Friday, June 08, 2012

150 Years of Oil Prices: What Can We Learn?

Over 150 years, a lot of things can change. One of the things that has changed -- and not in a good way -- is the value of the dollar. The price of oil below is given in both 2010 dollars and in the nominal dollar price of the time.
BP Statistical Review via Asia Times

Here is one man's view of what drives oil prices, Hossein Askari in Asia Times:
Let's start by stating the obvious. Oil prices, like all other prices, are driven by both supply and demand. On the supply side, an increase in the immediate or short-run supply of oil is limited by the available excess capacity (of a particular type of crude) and by the oil that is stored in strategic reserves, company reserves and on tankers.

The long-run supply of oil is not fixed. As oil prices rise, a number of related activities are encouraged on the supply side. New technologies are developed. New areas are explored for crude. New fields are developed. Producing wells are brought on line in the new fields. More crude is produced from existing fields using new technologies. That is, in time, installed capacity to produce oil could be increased and more oil can be produced.

But can this go on forever-higher oil prices encouraging new technologies and exploration activities to increase global oil output? No. While new fields come on stream, older fields are depleted and stop producing.

It would appear that at some point these opposing forces-additional production from new fields and decline in production from existing fields will be in balance and at some point thereafter global oil output will likely decline.

... As oil prices rise, energy conservation increases, reducing demand for oil. Oil is used more efficiently. Similarly as oil prices rise, other energy sources will be increasingly substituted for oil - although within limits, especially in the short run, as substitutes for oil in transportation are not readily available.

But still the key point is that as the demand for oil increases and oil prices rise, helpful factors both on the energy supply and demand side reduce the pressure on oil supplies. We should note that while new sources of conventional crude come on line (as production in older fields decline), production of non-conventional crude (tar sands and shale) increase and alternative energy sources (conventional natural gas, shale gas, solar, wind, and so forth) increasingly substitute for oil.

...What about oil demand? The demand for oil, as with anything else, depends on its price, the price and availability of substitutes (including mass transportation), climatic conditions, government regulations and, possibly most importantly on gross domestic product (GDP).

... The more the central bank prints money, the higher the demand for goods and the more intense the speculation. Knowing that money is depreciating at a fast rate, consumers and producers become speculators and develop high inflationary expectations. This means that producers withhold commodities anticipating higher prices around the corner. Similarly, consumers rush to buy and store commodities in anticipation of price increases.

In the case of oil, while producers can keep oil off the market in anticipation of higher prices, it entails a cost. For consumers to hoard oil, they incur a storage cost.

Speculation on futures markets could potentially increase price volatility but not long-term prices. If a speculator buys an oil futures contract, the purchase adds to the demand for oil. But if the speculator does not take delivery, use the oil, or take the oil off the market and store it, that is sells the futures contract before maturity, then there is no net addition to demand and it is difficult to see how oil prices (as opposed to price volatility) are affected.

...Consider the two recent price peaks (1979/80 and 2007/08). The first was largely due to the Iranian Revolution and then the onset of the Iran-Iraq War, leading to disruption in supply and the some panic hoarding of crude. Iran was a more important exporter of oil at that time than it is today and there was insufficient excess capacity around the world to immediately compensate for any shortfall. But in time, and although the Iran-Iraq War continued with further supply disruption, oil prices (in dollars) declined dramatically in the course of the decade.

More Saudi and other sources of crude came on line, the dollar appreciated (with the tightening of US monetary policy) and global economic growth slowed down reducing the demand for oil.

The most recent (dollar) price peak was in large part driven by a rapidly growing world economy and a depreciating dollar. _ATimes
More at the link.

This is a very basic and common sense approach to some of the more common drivers of oil prices. A discussion of several deeper issues driving oil price involving higher level oil traders with close ties to national oil producers, and with ties to governments which rely on oil revenues to fund national budgets, would require a lot more time to flesh out.

The author promises to look at some of these issues in further articles.

As long as global demand tracks global growth in population, producer cartels such as OPEC are in a good position to influence vague price levels. But should something happen to derail global demand, the ordinary calculus for oil pricing will need to be modified.



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