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Like a roller coaster ride, 2011 saw oil prices climb gradually, only to fall dramatically this last week. Here I offer my thoughts on some of the key contributing factors.
Let's begin with the relation between oil prices and the exchange rate. If the dollar depreciates by 1%, the dollar price of oil would have to go up 1% to keep the price paid outside the United States constant. This is a bit simplistic, one reason being that there is usually some third factor, such as a rise in incomes outside the United States, that is causing a change in both real oil prices and the exchange rate. Different factors affect the two series differently, so one might see a 1% depreciation correspond to an increase in dollar oil prices of more or less than 1%, or sometimes even an oil price decline. Between September 2009 and September 2010, a 1% depreciation of the exchange rate was associated on average with a 1.3% increase in the dollar price of commodities like oil or copper. The dollar rose about 3.5% against the euro between Wednesday and Friday, and the 4.5% decline in the price of copper could be pretty well explained by the exchange rate alone based on the recent correlations (3.5 x 1.3 = 4.5). But something more is involved in the 11% drop in the dollar price of crude oil observed those same two days.
Looking at the broader trend, the price of oil shot up 19% in February and March, during which the dollar depreciated against the euro by only 3%. The exchange rate can account for only a small part of recent movements in the price of oil.
What I believe should instead be the first place to begin any discussion of recent oil prices is the broader global trend of supply and demand. The graph below plots world oil consumption over the last 15 years. This increased by 7.3 million barrels per day between 2000 and 2005, but by only 1.2 mb/d between 2005 and 2010. But very importantly, consumption by China increased by 1.7 mb/d between 2005 and 2010.
Please note the necessary implications of this arithmetic: if China is consuming 1.7 mb/d more, but the world as a whole is only consuming 1.2 mb/d more, that means that people outside of China, as a group, have decreased our consumption by 500,000 b/d over the last 5 years. And the first question to ask anybody who claims that the price of oil has been "too high" recently, is, how much of a price increase do you think would have been necessary to persuade consumers outside of China to reduce consumption by a half-million barrels per day over a five-year period?
I've been talking about global consumption, though the EIA also reports data on world production. It's not accurate to conclude that if reported production exceeds reported consumption, then there must be excess supply with the difference going into inventories somewhere. The two series are collected from different sources, and the difference between reported production and reported consumption is often just reflecting errors in measuring the two series. But it's interesting to note that, from production data, it looks as if we're finally lifting above the five-year plateau, with the latest production figures showing significant increases relative to 2005 in countries such as the U.S., Brazil, Russia, Angola, Iraq, Azerbaijan, China, and Canada far in excess of the declines in the North Sea, Mexico, Venezuela, Indonesia, and Saudi Arabia over that period.
We can also look at direct oil inventory data for the United States. The black curve in the figure below plots the average seasonal behavior of U.S. crude oil inventories. The green curve gives the values for 2008. Inventories were significantly below normal in the first half of that year, making it difficult to insist that the price at that time, though rising quickly and very high by historical standards, was higher than it needed to be to keep demand from outstripping supply. By contrast, the orange curve (2011 data) indicates that current inventories are currently well above normal, suggesting that, particularly given the recent production gains, a lower price would likely be consistent with the quantity consumed being equal to the quantity produced.
I believe that events in Libya had been a key driver of the price of oil over the last few months. The country produced about 2% of total world supplies last fall. If one assumes a short-run price elasticity of demand of 0.1, that would warrant a 20% price increase if those supplies were knocked out and no one else had the excess capacity to replace them. Not all of Libyan production has been lost, but on the other hand, I have heard some analysts claim that Libya accounted for 15% of current light sweet production, where the real crunch has been recently.
The political currents recently manifest in North Africa could still easily spread to other key oil-producing countries. But if that does not happen, then with the likely response of consumers to the still-high price, and the promising near-term production gains, it is possible that this week's dramatic oil price declines are only the beginning.
In terms of what this means for American consumers, each $1/barrel change in the price of oil usually translates into 2.5 cents per gallon of gasoline at the pump. With the price of oil now down $16 from its peak, that might mean a drop of 40 cents per gallon in the retail price of gasoline.
Posted by James Hamilton at May 8, 2011 10:09 AM
Over the long run market prices will reflect the risk of a supply disruption that will overwhelm spare capacity and the ability of producers to bring on new production to make up any shortfall. The problem is that with no new supply solution in the cards the only way for prices to decline is to have a price increase force marginal users out of the market and create economic contractions. This means that until a new source of cheap energy is found we cannot have a healthy economy without very high oil prices. It also means that the predictions made by CERA, EIA, and IEA a decade ago are totally discredited and any assumptions that they make need to be supported with logic and actual evidence.
Posted by: Vangel at May 8, 2011 10:58 AM
Are not here to stay.
Posted by: Ivars at May 8, 2011 12:40 PM
Regarding short term oil prices versus average annual oil prices, I frequently use the example of a salesman, who makes a living off commissions. He had a good month in January, with a $50,000 commission check, but his average monthly commission for the entire year was $20,000. What is a better indication of his annual income, the $50,000 peak or the $20,000 monthly average?
In a similar fashion, I think that average annual oil prices and production give us the best indication of fundamental supply & demand factors.
Here is a chart of annual US spot crude oil prices: http://www.eia.doe.gov/dnav/pet/hist_chart/RWTCa.jpg
And here are the annual spot crude oil prices and year over year exponential rates of change for 1998 to 2010:
1998: $14 (-41%/year)"¨ 1999: $19 (+31%/year) "¨2000: $30 (+46%/year)"¨ 2001: $26 (-14%/year)"¨ 2002: $26 (0) "¨2003: $31 (+18%/year)"¨ 2004: $42 (+30%/year)"¨ 2005: $57 (+31%/year)"¨ 2006: $66 (+15%/year)"¨ 2007: $72 (+9%/year)"¨ 2008: $100 (+33%/year)"¨ 2009: $62 (-49%/year)"¨ 2010: $79 (+24%/year)
We have nine years showing positive year over year rates of change, and the median is +24%/year, within a range from +9%/year to +46%/year.
Assuming that 2011 does show a year over year increase over 2010, based on these numbers, we would expect to see an average annual price for 2011 between $86 and $125, with a median expectation of about $100, which is the approximate average to date for 2011.
And following are what we show for global net oil exports for 2002 to 2009 (oil exporters with net oil exports of 100,000 bpd or more in 2005, which account for 99% plus of global net oil exports).
Note that global net oil exports increased at about 5%/year from 2002 to 2005, and then we had flat to declining global net oil exports. I suspect that this inflection point was quite a shock to oil importing countries, especially developed oil importing countries.
Also shown are Chindia's combined net oil imports. The difference between the two is what I define as Available Net Oil Exports (ANE), i.e., global net oil exports not consumed by Chindia.
As you can see, ANE fell from 40.8 mbpd in 2005 to 35.7 mbpd in 2009. A plausible estimate is that ANE could be down to about 27 - 30 mbpd by 2015.
Global Net Oil Exports Less Chindia's Combined Net Oil Imports = ANE (BP + Minor EIA data, mbpd, total petroleum liquids):
2002: 39 - 3.5* = 35.5 (ANE) "¨2003: 42 - 4.0 = 37.4"¨ 2004: 45 - 5.1 = 39.9 "¨2005: 46 - 5.2 = 40.8 "¨ 2006: 46 - 5.5 = 40.5"¨ 2007: 45 - 6.1 = 38.9"¨ 2008: 45 - 6.6 = 38.4 "¨2009: 43 - 7.3 = 35.7
*Chindia's combined net oil imports
This table shows the detailed data for 2005 to 2009:"¨http://i1095.photobucket.com/albums/i475/westexas/Slide3-1.jpg
For more info, do a Google Search for: Peak Oil Versus Peak Exports.
Posted by: Jeffrey J. Brown at May 8, 2011 02:59 PM
Regarding US crude oil inventories, I am reminded of the old joke about the drunk looking for his keys, under a streetlight, late at night. He lost his keys down the street, but the light was better under the streetlight.
In a similar fashion, we (presumably) have great oil data in the US, but that is not where consumption is increasing. Weak demand in the US is not a new story, since our oil consumption probably peaked for good in 2005.
As I have previously noted, our work suggests that the US is well on its way to "freedom" from our dependence on foreign sources of oil, as we are outbid by developing countries for access to declining volumes of global net oil exports.
Posted by: Jeffrey J. Brown at May 8, 2011 03:13 PM
EIA STEO last three months 2012 vs last three months 2010:
US: -0.7 mbpd (collapse of the Gulf) Russia: flat China: +0.2 (very mature producer) Canada: +0.2 (declining convention vs increasing oil sands) Other non-OECD: +0.6
and...
OPEC: up 2.9 mbpd of which, NGLs: +0.9 mbpd
Angola is producing less than it did in 2008. Brazil has a steady growth policy. They could do more, but that 0.2 mbpd / year is about what can be expected under current government policy. Iraq could over-perform, +300 kpbd this year compared to recent expectations (Mission Accomplished!).
If you're looking for production growth, in the eyes of the EIA, it's all OPEC, all the time. Nevertheless, without Saudi Arabia, it's hard to see where the production growth comes from.
On the other hand, the carrying capacity of the US is around $90; China, about $105 / barrel. So if Brent's at $125, it's not clear prices are sustainable.
But we're missing a piece of theory here concerning how prices depart from fundamentals. We can say there's no speculation, and maybe there's not. But how then do prices exceed the carrying capacity of China, the price setter on the demand side? In theory, that shouldn't be possible. And yet it is, to all appearances.
Posted by: Steven Kopits at May 8, 2011 07:15 PM
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