What Really Dictates the Price of Oil?

An oil well on the plains of kansas. With black storage tanks and fire berm. No people, Copy space. And a blue sky backgroung
J Reader, President of Barchan Advisory Services Ltd. ©

The last thirty years have seen a number of dramatic, short-term changes in oil price. Sometimes the changes are up, but the ones we tend to remember in the industry are when the price falls precipitately as it has done over the last few months. When it happens, energy pundits everywhere weigh in with predictions of the future trajectory and the reasons why they firmly believe in their viewpoint. About half will be predicting a rebound and the other half will see further decline. Almost all analysts will refer to the standard Economics 101 supply and demand dynamic to explain their position.

Again about half the analysts will point to supply overhang, and the other half will be talking about economic slow down and demand erosion. Who can blame the average observer for being confused and perhaps even skeptical about all these varying viewpoints?

Let’s discuss the six main drivers of oil price: supply, demand, storage, foreign exchange rates, speculation and politics.

Supply

In the last two months it has been common to hear supply has exceeded demand by first about 400,000 bbls/day, then 1 million bbls/day and the latest consensus (if you can call it that) is 2 million bbls/day against a backdrop of global daily demand of around 90 million bbls/day. Given the rate at which estimates have changed from a balanced market six months ago to the 2% overhang today, it might be reasonable to conclude that the over supply, if indeed there is one, is difficult to determine with any accuracy.

One thing for sure is, the upstream oil business has great difficulty bringing on new production at a sustainable rate of 2 million bbls/day. Without accounting for replacing production declines, normal industry metrics might suggest this would cost $70 – $100 billion to achieve and it doesn’t happen overnight either. Replacing today’s rapid base declines would easily double or triple this amount, and that represents a lot of drilling.

A casual observer could conclude either that demand has fallen off significantly, that the industry is really doing exceptionally well at bringing on oil production, or that our ability to measure actual supply is challenged.

Demand

A certainty about society today and historically, is that it requires external sources of energy to function. Further, the demand for energy is relatively inelastic in the short term – in other words we cannot change our energy consumption habits very easily in a meaningful amount. We still have to drive to work, our products need to be manufactured and delivered, our houses need heating and cooling, etc.

Although the fastest source of immediate energy surplus is to reduce our consumption, permanent structural demand reductions are really only achieved over extended periods of time. The best example is the development of energy efficient cars after the oil shock of the seventies. It took the better part of a decade to deliver on the societal need to reduce oil consumption, after which oil prices collapsed for 20 years.

Another key factor about oil prices is that they are inversely correlated with economic growth. When oil prices are high, because of the inelastic demand, then other sectors of the economy suffer as available wealth goes to the cost of purchasing necessary energy. Of course, the opposite also applies. When oil prices fall, it tends to spur other economic growth that curiously tends to spur increased energy demand. What is very certain is that these changes don’t happen overnight. They are instigated on time frames more like years than months.

There is a lot of press today about the slowing China economy and the challenges of the Euro zone. We are fed via the media weekly reports on economic measurements that claim to point unambiguously to rapidly expanding and contracting growth. Often these metrics are subsequently updated leading to entirely different conclusions, but by then the original statements have been forgotten – swamped by a tidal wave of new spurious data.

Generally, demand patterns for energy change relatively slowly, not unlike the supply patterns. Globally, oil demand has been trending upward consistently for years and is likely to continue to do so as the Asian economies continue to expand.

Storage

Intimately associated with the lack of clarity about supply and demand is this issue of storage. Storage occurs in many forms; on board ships, in tanks, in pipelines, as refined product, and even in the ground when wells are shut in (think OPEC) or caverns are used. The benefit of storage is that it evens out the day-to-day discrepancies between supply and demand. The problem with storage is that no one knows really how much there is or where it is in any precise manner. It is the buffering effect of global storage that creates so much fuzziness about what supply really is.

Foreign Exchange

In the heat of the moment when a rapid oil price change takes place, everyone forgets that the world is used to pricing crude oil in US dollars. The US$ exchange rate has a tremendous impact on the apparent price of oil, and it also has a huge impact on the competitiveness of US-operating E&P companies whose costs are based in the same currency.

Of things that can create a rapid change in oil price, foreign exchange is the quickest. This is because perceived currency value adjusts instantly as capital flows move from one currency to another. A substantial portion of the recent oil price collapse at the moment is the flood of capital to the US$ due to the recognition of the improved performance of the US economy post-2008, and the current worry about the Euro-zone stability due to Greece which is moving investors away from the Euro and to the dollar. Perceived slower growth in China is compounding this effect. In short, when you observe a rapid change in oil price, remember to look at the nature of currency capital flows first, because the nuts and bolts of the actual oil business move ponderously in comparison.

Speculation

In days of yore oil producers sold their product to refineries who in turn sold their product to consumers. In some cases, producers actually built refineries in order to be sure they could move their product reliably. Product transfer prices were a bit hazy which some would argue was a bad thing.

Today, the oil business is subject to speculative investment by huge investment bank and hedge fund accounts that operate on the same kinds of platforms as high frequency traders. Participants take large positions both long and short, making bets on future price movements. This is supposed to provide “price transparency” to the benefit of all. In reality there are tremendous problems for society based on massive price speculation by people who wouldn’t know a walking beam if it hit them on the head.

While speculators cannot create long-term changes to fundamentals, they sure can create short-term chaos. Any initial rapid price signal will be followed by a self-fulfilling exaggeration of the price motion as some speculators gang up on the trend and others rush to clear their heavily margined, wrong-sided positions. The result is increased volatility and a tendency to strongly overshoot any genuine market signal. Another side effect is that pundits get to read these tealeaves and comment on the non-existent fundamental changes to supply and demand.

Don’t worry though, these aberrations only persist for a few months at a time and also dictate what you pay at the pump and what you pay for other oil-based products. It might also affect your job if you work in the industry.

Politics

Wars are often fought over access to raw resources, especially energy resources because they are so fundamental to the economy. Oil in particular has been a nation-builder for many countries. So, it would be naïve to think that there are no strong political undercurrents impacting the price of oil, never more so than when prices make rapid and sustained excursions from the norm.

Acts of war do actually impact supply and demand in measurable ways. Consider today the impact of the destruction of oil tank farms in Libya where hundreds of thousands of barrels have been burnt. Pipeline disruptions and field sabotage also prevent established reserves from getting to market. On the other hand, war is a strong source of demand increase as people and materiel have to be moved, and jets, tanks and trucks fueled, and so on.

With respect to political economies, oil has the characteristics of a monetary standard (recognized and universal value (subject to well-defined quality adjustments and transportation costs), and fungibility). It is used in trade to source recognized currencies for the purpose of other economic transactions. For example, even though Russia and Iran are currently subject to various sanctions and their internal currency is devalued as a result of their weakened circumstances, both can implicitly gain access to US dollars through the sale of their oil, ensuring their ability to trade. Only a complete barring of oil exports from these nations, something that will never happen, could truly isolate their economies. In fact, their competitiveness from a labour cost of production perspective is highly advantaged due to their home currency devaluation.

Some Concluding Remarks

One of the reasons that energy market dynamics are typically poorly reported in the media is because the complexity of those dynamics is so profound. What seems like it should be explainable by simple supply and demand nostrums simply isn’t. The natural herd instinct of analysts and marketers leads to chasing simple explanations down rabbit holes. The real world dynamics of oil are far more interesting and intellectually stimulating than is generally understood or reported. In the final analysis the price of oil over the long term is the true cost of the marginal barrel replacement – something that we will speculate on in a later note.

“What Really Dictates the Price of Oil? ” in PDF


Copyright © Barchan Advisory Services Ltd. 2016

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