Oil Prices

I heartily recommend this post by James Hamilton on oil supply, demand, and pricing.  I would also add that the diplomatic dance with Iran plays into short-term price swings, probably including the recent downward slide.

Comments

[Rick Ballard]

The article cited is rather tightly focused on the demand side without much attention paid to the EIA forecasts on the supply side. Even the demand side focus neglects an examination of the China's ability to sustain the Potemkin Olympic "boom" beyond the end of the games.

Someday we'll see an econometric model which analyzes the changes in the underlying estmated market price used by oil companies and oil ministries in making their investment decisions. Right now that price cannot be much above $80, because if it were, then Shell would be pouring money into its shale play in the Green River area. It's also not a lot less than $70 because Petrobras would not be committing tens of billions to infrastructure to support the Tupi and Sugar Loaf plays if they believed oil was going to break down below that number for any length of time.

I would also note that the very latest EIA projections (released in late June - see Table G1) showing a jump in production of 4.6 mbd over the cited 2007 84.6 mbd level by 2010 might have had some small impact on current prices.

Leaving aside President Bush's recission of the Executive Order banning offshore drilling, of course. That certainly couldn't affect oil prices.

[jimmyk]

Agree with Rick about Hamilton's neglect of the supply side. Look at it this way: For decades oil consumption increased without any increase in the price. From Hamilton's article you would think such a thing would be impossible, but the point is that long-run price trends are driven by supply (i.e. the cost of producing a barrel of oil) not demand. As we saw in the 70s, lots of weird stuff can happen over the span of a few years, but eventually supply catches up and the price reverts back to the long-run trend.

The only way things could be different now is according to some version of the "peak oil" hypothesis, which is just another way of saying that the cost of producing a barrel has finally started to trend upward. That may be true, but I doubt it can explain the magnitude of the increase we've seen over the past couple of years. This is why I expect oil to fall back to double digits with in the next few years.

[RichatUF]

From Hamilton's article you would think such a thing would be impossible, but the point is that long-run price trends are driven by supply (i.e. the cost of producing a barrel of oil) not demand.

It would also be worthwhile to point out that pricing is also driven heavily by international politics because so many of the world's oil producers are firm states. The same oil market power that Iran and Russia took advantage of when KSA announced their modernization and upgrade plans produced the supply squeeze and higher prices (any other sorts of manipulative devices aside). However that same dynamic will hold in reverse as new KSA and Iraq supply comes on line and those 2 fight for Iranian and Russian market share.

I'm also non-plussed by the China demand argument and surprised that that blog posting didn't include anything about the last Asian Oil and Gas conference and how country after country has reduced or eliminated consumption subsidies.

[Rick Ballard]

"I'm also non-plussed by the China demand argument"

He does link to a previous piece where he does a decent "if this tree keeps growing, it will punch a hole in the sky" analysis but the analysis does not mention that 43% of China's workforce spends each day staring at a bullock's butt (60% for India, 7.5% and 4.5% for Korean and Japanese tractor drivers), nor does he mention where the increase in demand for Chinese products necessary to drive the export trade, which is 1/3 of their cash economy, is supposed to occurr. I wouldn't put any money on continued annual growth of consumption of 7.2% in China with more than 40% of the Chinese labor force "in the fields".

[Barney Frank]

I wouldn't put any money on continued annual growth of consumption of 7.2% in China with more than 40% of the Chinese labor force "in the fields".

Yes Rick,
But isn't a great deal of what's driving China's economy the industrial revolution led migration from that bullock's arse to the cities? Say's law and all.

As far as oil prices are concerned, two words suffice: markets work.
'Peak oil' in its common use is the stupidest argument I have heard in quite some time and would probably kill Julian Simon if he wasn't already dead.

[jimmyk]

'Peak oil' in its common use is the stupidest argument I have heard in quite some time and would probably kill Julian Simon if he wasn't already dead.

Yes, if by "in its common use" you mean the notion that oil prices are going to continue to increase as oil gets more and more costly to find and produce. Simon's argument would be essentially that as (before?) that happens, technology will advance and substitutes will appear that will make oil cheap and/or obsolete. I'm a big fan of Simon's, but I don't think he has a lot of evidence about the "as" vs. "before" in that previous sentence, meaning that the price of oil could rise somewhat during the transition. It's a hypothesis about the long-run.

But Hamilton's argument seems very thin, and depends a lot on the endpoints he chooses. If you go back even just five years, to say current prices are even close to "correct" would mean that the cost of producing oil had to have skyrocketed, like we've just hit a wall, not the gradual increased difficulty that even the peak oil fanatics argue for.

[Barney Frank]

JimmyK,

Well, sure the price will rise; that is the market mechanism that makes it all work. Simon's argument wasn't ultimately that there are infinite supplies of each commodity but that there are infinite solutions. And the price mechanism is what makes it all work.

A short example. I'm in the timber industry. In 1992-93 timber prices tripled when the enviros shut down supply from the national forests. I had level headed foresters tell me prices would never go back to their historical level as nothing could replace all that supply. Within two years a combination of cheap imports, other materials such as steel studs and laminates and previously unmarketed private supplies started timber on the long decline back to historical levels. It is now as low or lower as it was in the recession of 1982. Oil will follow the same trajectory, as the market gets ahold of it; it will just be slower as it is a takes a lot longer to develop new oil fields and oil substitutes than it takes to go out and cut down some trees.

[Rick Ballard]

Barney,

Does Says Law work in a command economy run on slave labor? I know there are 150-200 million peasants who want the opportunity to work for $1 per day (plus found) on the southern littoral but I also know that those without the correct internal passport are rounded up and shipped back whenever the coastal cities become overcrowded. IOW - the Japanese/Korean post war growth scenario can't play out in full in China. Not until the central government falls.

The substitution materials for oil, kerogen from shale and syngas from coal, are available in abundance and the technology isn't awaiting any particular breakthroughs for implementation. If the US truly needed to be energy independent it could be so in 10 years or so. The barriers are 100% political - not practical, nor even market driven.

Get rid of the idiocy of engendered by the abuse of the precautionary principle being peddled by the Warmer/Peakers and the regulatory labyrinth erected by the neoluddite watermelons and the engineers will solve the "problem" quite expeditiously.

[Rick Ballard]

Barone on the political aspects.

Sometimes public opinion doesn't flow smoothly; it shifts sharply when a tipping point is reached. Case in point: gas prices. $3 a gallon gas didn't change anybody's mind about energy issues. $4 a gallon gas did. Evidently, the experience of paying more than $50 for a tankful gets people thinking we should stop worrying so much about global warming and the environmental dangers of oil wells on the outer continental shelf and in Alaska. Drill now! Nuke the caribou!

Hear! Hear!

[Rick Ballard]

Barney,

A WaPo article on the Chinese juggernaut. The author demonstrates an excellent understanding of several of China's very basic problems.

[kim]

Yes, Rick; fascinating and frightening. TNX for the link.
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[Barney Frank]

Rick,

They may round them up but that the mass migration is occurring anyway is undeniable.
And while I harbor no sympathies for the chicoms and their control of the economy neither do I dismiss the command and control aspects of the Japanese economy. Less pervasive and of a different form than China's but real nonetheless in that it distorted large segments of their economy.
It's quite possible China may have a profound economic crisis; I'm not saying 10% growth is unstoppable. Their financial system and state owned industries alone are terrible risks. But these peasant-to-urban migrations often take on their own momentum regardless of what governments would like. Today's China is not Stalin's Russia. The chicoms walk a tighrope he never would have considered. Killing a few million in the gulag was just part of the five year plan. Trying that now in China will bring their whole strategic vision crashing down on their heads. And without that lever in a totalitarian's armory they stand a good chance of having their people realize societies are stronger than governments; if they flex their muscles.

And I'm not sure the barriers to a kerogen/syngas future are not also market driven even though there obviously are tons of idiotic political barriers. The booms and busts of the 70s, 80s and 90s are not forgotten in the oil industry. With the amount of conventional crude still out there and the nimbleness of end users to soften demand most oil companies are not banking on even $100 oil for where they're putting their money.

[Barney Frank]

Rick,

Tanks for the link.
Actually its about spot on with where I am regarding China.
Barring a massive economic crisis I think they will absorb some siginificant portion of the remaining peasants. As they do so they will slow, as all economies do in such situations. People will get richer and begin demanding more luxuries and less work and pollution. When that slowdown occurs they better hope they got extraordinarily rich because they will have a demographic time bomb on their hands of unparralled proportions. Combine that with the unmitigated hostility and wariness of every neighbor they have and I have no illusions about China becoming some collossus astride the world in 2100. Their long term prospects are not sanguine. I just hope they slide into mediocrity peacefully and can then somehow build a free society. The alternative will be mighty ugly. In the meantime I suspect they may continue on a course not far from where they're at for some time, but with the caveat that just when one thinks a trend is stable it makes a fool of you.

[Andrew Reynolds]

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