10/08/2005

Daily Kos: The case for an oil price bubble?

The case for an oil price bubble?
by Jerome a Paris [Subscribe]
Sat Oct 8th, 2005 at 08:05:27 CDT


The Oil Bubble. Seventy dollars a barrel? Relax, it'll come down.

We keep hearing the word "bubble" to describe industries with rapid and unsustainable rising prices. Hence, the Internet bubble, the telecom bubble, stock market bubble, and now, some analysts believe, a housing bubble. Yet for some mysterious reason no one speaks of the oil bubble--though prices have tripled in two years to as high as $70 a barrel.

Reviewing the history of oil-market boom and bust confirms that we are in the midst of a classic oil bubble and that prices will eventually fall, perhaps dramatically.

This is coming from the WSJ's Opinion Journal, and they have an agenda (which we'll go into below). But a number of commenters in my previous diaries have made the same suggestion, and recently, a Kossack with a lot of expertise on the topic, HiD made a similar point in a well argumented diary over at the European Tribune.

So, what's the case for an oil price bubble? Below, the ideological case and the reality-based one.

* Jerome a Paris's diary :: ::
*


Despite apocalyptic warnings, the world is not running out of oil and the pumps are not going to run dry in our lifetimes--or ever. What's more, the mechanism that will surely prevent any long-term catastrophic shortages in energy is precisely the free-market incentive to make profits that many politicians in Washington seem to regard as an evil pursuit and wish to short circuit.

The Opinion Journal's position is simple: we'll never run out of oil thanks to unchecked capitalism. (Unsaid is who's the "we" - or who's included in "the world" that will not suffer catastrophic shortages, of course, but that's a separate point). And their argument: doomsayers were wrong before:


The best evidence for an oil bubble comes from the lessons of America's last six energy crises, dating back to the late 19th century, when there was a great scare about the industrial age grinding to a halt because of impending shortages of coal. (Today coal is superabundant, with about 500 years of supply.) Each one of these crises has run almost an identical course.

First, the crisis begins with a spike in energy prices as a result of a short-term supply shock. Next, higher prices bring doomsday claims of energy shortages, which in turn prompts government to intervene ineffectually into the marketplace. In the end, the advent of new technologies and new energy discoveries--all inspired by the profit motive--brings the crisis to an abrupt end, enabling oil and electricity markets to resume their virtuous long-term downward price trend.

The limits-to-growth crowd has predicted the end of oil since the days when this black gold was first discovered as an energy source in the mid-19th century. In the 1860s the U.S. Geological Survey forecast that there was "little or no chance" that oil would be found in Texas or California. In 1914 the Interior Department forecast that there was only a 10-year supply of oil left; in 1939 it calculated there was only a 13-year supply left, and in 1951 Interior warned that by the mid-1960s the oil wells would certainly run dry. In the 1970s, Jimmy Carter somberly told the nation that "we could use up all of the proven reserves of oil in the entire world by the end of the next decade."

So, the government was wrong, Carter was wrong, and the "limits-to-growth crowd" was wrong. You got to hand it to them, they do a brilliant job of indirectly demonising their enemies while making apparently sensible points.

That's about the extent of their arguments, which never tackle the question of why prices would go down. (Being able to find a substitute to an increasingly expensive input is not the same thing as getting the price of that input down). They note, in order:

* that oil is cheaper, in relative terms, than in the past. [true, but again, irrelevant to the direction of future prices (you could say that we could easily tolerate more increases)];
* that world reserves have actually increased in the past 30 years. [They use official Saudi numbers uncritically - presumably their government is effective and not prone to incompetence or manipulations...]
* vast reserves in Canadian oil sands and Colorado oil shales will soon be competitive (if prices go up a little bit more [which again is consistent with capitalism's ability to find substitutes, but not an argument towards lower prices])
* China's growth means that they will become more efficient users of energy [which means that growth of energy consumption will be lower than GDP growth, but it will still be growth, but that's conveniently overlooked]
* and, finally, the main argument:

Higher prices for gas and fuel for home heating have cost the average U.S. family about $1,500 to $2,000 a year. (Thankfully the Bush tax cuts have given back about precisely that amount in lower tax payments to the IRS.)

["We" did not even feel the oil price increase. Again that unidentified "we".]

Thus their solution:


The real constraints on oil production are barriers created by government. Myron Ebell, an environmental analyst at the Competitive Enterprise Institute, notes that roughly 90% of the oil on the planet rests under government-owned land and these resources are abysmally managed.

In the U.S., environmentalists have erected myriad barriers to drilling for new sources of oil. The American Petroleum Institute estimates that there are at least 100 billion barrels that are fairly easily recoverable in Alaska and offshore that oil companies are not permitted to exploit. Once, we could afford the luxury of not drilling there. Now, thanks to a witch's brew of unforeseen circumstances--political turmoil in the oil producing countries, China's surge in demand, and hurricanes that have knocked out Gulf refineries--it's an economic and national security imperative that we do.

Here's one simple idea to increase the domestic supply of oil: Have Uncle Sam share its oil-drilling royalties with the California government. If Californians realized they could go a long way to solving their deficit and overtaxation problems by raising billions of these petro-dollars, the aversion on the left coast toward offshore drilling might well begin to subside.

There is enough oil, but it's the fault of the government and the environmentalists that we cannot get hold of it. Maybe if we bribed the naive citizens of California, all would be fine...

I thought I read above that oil was plentiful around the world, and that prices would soon go down brutally. Why is it an "economic and national security imperative" to produce the smallish volumes of Alaskan oil (and to abandon environmental restrictions)? If we're not going to "ever" run out of oil, even 100 billion barrels - 3 years of world consumption - are not going to make a difference, are they?

It's almost too easy to shoot down the silly or incoherent arguments of the WSJ, and this diary is thus not really making so far the case of an oil price bubble. So let's have a look at the more rational arguments of HiD:


* Demand destruction -- mogas at $3 bucks and jet fuel over $2 is starting to really bite hard. US oil demand was down 3% (600 MBD). Some of this is lost industrial demand on the USGC due to hurricane damage.

* Saudis offering crude with no takers. While lighter crudes make more mogas, heavy sours produce more fuel oil which may well be needed to offset the loss of natgas for electricity generation (sorry birds/lungs).

* more refinery throughput lost than crude production. Right now there's about 500MBD to 1MMBD more lost refining capacity on the USGC than lost crude production capacity. Sounds like most of the refineries will be back within about 4 weeks though. Only the 3 near NO + Valero Pt. Arthur sounding really screwed. Chevy Pasc may start some units with Oct, and most by T-giving.

* But why are products fading too? First, imports to the US are gushing. Mogas imports are up 500 MBD as European/S.Amer/other refiners keep refineries maxing mogas in a period that ususally has mogas demand slumping. Diesel/heat imports are up 200 MBD as well. Even with all this production lost, diesel/heat stocks only dropped from 133 MMB to 128. We're not that far off last year's stock levels (lucky to have been ahead of the curve a bit).

* Demand destruction. Once people change habits they don't rush right back to piggery. And it's not like the pump prices are moving down much. My price at the pump is still up from $2.85 to near $3.40. We've shut down most optional trips just on general principle.

* Refineries are deferring maintenance from this fall to next spring (get ready for high mogas next April/May) to play catch up.

* Hoarders arms are getting tired. At some point you sell your "fear" stocks rather than have your ass handed to you when/if the bottom drops out.

* Recession brewing? Stock market thinks so at least this week.

All these arguments are real and backed by facts:

- demand destruction:


Oil prices fall as US fuel demand eases (FT, Oct. 7)

Oil prices yesterday fell almost 2 per cent to $61.65 a barrel as data showed US demand for petrol and diesel easing. Some evidence that US drivers are changing their ways in response to high petrol prices has helped push oil down almost $10 from the $70.85 a barrel record of August 30 when Hurricane Katrina blew through the US Gulf.

(...)

Data from the US Department of Energy yesterday made clear that the fall in demand was not just seasonal. It added that US petrol demand was likely to be about 200,000 b/d less than forecast for at least the next two weeks because of high retail prices.

Demand usually decreases at this time of year, between the end of the summer holiday driving season and the start of winter, when thermostats are turned higher and heating oil is in demand. However, DOE data showed that today's demand is down from the same time last year.

Petrol demand averaged 8.8m barrels in the past four weeks, down 2.6 per cent from last year while demand for distillates such as diesel and heating oil was down 3.8 per cent at 3.9m barrels in the past month. The trend is expected to continue in the next two weeks, with the DOE saying demand is about 200,000 barrels less than it had previously thought.

So demand IS currently lower than expected. Although it is not clear yet if this is due to a real change in behavior or to the disruption from the Hurricanes (people displaced, losing their cars and jobs, logistical chains disturbed, etc..), the effect on oil prices has been very real this past week. It's an open question if it is a short term or a longer term phenomenon as of today.

- excess of oil supply

The second point made by HiD is also a valid one. Ol prices are going down because there suddenly is an excess of supply. Some of that excess comes from the fact, as he points out, that more refining capacity was damaged than oil production capacity in the Gulf of Mexico, so more demand (from the refineries) has been taken out than oil supply. Again, this is a short/medium term fact (depending on how long it takes to put the refineries back on line, which is not clear at that point) which has a real downwards effect on oil prices now but which may also cause a bigger price build up as shortages downstream build up.

- excess of gasoline supply

The above explanation (loss of refining capacity) makes sense for oil, but should logically have triggered an increase in refined products's prices. It did in the early days after hurricane Katrina struck, but this has not lasted. The reason for that is that European refiners have covered the gap, both by tapping in their strategic gasoline reserves (in September, they announced that they would send 1mb/d over 30 days), and by increasing their gasoline production, which would have otherwise gone down at this time of the year.

Another reason is that the other refineries, which would have been been slowed down at this time of the year for maintenance and to switch to their winter production requirements (more heating oil and the like) have not done so. This has kept more supply available, but at the risk of longer stops further down the line if equipment is overused, and of having lower stockpiles of heating oil.

- speculators getting tired and markets pricing a recession

This is harder to say. There has certainly been a speculative component in oil price increases over the past year, as hedge funds and others bought positions in the (well-founded so far) expectation that prices would go up. if the idea takes hold in the market that the economy is not doing so well and that high prices have changed behaviors, then speculation could start moving the other way round, and sell their bullish positions, triggering more downwards movements on oil prices.

This week has certain seen a resurgence of bearish sentiment on the market, with fears of inflation, net loss of jobs in September, and a sharp drop in confidence. But one week of market movement is hardly conclusive.

As HiD makes clear in his diary, these factors are really applicable in the short term (2005) and may not change the long term dynamics towards higher oil prices. He also points out that the focus on oil should not hide the very real, and continuing increase in natural gas prices. ..

Despite these arguments, which are all very real, I think that the case for higher oil prices in the medium and long term is pretty strong.

* the short term disruptions to all parts of the oil supply chain (production, refining and consumption in the Gulf Area) has created unusual imbalances in parts of the chain, thus leading to temporarily lower prices, but building up pressure elsewhere - and especially in stock build up for winter.

Katrina and Rita blow kisses at oil

Katherine Spector of JPMorgan says 18 per cent of US refining capacity is likely to be offline for the next month or so, and up to 8 per cent may stay off until the end of the year.

"Either distillate, gasoline, natural gas, or potentially - with a cold winter - all three are going to end up short this winter," says Paul Sankey of Deutsche Bank. "We see the US, and global products, as somewhere between crisis and emergency."

* the jury is still out on whether higher prices have really led to lower consumption. If they have, that's good news and it would indeed lead to lower prices on the longer term

* the geopolitical premium is still pretty high and there is no real reason for it to go down. With spare capacity being at record lows, any kind of "normal" disruption (a strike in one of the big oil producing countries, another weather event or natural catastrophe hitting an oil production area, or a big terrorist attack anywhere) will have an impact. Any tension with Iran, a big producer and the gatekeeper of the Hormuz Straits would have an even worse impact. The probability of such events is low but not nil, and as their impact on prices would be really massive, this will lead to an upwards pressure on oil prices for as long as spare capacity is low. Bush's vindicative speech this week is not going to calm things down.

In conclusion, there are a number of valid arguments to bet that oil prices could be close to 50$ rather than to 100$ at the end of this year (You can still take a bet of your own in this diary: Countdown to 100$ oil (9) - I am taking bets - it's free and you can win some champagne), but fewer arguments that long term prices will go down, and even fewer that there will not be an energy crisis this winter.

Also, while I have no doubt that our economies will eventually find smart substitutes to 100$ oil or to 300$ oil (thus ensuring that "we" do not suffer from any shortages because "someone else" will have stopped buying the stuff), the economic pain from this transition will be really bad for those that are not lucky (or, presumably, talented or hard-working) enough to be part of the WSJ's "we" crowd. That's why we (all of us) need to react today to the coming energy crisis, to make the transition more bearable to the weakest economically amongst us, who will be crippled by higher prices.

And is this a bubble? No, cheap energy is getting scarce (which is different from "energy" is getting scarce) and cannot be expected to come back now that we have used most of it. Does that mean that prices can only go up? Not necessarily. A consequence of the current scarcity and lack of spare capacity is the increasing volatility of the prices, which go up and down in bigger steps. Call each spike a "bubble" if that makes you happy, but we will keep on seeing higher and higher spikes, followed by pauses or withdrawals.

And dropping environmental safeguards is a stupid bet. It lowers the apparent costs today in return for much higher costs (for energy, health, and irreversible damage to the land around us) in the future.


Daily Kos: The case for an oil price bubble?

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