## 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.