Thursday, 26 June 2008

Oil Prices and Speculation - One more time

Why is oil so expensive?

Let's look at the fundamentals.

Oil is expensive, because of reserve production capacity has diminished and continues to diminish:

...and because oil exports available to oil consuming countries are shrinking:

...and because demand mainly from Asia is outstripping global oil supply:

...and because tight refining capacity is causing distillates to rise in price even further:

That much is certain and undisputed.

However, some seem to think there is also a speculative bubble on top of the fundamental supply-demand crunch causing the initial price rise. George Soros is one of these people, so if you believe this yourself, you are certainly within esteemed company.

So, who are the people making this bubble?

Are they the commodity speculators, who buy up oil? At least index fund shares are going up, look at this graph!

Certainly the positions of index funds has grown for oil futures. However, oil futures do not create the spot price, which is the price paid by those who actually use the oil. That is created by demand/supply balance on the market.

So, speculators would need to store the oil they bought into inventories to cause a global shortage, which in turn would raise the price, allowing them to speculate with crude oil futures contracts.

But inventory levels show this is not the case:

Same for OECD:

So, if the inventory data is correct and there is no significant difference in the Asian inventory data, commodity hoarding is unlikely to have a great influence on the price currently. In fact, the only big inventory rise in the Asian market has been for the Chinese market, for which the official explanation is building stock for the Beijing Olympics.

Thus, low inventory levels indicate that while speculation in general may have some effect, but it is unlikely that it accounts for $80/barrel out of the current price, like some are claiming.

Now, if not oil hoarding speculators, then who could it be?

Maybe those 'evil' (sic) Arab OPEC countries are behind it? They are an oil cartel after all, right?

That theory is again hypothetically possible, were it not for the fact, that they all publicly say that they are uncomfortable with the price, they do not want demand destruction, which is already happening:

Further, considering the infighting amongst OPEC countries, it seems unlikely on the surface at least that they would act in unison to raise the prices by not producing what they can, especially when it would be to their detriment by causing diminishing demand in the future.

Historically oil prices have always crashed, if they rise much too fast. This has never worked to the advantage of the oil producers, but has in fact put them in debt. They have publicly stated they will do anything to avoid this scenario repeating.

So, what other possibilities are there?

Those big oil corporations! ExxonMobil, Shell, BP and the rest. Maybe we should tax them, because they are behind this?

Not so fast. This is the amount of oil flow in the world IOCs control:

While it is theoretically possible that in a very tight demand situation (like now), they would be able to raise the price somewhat by not producing that which they've got, it doesn't really make economic sense in the long run (cf. above). However, they are not a cartel and as such do not act in unison.

So, in the end, the only thing left is to accept that the fundamentals and acceptance of most probable things to come are the reasons driving the price:

If not, we can of course conjure up strategic conspiracy theories, which are always nice, but very, very hard to prove:

"Maybe the price rise doesn't reflect cost structure fundamentals"

"Saudis themselves prefer a lower price"

"Saudis are cutting production to put a squeeze on the new US president

While ideas like presented in the last three slides are perhaps possible, there really isn't fundamental data to back them up. As such, I would leave them for what they are - possible, but highly unlikely. As to refuting the argument itself, it can only be done by waiting till the new president comes to power. If KSA suddenly starts pumping oil from some hidden reserve capacity and crashes the price of oil after the first visit by Obama to KSA, then this theory might be true. Or not. As a theory is impossible to prove, it can only be refuted if the prices do NOT crash.

Is the guilty party for rising oil prices staring us in the mirror?

It may take a while to accept, but in the end it will sink in.

We drive up the price of oil, by using more and more of it (us humans, globally). And it doesn't help blaming the Indians or the Chinese, because they are using the oil, in order to build us all the goods (and much of the food) we consume.

Blaming others in this situation is neither truthful nor helpful. Only accepting the facts of oil depletion and acting on it is going to help.