A Deeper Dive into Oil Pricing
In the previous post, I suggested that speculation is driving oil prices higher than they should be. In this follow-up, I think I can show that oil prices are not behaving in a completely supply-demand determined way. We’ll look at price activity, volatility, and an estimate of what rational pricing might be.
First, here is Brent Crude spot price activity since 1987, data from the U.S Energy Information Administration. I’ve taken a weekly average of daily data, and plotted it as of each Friday (it was just a lot easier than trying to work their data table into a daily data plot.) Also included is a 55 week moving average.
As you can see, the price really took off after 2000. Coincidentally, the Gramm–Leach–Bliley (Financial Services Modernization) Act of 1999, which undid portions of the Glass-Steagall of 1933, was signed into law on Nov 12 of that year, and the Commodities Futures Modernization Act of 2000 was signed into law on Dec 21 of that year. These new laws allowed mega-consolidation in the finance industry and prohibited the regulation of certain speculative activities.
Here is the same data, separated into two graphs around the year 2000. Also shown are the 55 week moving average, and an envelope one standard deviation above and below the average. St Dev is based on the same 55 data points as the moving average. The sections of the price line that extend above the {Avg + St Dev} line are highlighted.
The entire data set contains 1166 points. Of these, 428, or 36.7%, lie more than 1 Standard deviation above the moving average. For the segment through 1999, 156 of 574 points, or 27.18%, lie above the St Dev envelope. For the segment 2000 on, 272 of 592 points, or 45.95%, lie above the St Dev envelope.
For data normally distributed around the mean, about 1/3 of the data points should lie outside the 1 Std Dev envelope, half of them (1/6 of the data set) above and half below. I’m no statistician, but this is not a well behaved data set. Clearly, there is a powerful high-side bias. What could be the cause? Here are some possibilities.
1) Supply-demand forces in a growing world economy are so skewed to the demand side that this is that natural result.
2) External forces, such as panic due to war and instability in the Middle-East, have irrationally raised prices.
3) Speculative forces with a strong long-side bias have skewed the market away from a supply-demand determined price level.
4) Withheld supply due to OPEC activities, contango (hoarding on leased tankers), and the disruption of Iraqi supply for the last decade have unnaturally skewed the supply component.
My view is that possibilities 2 – 4 are all operating to some degree.
I have no way of evaluating 2 and 4. However, 4 seems reasonable, in view of the classic description of inflation: too many dollars chasing too few goods. This effect could also spill into into futures speculation, where the amount of oil traded is finite, but the amount of speculative money available appears not to be.
To be clear, I’m not talking about CPI inflation, I’m talking about commodity-specific inflation. I believe that financial tail-chasing has not been limited to oil speculation. There is enormous wealth in the world, and to a large extent, it is not being devoted to legitimate investment. It is being devoted to computer generated program trading that capturess tiny fractional percentage gains millions of times per day, to skim money away from those who use exchanges for valid purposes.
And maybe we can get a handle on speculation. My hypothesis is that deregulation in the 1999-2000 time frame has enabled and encouraged speculative rent-seeking activities in the oil futures market, which has inflated the price of crude. One way to go at it is to have a look at volatility. We already have standard deviation in our hip pocket. Let’s see what we can do with it.
Here is standard deviation, based on 55 consecutive data points, divided by the average of those data points. Just for kicks, included are a 55 point moving average of the St Dev in red (for what it’s worth – not much, I’d say) and a best fit (least squares) trend line.
Well – the trend line slopes up a bit, but that’s not really a lot to go on. On the other hand, the entire 90’s lie below the trend line. In fact, except for the 1990 price spike, most of the of the St Dev values prior to about 1999 lie below the trend line. Let have a closer look.
Here, the data are divided into two segments, up through 1999, and 2000 and beyond. For the early segment, the St Dev/ Price line is in dark blue and the 55 week average is in red. For the latter segment, the lines are light blue and yellow, respectively. Now, the trend lines tell an interesting story. For the early period, the trend line is essentially flat, with a slight downward slope. For the latter period, the slope is clearly upward. Despite the localized gyrations, we can see that prior to deregulation, volatility had no trend. After deregulation the trend is up.
Up to 1999, St Dev / Price averaged 12.65% (exclusive of the 1990 spike, taken as August, 1990 through January, 1991 the value is 12.01% ) From 2000 until now, the St Dev / Price averaged 15.06%.
So, what we see is that since since deregulation, prices have gone up, volatility has gone up, and upside bias in the data set has gone up. Let’s resurrect possibility 1) and see if demand pressure can be the cause. To get a handle on this, I took a closer look at my speculative idea from the previous post, and extrapolated prices forward from 1990, based on hypothetical constant growth rates. Originally, I took a SWAG at the 1990 average price, and came up with $30 per barrel. With a growth rate of 4% over 21 years, that would result in a current price of $68.36. The 4% growth rate came from a generous estimate of World GDP growth over the period, assuming a direct, linear link between GDP growth and demand for petroleum.
Here is a graph based on the data instead of a SWAG. It shows constant price increase rates of 3, 4 and 5% per year, based on the actual 1990 average price of $23.66. The first thing to note is that my $30 SWAG was more than $6 too high. The next thing to notice is that 1990 was the worst possible year to select, given the point I’m trying to make. Due to the local spike, the 1990 average of $23.66 is almost $5 higher than the 1987 to 1993 average of $18.84. So, if anything, my estimate of $68.36 is artificially high.
Still, I went with the 1990 average for this chart. Extrapolations are based on growth rates of 3 (yellow), 4 (red) and 5(green)% from the 1990 average of $23.66. This gives Mid 2011 price estimates as follows.
At 3% $43.34
At 4% $53.02
At 5% $64.09
I’m not suggesting that this is a fool-proof method. However, it is gratifying that it is more-or-less consistent with the oil industry estimation of a supply-demand determined price. Further, these price growth estimates are quite generous, since estimates of petroleum demand growth are in the range of 1.6 to 2.3 %.
My conclusions:
1) The price of oil is far above rational, market-based pricing.
2) While other distortions and manipulations are likely to play a part in an inflated price, it’s not clear how they could contribute to increased volatility.
3) Unregulated, excessive speculation, with a long side bias is indisputably taking place. I believe this is a major contributor to excessive price inflation, and the sole contributor to excess volatility.
Do you have a better idea? Let’s hear it.
Bush family kissing Saudi royals…………………
I did some oil work in late 80’s read API stuff on the economic regularly.
At the time it cost $5 US to get Saudi’s 10 or 15% of supply to tanker head.
Brent etc had high costs and lower quality.
Inelasticity of demand especially since Reagan etc broke Carter’s energy trends.
No one doubts that physical speculation can move the spot price. And how much it is can be seen by how much is being hoarded (see P. Krugman on this).
Most economists insist that futures speculation can’t move the spot price (see P. Krugman).
You seem to be wandering a bit between the two different things there.
“These new laws allowed mega-consolidation in the finance industry and prohibited the regulation of certain speculative activities.”
Yes, that is what the law did. It confirmed the previous situation. Legislated what was already happening. So there wasn’t actually a break in regulation and certainly not the deregulation you later claim. We just moved from a common law situation of no regulation to a legislative basis for the same no regulation.
Tim –
If I read you correctly, You’re suggesting that the Commodities Futures Moderization Act and the Financial Servoces Moderization Act are irrelevant to the changes in oil futures market behavior.
It looks to me like there are two regimes, with a break in the early 2000’s. I’m suggesting the break means something. The next question becomes, “What changed?” The law changed, the activities of big financial players with no direct commercial interest changed, market dynamics that I talked about in these posts changed.
I look at data and try to construct a rational, consistant narrative. I’m willing to be wrong. But that requires, at the very least, an alternative narrative that’s consistent with the facts.
Cheers!
JzB
If you look at the chart, it’s not clear that it rises from 2000; there seems to be a small slide (the 2001 recession) and then it takes off from about 2002. That’s consistent with this report about production costs, from the EIA, which suggests the price is driven by rising exploration and production (E&P) costs:
http://205.254.135.7/oiaf/aeo/otheranalysis/cecei.html
Thereafter, you have recovery in the US, and astounding growth in Brazil, China, and India, leading to increasing demand. Since the cheap producers (OPEC) couldn’t (or wouldn’t) raise production all that much, oil majors went out into more expensive prospects: first deep-water, then oil sands, as the rising price made them profitable.
Finally, there’s a double-whammy in 2008 as China does two things: first, imports a ton of diesel to fuel the relief effort after the Sichuan earthquake, and secondly, imports 100+kbd of gasoline for the Beijing Olympics (China is normally an exporter). These shocks drive the spike, then the economic crisis drives the prices way back down as demand slumps.
(As a side note, the futures market is worth around $200 billion, but the physical market–producers, refiners, users–is worth about $3,8 trillion. So if you assume the speculators are in derivatives rather than physical oil, which is borne out by CFTC data, it’s hard to see how they’re driving things.)
As a bonus, here’s some interesting reading from the vampire squids. 😉 It’s consistent with the above, which came from different sources:
http://www.gceholdings.com/pdf/GoldmanReportFoodFeedFuel.pdf
How’s that?
Asking whether price is determined by fundamentals without looking at all at supply or demand would seem to have some weaknesses as a method. Surely the flatlining of crude+condensate production since 2005 despite the price increases is of some relevance?
I don’t think your identity of contango with “tanker hoarding” is fair. Tanker hoarding is the product of belief that prices will go up and it is often in conjunction with the crossing of risk tolerance with the cost to lease versus the futures price. It’s effectively a form of arbitrage, and no different than cash & carry with eligible goods at the clearinghouse.
Likewise, the use of HFTs *can* be liegitimate to keep the electronic exchange in line with the floor: simply another arbitrage.
It should be noted though that none of them are a free lunch. Maintaining such systems and considering the tradeoffs is an expensive operation.
I would contend that the inflation on commodities like oil is consequence of globalization. It’s easier to balance your large-scale global investments if you use commodities as an asset class alongside currencies. It’s just that global exchange, velocity and production have made certain commodities (like oil) a suitable substitute for some fiats.
Ooops, I have typos. Strike “about production costs” after “this report”. And pretend I’m European at “$3,8”.
—
And, of course, there were also two wars started in the early 00s ….
Ooops, I have typos. Strike “about production costs” after “this report”. And pretend I’m European at “$3,8”.
—
And, of course, there were also two wars started in the early 00s ….
FYI, Stuart Staniford has an interesting blog on supply (amongst other things) at Early Warning. The oil-related stuff is here:
http://earlywarn.blogspot.com/search/label/oil%20supply
I found the peak-oil-per capita graph, in Cameron’s link, to be interesting. Essentially, it shows that worldwide oil per capita has been flat since 1980.
If you Google “world energy consumption per capita” the first result is a graph showing flat energy consumption in the 90s and steadily rising energy consumption in the 2000s (per capita). I dont’ see how supply/demand explanations can be so easily dismissed.
I think a technical view toward production cost and quality.
While it costs pennies to get Saudi good oil there are limits and planning delays to getting over 15% of demand from there.
Other sources, enter rising production costs and declining quality which lead to micro econ analysis of marginal revenue product etc.
Why is the US deploying 2400 F-35’s single seat single engine aircraft that are dangerous to the pilots and ground crews ($388B acquisition costs, and $700B support costs over 20 years) instead of 30,000 3MegW wind turbines is an “unwarranted influence” thing and not just for the Boeings and Lockheeds.
downpuppy –
You’re right, world production has flatlined since 2005.
I just took a look at price and volume moves, and they do tend to generaly go together. Price increases and decreases lead volume increases and decreases, in general.
But, what we’ve seen during the flat-line period are the biggest moves both up and down in history. The most dratic change was the initial drop from the bubble peak.
In the specific context of the bubble, I have to call that a non-correlation.
Cheers!
JzB
Cameron –
I’m not claiming the supply side has no effect. But it’s awfully hard to make a correspondence between supply factors and the initial post-bubble drop.
Cheers!
JzB
Brian –
I didn’t dismiss Supply and Demand. I gave quite a bit of consideration to the demand side, at least. If the wild gyrations in price these past few years can be explained by Supply flat + demand increasing at 2.3%/Yr, I’m very open to a convincing narative.
The biggest challenge is going to be the $100 drop from the peak.
Cheers!
JzB
I appreciate all the thoughts in this discussion. In retrospect, it seems I have implicitely assumed that a bubble is a demand-driven phonomenon, with supply considerations either irrelevant or simply swamped by the magnitude of demand changes.
I never explicitely articulated that thought – even to myself, until now. It does strike me as being correct. But, then, I guess it would.
Noah Smith has an interesting post up about bubbles.
http://noahpinionblog.blogspot.com/2012/01/why-do-bubbles-happen.html
Cheers!
JzB
Hello JzB,
In theory, given inelastic demand and limited supply, an incremental increase in demand can cause an infinite increase in price.
It appears to me that the data we have can nicely explain wild flucuations in the price of crude since 2002:
Pre-2002, total global oil capacity was greater than supply. The price of crude was determined by the highest cost producer. In this situation, you would expect relatively stable oil prices.
Post 2002, world wide per capita energy usage took off, but world wide per capita oil stayed flat. The demand for oil outstripped supply and the price of oil was no longer determined by the highest cost producer. In this environment you would expect high volatility and high oil prices.
To say demand for oil has only increased 2.2% anually is a red herring. Demand would have increased a lot more if it wasn’t for high oil prices. Other energy sources, such as coal, have been used instead (worldwide coal usage blasted off starting in 2002). Demand can’t increase beyond ~2% in any circumstance; it is limited by supply.
Brian –
You raise an interesting point. I have no idea to what extent coal and oil are fungible.
Coal use really took off in 2003. Greatest year over year increases were in 2003 (8.12%) and 2004 (9.17%) – well before the oil bubble peak. Then, through 2009, annual increases were about 4%, on average.
http://www.indexmundi.com/energy.aspx?product=coal&graph=consumption-growth-rate
So – while oil prices were going through their great gyrations, the growth of coal use was essentially constant.
I’ll agree that 4% YoY is pretty hefty, especially in comparison to the last couple of decades. But I don’t think this goes very far toward explaining a bubble, crash, and post bubble bounce in oil prices.
Cheers!
JzB
I’ve no problem with spotting that the law and the behaviour change are correlated. But that’s when it gets interesting: what’s the cause and effect.
Which, given that the law change didn’t in fact change the law, it simply codified extant legal situation, I rather doubt that the law change was the cause.
My interpretation is that the oil market was manipulated for smoothness up until it couldn’t be. This comes from 30 years of reading news of OPEC setting production quotas & price targets, which they more or less followed to the extent it was convenient.
The increase in volatility followws naturally from OPEC running out of spare capacity. As long as they had something in the area of 2-6 million barrels a day of slack, they were a going concern. Now they’ve pretty much let everybody go full out, except in emergencies like the 2008 crash, so it’s much more the nervous, jumpy market you’d expect given the very low short term elasticity of demand & tendency towards political & natural outages.
And yet the last 6 months have been weirdly stable, despite the Iran idiocy, so who knows?
Don’t forget that China joined the WTO in 2001. That was a massive demand-side factor. Throw in the Iraqi disruptions and (then) declining U.S. production and it’s not at all hard to see how prices made a huge jump from 2000 to 2008. Post financial crisis, prices remain below those levels despite ongoing concerns regarding Iran and the Saudis largely maxing out production. If you look simply at inventory figures of already produced barrels (obviously, “pump later” is one storage strategy for producers, but this is not likely for speculators), the supply/demand case is very, very strong.
I say go to the theoildrum.com to get a better idea on the supply/demand issues:
1) China/India because of higher economic output per barrel than OECD, can pay more than the OECD (the US is the worst offender – with a lot of oil going to no economic value)
2) OECD is in production decline (and has been for 10 years?)
b) Also, look at countries like the UK, which had real production dropoffs in the North Sea (there are other examples as well: Mexico, Indonesia).
3) New production is more expensive (tar sands, horizontal fracking).
4) Remember importers are paying for *exports* – they don’t get to bid on total production.
Also someone really needs to understand that supply above demand by 1% could drop the price by 10% – they aren’t a linear matchup. Same in reverse. I don’t understand why people always seem to gloss over this. Thus the financial collapse which lowered demand by a couple million barrels a day (or more) dropped the price to the floor.
Matt Taibbi said the same thing, that oil prices were being greatly affected by speculators and the consolidating financial corporations. It’s well doccumented his 2010 book “Griftopia.”
http://www.rollingstone.com/politics/blogs/taibblog/wikileaks-cables-show-speculators-behind-oil-bubble-20110526
http://www.inmalafide.com/blog/2011/08/02/matt-taibbis-griftopia-how-capitalism-and-socialism-became-obsolete/
http://trueslant.com/justingardner/2009/07/03/matt-taibbi-blows-the-lid-off-oilgas-speculation-by-goldman-sachs/
I forgot this 2008 link about the run up in oil prices based on speculators.
http://www.econbrowser.com/archives/2008/05/oil_speculation.html
Matt Taibbi said the same thing, that oil prices were being greatly affected by speculators and the consolidating financial corporations. It’s well doccumented his 2010 book “Griftopia.”
http://www.rollingstone.com/politics/blogs/taibblog/wikileaks-cables-show-speculators-behind-oil-bubble-20110526
http://www.inmalafide.com/blog/2011/08/02/matt-taibbis-griftopia-how-capitalism-and-socialism-became-obsolete/
http://trueslant.com/justingardner/2009/07/03/matt-taibbi-blows-the-lid-off-oilgas-speculation-by-goldman-sachs/
And this 2008 blog entry about the run up in oil prices based on speculators.
http://www.econbrowser.com/archives/2008/05/oil_speculation.html