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oil prices

Page history last edited by Brian D Butler 12 years, 1 month ago

 

 

Table of Contents:


see also our discussion on  commodity

 

 

 

 

Trends:

Booming emerging markets leads to rise in prices of commodities such as High Oil Prices, and fears about "energy security".

 

See related page from GloboTrends:energy security

and, see the video Summary:

 

Energy's future: Securing supply from Energy Realities Videos on Vimeo.

 

 

 

 

Trends affecting Oil Prices:

 

Rise of China in oil consumption: 

see Recent blog posts from globotrends:

 

 

Oil "bubble" of 2008:

As oil prices began to rise in 2009 from a low point of about $40 a barrel in January to around $70 a barrel in July, a question is whether the world is in for another oil price spike in the near term similar to that witnessed in early 2008. World oil prices skyrocketed from about $90 a barrel in January 2008 to cross the $140 a barrel mark in June, finally hitting a record high of $147 a barrel on July 11, 2008, before collapsing to less than $40 a barrel in December. Was the oil price increase of over 50 percent in the first six months of 2008 a bubble? If it was a bubble and oil prices overshot their long-term equilibrium level in the first half of 2008, did they undershoot when the bubble burst in the second half of the year?  source: Peterson Institute for International Economics

 

 

 

In 2007-08, why did the price increase?

 

There are many theories as to why the oil price has continued to rise, here are some of the more credible:

 

  1. Supply and demand:   oil output production has been growing slowly, so supply has not kept up with rising demand
    • increased demand from emerging markets (as the swelling middle classes in China, India, Brazil all want cars).  
    • oil subsidies in emerging market economies:   countries such as Venezuela subsidize gasoline and diesel so that consumers dont pay the real prices, and are given false inventives to drive bigger cars (Hummer sales are booming inVenezuela).  This is also true (but changing) in IndiaChina, Indonesia, the Gulf Coast Countries, and more...causing major distortions in the world oil markets.
    • Loose monetary policy:   the result of easy money globally is that consumers are spending more, driving more, investing more, etc.  By doing so, they demand more oil, and prices rise
    • Iraq war & fears of terrorism:  lead to uncertainty about future supply, so futures contracts bid up the price.  This is a good theory, but then the reverse must also be true, that a stable Iraq should lead to a fall in prices.  But with Iraq currently producing nearly as much oil as they did prior to this war, and with global fears of terrorism abating, this theory is more difficult to believe.  The real impact of the Iraq war on the global financial system may be the weakening of the US dollar, which indirectly effects the price of oil.
    • Currency pegs + oil subsidies in emerging markets (combined): see the discusson:  "twin peg of currencies and commodity prices in emerging markets"...a theory put forth by Merril Lynch economis Francisco Blanch, and published in the Financial Times
  2. speculation - probably not:  Because speculating means buying futures contracts, but at some point, the actual oil must be delivered, and speculators would be caught with their pants down if actual market (supply and demand) proved them wrong.  Remember;  speculation last year comes due today, so there should be a constant stream of pressure on price today.  No, its not realistic to assume that speculators drive the market.  If they are right, and bet on price moves upward, they can push it higher, but underneath, the fundamentals are more important (as they can ruin speculators)
  3. Weak US dollar.  Because the price of oil is quoted in US dollars, then if the US dollar depreciates vs other currencies, then the price of oil (in dollars) must climb.

 

 

Speculators to blame?  Not likely....

 

It drives me crazy to hear again and again that “speculators are driving up the price of oil”. This is just not true, and clearly shows the ignorance of news broadcasters, politicians, and it exposes a deep misunderstanding of finance, and the way in which financial markets operate.

 

Lets clear the air…first of all…speculators don’t buy any physical oil, but instead are trading paper (futures and options contracts). This means that speculators can not influence the market where physical oil is traded because they are not actually buying any of that oil. In reality, only the refineries are actually purchasing any physical oil. Every contract for oil that speculators buy must be sold back to the market before the contract expires. At the future date, when the future contract is set to expire (as they do all the time), they have to settle their positions. If the price of oil didn’t go in the direction they bet that it would…they could loose a fortune.

 

One of the popular targets of this rage against speculators is the “index funds” that bet on price increases in oil. The popular line on TV goes that these speculators are to blame for the price increases. But, index funds, in order to keep their position in oil, must not only buy, but also sell futures contracts for oil. Why? Because the short-term nature of the contracts means that index fund managers must constantly sell their old contracts and replace them with new contracts to maintain the same position. This means that index funds end up being big time sellers of futures contracts. With this unique dynamic going on, and considering that they are not buying any physical oil itself, but instead are just trading paper bets on the future price movements, it’s difficult to see how they could be to blame for the actual price increase in oil itself.

 

Betting on the price of oil prices is very similar to betting on a sporting event. It doesn’t matter how much money is changing hands in the stadium because the bets don’t change the outcome of the actual game. Oil speculators are like fans betting on the outcome of the game. If you bet a hundred dollars or a million dollars, it only makes money for you if the outcome turns out as you expected. If the price moves in an opposite direction, you lose.

 

Further evidence that speculators don’t move markets can be found by looking at other commodity markets in which speculators trade. One blaring example is the metal “nickel” in which there is a thriving speculation market, but the price has fallen by over 50% in the past year. On the other hand, there are other commodities such as iron ore, or rice which are not traded on exchanges, but for which there has been a similar rise in price as we have seen with oil. So, as these examples illustrate; clearly its not the presence of speculators that is driving up the prices of these other commodities. There must be other factors going on globally that is working to drive up commodity prices. Perhaps it the booming emerging markets? Can anyone say “supply and demand”?

 

Size matters: The total value of all of these speculative contracts (typically index funds) is minute in comparison to the total value of yearly oil consumption. According to Barclays Capital, the oil index funds total value is only 2% of the value of oil consumed each year. With this small value, it’s hard to see how such a small trade (relative to the size of the oil markets) could actually be moving the markets.

 

There are many reasons that the price of oil is going up. But thinking that speculators are to blame is misguided. While they may play an important role in establishing price signals, it’s clear that speculators have neither the volume (compared to the oil market), nor the power to set the price of the oil markets.

 

In fact, oil speculators might be largely responsible for LOWERING the price of oil. By establishing a free market for futures contracts (and options), these speculators help oil companies to smooth out the expected price for future production. As happens in anycommodity markets (such as pig farming, corn growing, etc), it is very important for commodity producers to have stable and predictable future prices so that they can borrow more cheaplyinvest more wisely, plan accordingly, and produce more efficiently. If there were not orderly futures market established by speculators, there would likely be underinvestment, and a corresponding price increase in oil (over time, in the long run)

 

 

 

What Drives oil Prices?

 

supply & demand

long-run danger for the world economy is that oil capacity expansion has slowed in 2009 but world oil demand is predicted to rise by about 0.6 percent a year from 2010 on, reaching 89 million barrels a day by 2014. If supply does not keep up and provide the additional barrels needed, a serious imbalance between future demand and supply in the world oil market would emerge.  source: Peterson Institute for International Economics

 

traders:

 

If the contango is narrowing in rather dramatic fashion. To  begin, note that the average 1st-5th contango for Brent

and WTI has come in from $7.67 yesterday to $7.05 this morning, down from $7.46 a week ago. Those

who began buying nearby crude, hedging it by selling crude futures three and four and five and twelve

months forward, storing it in tankers, or rail cars, or above ground storage facilities, have begun earning

their profits on all sides of the transactions as the contangos narrow and as deferred futures wane from

their highs.

 

Oil Futures: "Backwardation"...what is that?

 

If reduced near-term supply may push nearby crude oil futures above longer-dated contracts, in an event known as backwardation.

 

 

Fundamentals 

 

Peak oil?

 

after the credit crisis is over...will we see the price of oil go back up?  

 

Peak oil argument:

Independent studies conclude that global crude oil production will now decline from 74 million barrels per day to 60 million barrels per day by 2015. During the same time, demand will increase. Oil supplies will be even tighter for the U.S. As oil producing nations consume more and more oil domestically they will export less and less. Because demand is high in China, India, the Middle East, and other oil producing nations, once global oil production begins to decline, demand will always be higher than supply. And since the U.S. represents one fourth of global oil demand, whatever oil we conserve will be consumed elsewhere. Thus, conservation in the U.S. will not slow oil depletion rates significantly.

 

Alternatives will not even begin to fill the gap. And most alternatives yield electric power, but we need liquid fuels for tractors/combines, 18 wheel trucks, trains, ships, and mining equipment. The independent scientists of the Energy Watch Group conclude in a 2007 report titled: “Peak Oil Could Trigger Meltdown of Society:”

 

"By 2020, and even more by 2030, global oil supply will be dramatically lower. This will create a supply gap which can hardly be closed by growing contributions from other fossil, nuclear or alternative energy sources in this time frame."  http://www.energywatchgroup.org/fileadmin/global/pdf/EWG_Press_Oilreport_22-10-2007.pdf   source: http://survivingpeakoil.blogspot.com/

 

 

 

OPEC:

 

OPEC, responsible for about 40 percent of world supplies, agreed in December 2008 to cut production 9 percent to 24.845 million barrels a day from Jan. 1 to prevent a glut and stem price falls.

 

 

 

Gasoline and Diesel prices at the pump

 

see:  gasoline and diesel prices

 

 

 

 

 

 

 

Dollar and Oil

 

Talking about the value of the US dollar and of oil, I wish analysts on TV would stop talking about the two trends individually, and would start tying them together to help viewers understand the interrelated aspects of the two. Saying recently that the price of oil has come down, but the value of the dollar has gone up only tells us that the price of oil is cheaper in the USA, but doesn’t tell us whether or not oil is cheaper or more expensive for everyone else in the world. In absolute terms, has the price of oil come down? Has the cost of oil come down for Europeans? For Brazilians? On average for most countries?

 

Its interesting that similar factors are causing these two movements: A slowdown in economies outside of the USA (see our discussion on decoupling) has resulted in investors betting that demand will slow down for oil, especially in emerging markets. But that same bet that economic growth will slow down in foreign nations has also led investors to bet that the US currency would appreciate and that others would depreciate. As slowdown contagion spreads, investors realize that its not just the US economy that is threatened by recessionary pressures. In fact, it looks like the US will recover relatively faster and easier than many other economies, especially than the European.  This has led investors to reverse their bets that the dollar would depreciate, and to sharply reverse recent trends of a weaker US dollar.

 

The result is that investors have simultaneously bet that the US dollar will appreciate (become more expensive for foreign investors) and that the cost of a barrel of oil will “depreciate” (become less expensive in dollar terms). But while the underlying factor that led to these two movements may have been the same (or similar), it should also be noted that the two factors also have a cause-effect relationship on each other.  As the value of the dollar appreciates the price of oil falls in dollar-terms on the international market. But at the same time, as the price of oil falls, many economists note that the dollar benefits. The two trends are self-reinforcing, just as they were also self-reinforcing in the other direction (as the dollar weakened, it caused the price of oil to increase, but as oil cost increased, it put further pressure on the dollar).

 

 

 

More comments:  Impact of Oil on the US dollar

 

We all know by now that dollar depreciation is causing some of the rise in (dollar terms) of the price of a barrel of oil.   As the dollar weakens, the price of a barrel of oil must get more expensive in dollar terms.  Easy.  But a more interesting question is:   Why doesnt a High Oil Price cause the US dollar to appreciate?

why the US dollar is not appreciating as the world is demanding more and more expensive oil (purchased in Dollars)?   This is an interesting question!

 

Background info: As you know, the value of the dollar (and any currency) is determined by supply and demand, in an exchange between buyers and sellers. As you point out, since oil is more expensive, there should be more demand for US dollars, which should drive up the price of dollars (US dollar should appreciate). This is happening, but....

 

But, there are other trades that are stronger, and are happening at the same time, which is driving down the value of the dollar (in spite of what is happening with the oil market).

 

What are these forces? The “simple” answer:

 

#1. There used to be a massive demand for US financial innovations (such as securitized mortgages, asset backed securities, SIV’s, etc). Robert Lynch (HSBC, in an article in Wall Street Journal) hit the nail right on the head when he noted that these financial innovations were by far the biggest US export in recent years. That market is now gone. With the credit crisis (caused by the subprime meltdown), the demand for US financial innovations has ground to a stand still. No longer are European Banks buying all of the asset-backed securities, nor securitized mortgages from the USA. This lack of demand, and all of the missing buyers of US dollars is the major driving force that is putting downward pressure on the US dollar.

 

#2. Lack of confidence. In any trading system; buyers want to buy assets that they think will appreciate in value. But, as traders have lost their confidence in the ability of the US dollar to hold its value, they have become sellers. Don’t underestimate the role that confidence and psychology plays in traders decisions! Traders buy currencies that they expect to appreciate in value, and they sell ones that they think will depreciate.

 

#3 Final comment: In the past, China was a massive purchaser of US dollars. They were very active in purchasing dollars in an effort to keep their own currency undervalued (to spur export growth). But, over time, they amassed a huge pile of foreign currency, perhaps too much. Recently, their policy of actively purchasing USD has been halted (or severely slowed down), and have shifted their focus away from US treasuries, and are now looking for higher returns through a Sovereign Wealth Fund. It’s a bit technical, I know….but the point is that they are no longer pumping liquidity into the US banking system, nor are they large purchasers of US dollars. This is one HUGE buyer of US dollars that is now sitting on the sidelines (perhaps looking at the Euro).

 

These three forces combines are very powerful, and offset any upward pressure that might be placed on the US dollar as a result of higher oil prices.

 

There is a much more interesting answer to your question, but it’s a bit more difficult to explain (unless you understand economics). It has to do with the “balance of payments” of a country. The basic theory is that if a country has a “current account” deficit (like the USA does), then it must also have a “capital account” surplus. In total, the total balance sheet for the country must balance. If it does not, then the currency must depreciate. In the past, the USA has maintained a current account deficit by also maintaining a capital account surplus. This surplus was possible only because foreigners had a very high level of confidence (see discussion above). But, as that confidence has been eroded by (a) excess spending on the Iraq war, and (b) the Credit crisis of 2007…we see a predictable downward pressure on the value of the US dollar. According to theory, the US dollar must depreciate.

 

 

Current Prices

 

 

 

Predicting future oil prices:

 

 

see our discussion on economic indicators and predicting the future

 

 

 

 

Impacts of High Oil Prices:

 

Shift to energy efficiency & alternative energy sources:

 

Back in the 1970's, there was an oil crisis when the price of oil increased 4x as a result of an oil embargo by oil producing states.   In response to the first two oil shocks, there was a massive response in the Western (oil consuming) world.  Not only did we see the introduction of fuel-efficiency standards in the USA, but we also saw more drastically the move away from powering our Power Generation industry with oil.   Starting in 2007 and early 2008, we saw once oil once again increase in price 4x to over $135 a barrell (and perhaps still increasing).  In response we see a massive shift toward energy efficiency and alternative energy investments.  Also, see our discussion on increased interest in alternative fuels for automobiles

 

Investments in public transport & rail

 

Measured by share-price performance, investor sentiment towards the railroads remains incredibly strong these days. Through the first 21 weeks of 2008, the six U.S.-based operators have seen their shares rally 25% or more, while the two publicly held Canadian railroads posted respectable, albeit more modest, gains. Shares of all eight railroads are up 400%, or more, in price from their pre-recession lows in 2000. (Comparatively, the benchmark S&P 500 Index has eked out a gain of just 7% over the same stretch.) The strong performance leaves what we think will be generally below-average investment returns over the next 3 to 5 years. That said, nimble trading accounts may want to ride the group's strong earnings and share-price performance in the short term. Our proprietary Timeliness Ranking System pegs five of the eight railroads to outperform the Value Line universe over the next six to 12 months.

 

Macroeconomic effects

 

Does high oil prices lead to INFLATION?

On one hand...

 

 

Traditional economists would argue that commodity price increases are not the cause of inflation, but are instead a symptom of inflation.  They would argue that inflation is actually caused by loose monetary policy (low interest rates from the Fed).   In this view, commodity prices used in economic statistics is like the way a thermometer is used to take a human temperature. The thermometer does not cause the temperature, but rather, only quantifies it. So it is with commodity prices.   In this view, inflation is caused by one thing only, and that is the failure of a country's central bank to properly manage its money supply. Saying you're going to solve inflation by subsidizing oil prices is like saying you can cure cancer by taking an aspirin for the pain.

 

On the other hand...

As we know from the history of the oil shocks of the 1970's, its clear that a sudden spike in oil prices can in fact lead to inflation.   While the root cause of initial inflation might in fact be due to loose monetary policy, the combination with sudden spikes in oil prices has the effect of "fanning" the embers of inflation, and has the potential to turn them into a real fire.  Commodity price increases act like that fan.  

 

Rising fuel prices puts extra pressure on inflation (it makes all other goods more expensive as it costs more to produce, and ship products around the world), and it hurts consumers because it makes driving cars, heating houses (etc) more expensive.  Mix this on top of another trend of the credit crunch, as well as rising food prices, and consumers are really getting hit.

 

 

High Oil Prices shifts wealth to the Gulf

  1. massive transfer of wealth to oil producers.

 

 

 

See discussion on CNBC:

 

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Businesss opportunities (that result from High Oil Prices)

 

High oil prices are effecting lots of other distant business models, and is having an impact on many aspects of business.  One of the more interesting trends Ive seen recently is that high oil prices led the USA to push for alternative energy sources, which led to the idea of subsidizing Ethanol production.  The simple idea of growing our own fuel, and becoming less dependent on foreigner was pitched as a matter of national security, and something that would be good for the environment.  

 

The trouble with corn-ethanol for fuel.......is that subsidizing farmers to grow corn (rather than other crops), and to produce fuel (rather than food) has resulted in a massive food price increases in crops such as corn and wheat, as well as other crops such as hops (which is a key ingredient in beer).   As a result of this, we are seeing countries such as Venezuela, Russia and Argentina putting pricing controls on food as poor people are having difficulty affording food.  Pricing controls, as we all know, will not work, and will only result in food shortages.  Another strange result is that the price of raw ingredients for beer production are pricing out independent breweries, and we are seeing closing of independent brew pubs all across the US as they are less able to absorb price increases than the major breweries such as Bush.   see articles: end of cheap food, and agriculture

 

 

Industries that could benefit from this high oil prices:

 

1.  Alternative energy companies such as solar, wind or ethanol companies.  Ever since oil prices have reached extreme limits, investors have been pouring money into alternative energy research and Venture Capital investments in the "clean tech" industry have been soaring.  I wonder, though, if these investments will still look good if the price of oil were to fall back to $30 a barrel? 

 

2.  Energy efficient investments and energy efficient companies.  Ever since the oil price has started to skyrocket, we see consumers moving away from driving SUV's (which hurt companies such as Chrysler), and toward smaller and more fuel efficient vehicles (which helps companies such as Toyota).  As governments fear dependency on "foreign oil", I wonder if there will be any increased incentive to mandate tougher fuel efficiency?  If so, then the effect of higher oil prices will be permanent as governments will create incentives for producers to switch to more fuel efficiency (even if the price of oil were to drop,and consumers would naturally switch preferences back to the larger cars).   

 

A related fear here is related to greenhouse gases, and to global warming.   This dual trend convergence of (a) higher oil prices, and (b) fears of global warming is combining to create the "perfect storm" for a movement toward more fuel efficient, and less polluting vehicles and products.  This is not just affecting the Automobile Industry, but is being felt in many industries all across the globe, from lighting, to air transport, etc.

 

3.  Oil exploration that might not be economical at $30 a barrel may be at $100.  For example, in Western Canada, there is a massive amount of oil in the "oil sands", but it expensive and difficult to extract.  But at the current price of oil, there is a boom going on in Western Canada as companies work to develop new techniques and pump oil from the sands.  This is having an unexpectedly negative effect on Canada's ability to meet with their Kyoto agreements (to reduce greenhouse gases to help with global warming), because the process of digging up the oil sands releases an intense amount of carbon dioxide to the environment.  For this reason, Canada is having a very difficult time to meet with their commitments.  All a result of high oil prices.   

 

Other examples are deep water drilling that may be too expensive when oil is cheaper, but is now economical at higher prices.  So, oil exploration companies should do well in an environment of high oil prices.  the risk is that exploration takes many years, and so a project that is started now when oil prices are high may come online in the future when oil prices are lower, making them uneconomical.   This is a high-risk investment and only becomes NPV positive when oil prices are high, as they are now.   Contractors such as Transocean (RIG), and Diamond Offshore Drilling (DO) are companies to watch in this sector. 

 

4.  The traditional Oil Industry should benefit as inventories become more valuable, but can they really pass on all price increases to consumers?  If their raw materials get more expensive, do they proportionally increase their selling price to make the same profit margins?  (more research needed here).  See our discussion about the Oil Industry to see which other oil companies could benefit from higher oil prices. 

 

 

 

Industries that could suffer from high oil prices:

 

1.  All industries could be hurt by rising inflation, which could lead the fed to raise interest rates, and slowing down the economy.  Higher oil prices can also affect the consumer spending as people cut back spending, or decrease travel.

 

2.  Shipping companies, and business models that depend on cheap shipping prices.  Importers that rely on air shipments, for example, will see their shipping costs rise, but will face difficulty passing on those price increases as they are competing against local competitors and with sea shipments.   Not just importers, but also the carriers such as FedEx, UPS, TNT trucking, and Con-Way trucking will all struggle with higher oil prices, and will attempt to pass on rate increases to customers. 

 

3.  Airlines and especially discount carriers may see their business models affected.  Especially since jet fuel can account for up to 30% of their costs.   Because profit margins are already tight (air travel is becoming a commodity), we see airlines having trouble making profits as fuel prices rise. 

 

4.   Chemical companies such as Dow Chemical, and plastics manufacturers such as 3M and Goodyear tire are hurt by higher oil prices because oil is a main component of their production.   As a result of higher oil prices, plastics becomes more expensive to produce....start looking for alternative packaging if oil prices stay high!

 

5.  Manufacturing companies that require a lot of energy will be hurt, such as aluminum and steel producers.

 

6.  Retailers may suffer a little as shipping companies force price increases due to higher shipping costs.  Online retailers may be more sensitive to shipping price increases becasue many of them subsidize the shipping costs to customers, so they will eat alot of the price increases themselves rather than passing on the costs, where more traditional retailers may be better suited to increase prices (or wont have to because consumers come and pick up the products themselves.  Business models that rely less on shipping will do better. 

 

 

 

 

 

 

External links:

 

Renewable Energy • Biofuels • Carbon Trading • Cellulosic ethanol • China's Water Scarcity • China's Coal Power Pollution • Clean Coal • Coal Power • Corn Prices

 

 

 

 

 

Links:

 

 

 

 

Links

 

 

(see Oil Industry): 

 

 

 

External Links

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Digg!

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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