Lost Force of Our Demand: The US No Longer Controls the Price of Oil

Back in the days when US oil demand controlled the price of oil, a massive recession in the United States would have sent oil to 12.00 dollars a barrel. That era, which ended last decade, was defined by ongoing spare capacity in OPEC, low-cost oil in Non-OPEC, and nascent demand for oil in the developing world. That was then, and this is now. And so it’s rather quaint that the energy analysts from that previous era still gather each week on American financial TV, to discuss the inventories at Cushing, Oklahoma. Inventories at Cushing, Oklahoma? The US has been removing discretionary demand for oil for years, starting back in 2004. And current unemployment in California is at 13.2%–another new post-war high. Yet oil is at 82.00 dollars? Get these analysts off TV. Please. We need analysis of diesel demand in Guangdong, and Uttar Pradesh.

With the closing out of the decade we also have the full data set, on global crude oil production. As you can see from the chart below, the twin peaks of oil production in 2005 and 2008 reveal that while the world was able to respond to a moderate price advance coming out of 2002, nearly all of the price action above 40.00 dollars a barrel starting in late 2004 did not produce more supply. Welcome to peak oil: when the world’s remaining supply of oil is more diffuse, of lower grade, harder to extract, and is unable to flow in the aggregate at higher production levels.

There is an extra measure of comedy today to our defunct and inward-looking group of oil analysts here in the States, as it was revealed that these weekly measures of US inventories are highly flawed. Well, actually, we knew that. But it’s always nice to get the proof. From tonight’s Wall Street Journal:

…documents, obtained through a Freedom of Information Act request, expose several errors in the Energy Information Agency’s weekly oil report, including one in September that was large enough to cause a jump in oil prices, and a litany of problems with its data collection, including the use of ancient technology and out-of-date methodology, that make it nearly impossible for staff to detect errors…Internal emails and a report from a consulting firm prepared in September describe a process at the EIA that served the oil world well in 1983, the first year that oil futures traded, but hasn’t kept up as the inventory data have become more influential and the nation’s oil infrastructure has become more complex.

The familiar names that you see on financial TV here in the US, talking about oil, are generally living in a past that no longer exists. One really has to go to London, Sydney, and Toronto to find not only the best minds in energy, but TV hosts smart and informed enough to even handle the conversation. Global oil production peaked in the 2005-2008 period and now trades at levels thought unthinkable in 2005 when unemployment levels in the OECD were half current levels, if not lower. The US no longer controls the geology or oil, or the price of oil. But, we carry on as though we will again in the future. After all, in places like California which is seeing a competitive race for the Governorship, phrases like Getting Back on Track are all the rage.

-Gregor

  • Ron

    Gregor, while I completely agree that Chindia are far more important to the price of oil than the US, but I find your chart and discussion of “peak production” a bit silly. How can you blithely ignore the ~4-5MM bbls excess capacity sitting out there? Or the effect of lower capex on further capacity due to the global recession?

    And I'm sure you don't think oil is $80 strictly on fundies – it can't be when there is substantial excess capacity. Oil is a proxy for the USD, inflation, and is a favorite trading vehicle – the volatility remains high despite oil remaining in a fairly stable band for ~6 months.

  • gregor.us

    Where was the 4-5 mbpd of spare capacity 24 months ago? Did we add 4-5 mbpd of spare capacity in the last 24 months? Who added it?

    Yes oil at 80 is on the fundies. In fact, oil always trades on fundamentals excepting windows that can last up to 90 days. Fundies are just another way of saying the price is the price. Remember, whenever you invoke the idea, as you are, that oil is not trading on fundies–then you are compelled to come up with a model for when it DOES trade on the fundies. And that model does not exist. One can always claim, always, that oil is “not trading on the fundies.”

    From a broader standpoint, there is no reason why oil has to trade like a fruit or vegetable. Oil can trade at a price that discounts its future value–not just today's supply and demand. That too would be based on fundies.

    Oil is dirt cheap at 80 now. After all, the marginal new barrel in Non-OPEC needs at least 70 to get developed.

    Saying that peak production is “silly” is not an argument, and is a sign you don't really have an argument. But you do have strong beliefs. And they are legacy beliefs that no longer hold sway.

    Why is oil not trading at 12.00 dollars? And if you think oil is unjustified at 82.00, why not release or post the information publically that would help the oil market “correct” itself to send oil to it's “true value.”

    Best,

    G

  • http://twitter.com/gnoll110 Noel Kelly

    Peak Oil: depression or recession chain saw?

    In early 2007, I listened to the podcasts from the 2006 'Fuelling the Future' conference in Kinsale, Ireland.

    From memory, a few speakers said peak oil was (most likely to have been) in 2005, the rest said most likely within five years, ten tops. Seems the most pessimistic were right. Speakers also noted that while there was extra capacity out there, the rate at which it could be brought on online wouldn't make up for depletion in current fields.

    One speaker talked about the down turn that would result from the massive kick up in prices when the markets as a whole realised the extent of the emerging supply/demand gap.

    One unanswered question remains. Are we in for a long recession/depression where the economies of the world adjust to the new energy reality or will there be a recession chain saw. Where the recessionary down turn reduces the demand enough to drop back oil prices, that boosts the economy and oil prices that in turn drives the economy back into recession. In a recession chain saw, the oil price doesn't remain high enough to long enough to allow the economy to restructure itself.

    These were the two broad scenarios the speaker talked about. Ultimately it looks like China will decide which is closer to what will happen. Will the Chinese economy be stable enough to keep oil prices high enough and result in the needed investment or will China join the bulk of the developed countries and setup a recession chain saw?

    G, interested in your thoughts about this.

  • Robert Happek

    In order to show conclusively that oil prices did rise due to supply not being able to meet demand for oil, it would be necessary to obtain information on marginal demand and marginal supply for oil. By definition, demand is always equal to supply so information on supply or demand can not explain prices. Rising prices are the result of a mismatch between marginal demand and marginal supply. If these match, prices stay constant. If marginal supply is greater than marginal demand, prices fall.

    The rising price of oil could also have been caused by financial speculation. We do not really know the full extent to which speculation influenced the oil price. We do know that the present financial crisis is to a large extent the result of fraudulent financial dealings. In 2007, these were subprime mortgages which were sold as AAA securities. This year, we have seen the usage of CDS instruments in order to push Greece to the brink of bankruptcy. The media are already getting excited about the potential collapse of the Euro (it will not happen in my opinion).

    Take a look at gold. Its price has been rising for a full decade. That price rise was not the result of increasing demand for gold in form of jewelery. The price of gold did rise because financial speculators started to build large position in gold. That put a pressure on the gold price. If these speculative positions are unloaded, the price of gold could fall significantly.

  • http://twitter.com/gnoll110 Noel Kelly

    In the case of gold, there is more supply growth than you may think. Again China & India come into play. Both cultures have a history on holding physical gold (far more than in the west). Particularly in India, where gold jewellery is widely used especially in weddings. Booming middle class, booming gold demand.

  • Robert Happek

    There is roughly three times as much gold above ground than there is gold under ground in form of mining reserves. Moreover, the yearly production of gold is roughly 2% of the existing accumulation of gold above ground. These two facts show that the price of gold is not really dependent on the mining of gold.

    The story with oil is of course completely opposite. There is almost no oil in storage. All the oil supply is essentially freshly pumped oil from the oil fields. As large as the oil market is, it is dwarfed by the financial market. The forex market transacts daily more money than the oil market in the whole year. It is therefore very possible that the price of commodities like oil and gold is more dependent on financial speculation than on geological supply constraints.

  • chriscook

    Nice post, Gregor, which I linked to at the end of this post today on European Tribune.

    Gas, Oil and the Central Bank of Saudi Arabia

    which brings together a few threads, both my own, and from FT Alphaville.

    I think that now the US has – as you point out – become definitively the tail on the global oil market dog then there is a window of opportunity to create a rational global market in energy.

    I have long thought that the gas market is the place to start, particularly now that producer pricing power is temporarily depressed.

  • gregor.us

    Thanks Chris. It appears many of my fellow Americans are going to start intuiting, correctly, that our previous control over the price of oil via the power of our demand is indeed gone and it's going to make them angry and frightened. They will try to comfort themselves with fairy tales of “manipulation” first by groups like Goldman Sachs, and then by OPEC. I keep trying to explain: a producer of oil can price oil at any level they damn well please. Seems obvious.

    G

  • chriscook

    a producer of oil can price oil at any level they damn well please.

    Indeed, and succinctly put.

    But pricing oil at a level and selling it are two different things, and you may disagree, but I think that it has become possible through financial sales of oil – rather than physical sales – to manipulate markets over long periods.

    That has always been easy in the metal market, and Hamanaka managed it for five years in copper before David Threlkeld blew the whistle, and for another five years after that. Then there was the pre-1985 tin market. And so on.

    I think every commodity market potentially has a lower bound – at which production dries up, and an upper bound, and tends to bounce around between these boundaries.

    But I think that it is possible with suitable cheap money (ie ETF) financial backing to keep a market at the upper bound, with forward price curves reflecting the yield curve.

    The 'Saudi Oil Bank' and a dollar peg for oil is just a thesis, but I think it's not an implausible one, and might account for why the Saudis got shirty about WTI and switched, and why they are so comfortable with and confident about 'perfect' oil prices.

    But I'm not close enough to the action these days.

  • MarkGoldes

    With the BlackLight Power News Releases yesterday, including a paper on Motive power that parallels our own work and supports the view that ordinary water will replace oil, the price may very well fall in ways that are not yet seriously considered.

    For example, BlackLight outlines a system without moving parts that they claim will allow a Prius sized car to travel more than 5,000 miles on a gallon of water. See: http://www.blacklightpower.com

    Our own Research and Development suggests modified engines may be able to propel a hybrid-electric automobile about 1,000 miles on a gallon of H2O.

    Both firms project cars and trucks becoming power plants when parked, selling electricity to the grid. Early Vehicle to Grid (V2G) systems are at the prototype stage in several locations.

    See the Chava article at: http://www.aesopinstitute.com

  • Robert Happek

    There will never be any car running on water. Chemically, water is an ash, the result of burning hydrogen. You can not make a fire from ash and for the same reason, you will not be able to run a car on water. A car running on water represents a perpetuum mobile. Put one gallon of water into the tank of the car and collect the water vapor coming out of the tail emissions. Voila! A perpetuum mobile is born.

  • pjcpjc

    Oil is dirt cheap at $80 huh? Then natural gas must be incredibly cheap at $4. The energy equivalence between oil and natural gas is 6:1, this historical price ratio is between 4:1 and 10:1. The current price ratio is 20:1.

    I guess that either (a) the price of gas is about to truly explode (in defiance of increasing production globally) or (b) the global economy is too stupid to replace oil with natural gas (in defiance of the huge quantities of oil being used globally for stationary applications like electricity, heating, and petrochemicals).

    Thanks for clearing that up.

  • gregor.us

    In the coming issue of Gregor.us Monthly, I will be putting my model into words which articulates how I think this plays out, over the next 2-5 years. It's an interaction between available energy on one hand, and the generation of credit on the other. But the simplest answer is that the end of cheap energy means the end of growth.

    See also: Overhead Crush on gregor.us
    http://gregor.us/oil/overhead-crush/

    I hope that this site can also function as a research source.

    G

  • gregor.us

    You describe well the mechanism to price oil — but only in terms of a price that is needed to clear supply. There are other very important factors in the price of oil, than merely the price needed to clear short-term available supply. For example, the rising cost of production has found its way into the price. And also, its justifiable for the market to price future costs and future supply, in the present price.

    Your description of pricing describes better the mechanism to clear commodities with a shelf-life. It's more complex than all that. And of course there are speculators in the market. They were there at 12 bucks, at 147 bucks, at 34 bucks, and now at our new domain which is around 70 bucks.

    Oil is special. It's different.

    G

  • gregor.us

    It is therefore very possible that the price of commodities like oil and gold is more dependent on financial speculation than on geological supply constraints.

    Possible. And in time periods extending about 90 days, even likely.

    Beyond 90 days, such as the last 10 years? Geological constraint is your best explanation.

    G

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    well, Comments can no longer be added to this story. …. IMO we will not see shrinking demand and low price regardless of the recession!

  • http://zixmailencryption.com/ zixmail pricing

    well, Comments can no longer be added to this story. …. IMO we will not see shrinking demand and low price regardless of the recession!

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    The rising price of oil could also have been caused by financial speculation. We do not really know the full extent to which speculation influenced the oil price. We do know that the present financial crisis is to a large extent the result of fraudulent financial dealings. In 2007, these were subprime mortgages which were sold as AAA securities. This year, we have seen the usage of CDS instruments in order to push Greece to the brink of bankruptcy. The media are already getting excited about the potential collapse of the Euro (it will not happen in my opinion).