3 Responses to "Oil price fundamentals"

  1. DC   May 29, 2008 at 12:28 pm

    Who is Inflating the Bubble in the Global Oil market? The Federal Reserve is the chief culprit, by slashing the fed funds rate 325-basis points to a negative -2%, after adjusting for inflation, and expanding the US-M3 money supply by 16.5% from a year ago, in a desperate effort to stop the slide in the sinking US banking sector. By slashing interest rates deep into negative territory, the Fed encourages speculation in commodities by pushing down the dollar, which in turn, is pushing up the price of dollar-denominated commodities, such as crude oil and gold.So far, the Fed’s aggressive rate cuts haven’t found any meaningful traction in the S&P Banking Index, which is still languishing at the March lows, and -40% lower from a year ago, with banks posting hundreds of billions in losses from toxic sub-prime mortgage debt. The Fed’s single focus on rescuing the banking sector, with no regard for the inflationary consequences of its actions, has led to the emergence of the “crude oil vigilantes” who punish central bankers with sharply higher oil prices, whenever they become too abusive with the money supply. http://www.sirchartsalot.com/article.php?id=87

  2. akmi   May 29, 2008 at 5:08 pm

    I agree. Different factors dominate prices at different times, but the long-term anchor for oil prices is physical supply/demand – though speculation, low interest rates, and occasionally geopolitics may be driving the oil spikes this year. Why extract oil now when one expects interest rates to rise in the future when one could earn higher returns on oil proceeds saved and invested in Treasuries?

  3. Taxpayer   June 2, 2008 at 1:52 am

    From a link in a comment on LB’s latest blog.It is about commodity prices in general, but I think it also applies to the the oil market."There has been no shortage and inventories of crude oil and products have continued to rise. The increase in prices has not been driven by supply and demand." Lord Browne, Group Chief Executive of BP, The Daily Telegraph, May 6, 2006."…Tom Buis, president of National Farmers Union, .. "If [farmers] can’t market their crops at these higher prices, we’ve got a train wreck coming that’s going to be greater than anything we’ve ever seen in agriculture….When regulators say a problem doesn’t exist, despite the fact farmers cannot market their commodities — that sounds an alarm."…Billy Dunavant, … cotton merchant Dunavant Enterprises, was more blunt, "The market is broken, it’s out of whack…"…industry insiders are not buying into the one-size fits all answer that emerging economies are the primary factor driving up prices from the demand side, reinforced by supply-side shocks and peak production fears. In a slowing global economy hit by a major credit crisis and reeling from a falling dollar, it is likely that money flows seeking safe haven in hard assets is the key driver of recent volatility….dynamics have changed because securitized commodity-linked instruments are now considered an investment rather than risk management tools. Of late, this has been causing a self-perpetuating feedback loop of ever higher prices….the source of return in commodities comes from. …self-created inflation….Securitized commodity products … allowed money flows to distort price discovery, while at the same time undermine the all-important hedging utility (function)…."Enron loopholes" …undermine the authority of the CFTC (US Commodity Futures Trading Commission), and put the futures industry as well as the economy at risk."http://www.safehaven.com/article-10107.htmWhat a shambles…Its a pity the main stream media and politicians can’t get their heads around this stuff.I am still hearing the, "its all due to market fundamentals" line from those who should know better.Perhaps it is not feeble mindedness, but dishonesty that clouds their understanding.The rush to secure unsustainable returns on savings and/or capital preservation is making life impossible for the vast majority of the people in the world who have no savings.It is going to take a big stick to get this monkey off our back.