The Price of Oil
The Energy Information Administration asks "Why Are Oil Prices So High"?First off, I believe that for reasons of context, it is useful to note that the price of oil was $10 in late 1998. When the price is that low, oil companies have no incentive to invest money in further exploration and new technologies. Major projects in the energy industry, at least the kind that have the power to modestly affect world markets, have a lead time of anywhere from 5 to 10 years. As a result, we are today seeing the results of ridiculously cheap crude oil prices in the late 1990's.
Anyhow, please read the entire article - it is long on facts and short on politics (no pun intended, if I have any readers familiar with the energy trading industry). Here is a summary of the main reasons for high oil prices followed by my commentary:
1) Soaring energy demand - primarily from India and China, and from about 2004 onward; the demand is far outpacing the production of oil; shockingly, the big bad United States with its herd of big bad SUV's driven by obese people who eat McDonalds and got to church and vote Republican is only a small part of the tremendous recent growth in demand; India and China's economies are rapidly growing, with a commensurate demand for new energy
2) Non-OPEC suppy has failed to meet expectations - due primarily to hurricanes in the Gulf of Mexico and a declining investment environment in Russia (to say the least); in turn, OPEC countries are attempting to make up for the non-OPEC decline, causing a decrease in OPEC surplus production capacity
3) Low OPEC spare capacity levels increase the demand for inventories - with OPEC's spare capacity much lower than normal, the market becomes highly vulnerable to price shocks (i.e. very volatile), market participants realize this, and thus demand to hold on to larger stocks of oil inventory than normal (as a hedge against the high price risk) - this increases demand for oil even further, which causes the price to rise
4) Geopolitical issues in major OPEC countries reduce supply - due to chaos caused by terrorists (Iraq, Nigeria) or madmen (Venezuela, Iran)
It is significant to note that the countries who have driven out western oil companies in the name of nationalism (Iran is a great example) do not have the capital or technological know-how to sustain production in their fields. As a result, their production is declining with every passing year. We do not take note of this here in the west because the high price of oil is temporarily disguising the fact that less and less of it is being produced by our enemies. If you take a global view of energy, a good rule of thumb is that state-run oil companies have the vast majority of the world's reserves but don't know how to extract the oil very well, while western oil companies have the capital and technology to extract oil profitably and efficiently but don't have as much reserves to work with.
5) Bottlenecks in the worldwide refining industry - lead to increased profit margins for refined products, which increases the demand for crude oil (i.e. refiners want more of it so they can turn it into high margin refined products, and when a group wants more of something the price will rise); I'd just kindly like to point out that the United States has not built a new refinery since 1976, and that virtually all of our refining capacity is located in Texas and Louisiana, which as we all saw last year is prime hurricane real estate
6) Weather - hurricanes in 2005 disrupted both U.S. refining capacity and oil production in the Gulf of Mexico (as well as pipelines to get the oil to shore); the threat of further bad weather pushes prices higher (thanks for your alarmism Al Gore!!!)
Finally, the paper notes that increased speculative activity in the oil futures market, primarily by massive hedge funds, is a symptom of price volatility (and high oil prices) rather than the cause of it. This merits some analysis, because what the paper says is true but it leaves out a few things.
Let me first summarize the paper's (excellent) points - the increase in speculative activity is due to the fact that oil producers perceive "a high risk of uncertainty surrounding the value of future oil prices", and thus want to shed that risk in the marketplace via energy trading. Speculators (read: hedge funds) are eager to pick up that risk in the search for higher and higher investment returns. The paper correctly points out that "in times of ample spare capacity there is little motivation for commercial producers and users of energy to shed risk, or hedge, since there is little perceived risk."
Fair enough. However, it should be noted that hedge funds have increased in size exponentially over the past five years or so, particularly after the bursting of the tech bubble in 2000-2001. Since then, wealthy investors decided they wanted to go with exotic hedge funds to earn them decent returns, instead of an untrustworthy stock market. As the world's economy declined, interest rates were slashed in a bid to turn things around. This helped out the world's economy, but hurt investors - who were forced to throw growing amounts of idle capital wildly around the globe in search of profits.
Hedge funds stepped in, offering returns of 20%, 30%, or more. They grew rapidly, and their power in the marketplace ballooned. Enter extreme price growth of crude oil (reasons outlined above), and the hedge funds suddenly saw a large opportunity to make money in oil futures. I don't believe that hedge funds can truly and substantively swing the market upward on their own (through increase demand for oil futures), but they can sure influence how strongly the pendulum swings. They have an exaggerative effect on the market, albeit in the short-term.
Over time, crude oil prices should closely track the reality of oil reserves and oil production, which Figure 5 in the paper shows.
posted by JM @ 7:13 PM
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