Volatility

April 3, 2009

Oil Prices and Peak Oil

Filed under: Peak Oil — Tags: — Russ @ 9:33 am

 

I wanted to try to get a basic understanding of how oil prices work. I’m not from the industry, but there has been plenty of expert commentary on the subject, so I thought I’d survey a few of these arguments, and try to distill a few basics.
 
I used the following pieces for this analysis: 
 
Robert Rapier The Next Five Years: Peak Lite and the Current Oil Picture
 
Jeffrey Brown A Simple Explanation For Oil Prices
 
Phil Hart The Economics of Volatile Oil Prices
 
Gail the Actuary Why Are Oil (and Gasoline) Prices So Low?
 
Why Are Oil (and Gasoline) Prices So Low – And Where Are They Headed?
 
Jeff Vail Predator-Prey Dynamics in Demand Destruction and Oil Prices
 
Mechanics of Future Oil Price Volatility (A Flubber Cobweb)
 
Dave Cohen The Price is Not Right
 
(There’s plenty of other good writings out there, but these seem like a good cross-section of what’s being written in Peak Oil circles.)
 
All commentary today is informed by the economic crash. During the price run-up of the last four years there was considerable debate over to what extent this was being driven by supply-demand fundamentals, as opposed to above-ground factors, especially speculation. (Thus we had the spectacle of conservatives, who normally deny on principle that there’s any such thing as “speculation” as opposed to the genius of the rational market, suddenly claiming high oil prices were completely the result of nasty speculators. This was because conservatives must obey their higher principle that there’s no such thing as resource limitations.)
 
Oil production stagnated in 2005, and from there we’ve seemed to be on the “bumpy plateau”. Oil prices were therefore rising on account of rising demand and the growing perception of constrained supply in the face of this rising demand, especially in Asia. It was feared that soon demand would reach the supply limit, the economic “growth” needed to fuel exponential debt would stall out, and first the financial system and then the economy at large would crash. This was the position of those emphasizing fundamentals (i.e. Peak Oilers).
 
Those who seem ignorant or in denial of supply fundamentals (most politicians, pundits, the MSM) were more likely to ascribe the price surge to speculators and war profiteering by the oil companies.
 
For Peak Oilers there were several questions. How far off is the acute Peak? Or have we already experienced it? What can producers do in response to the strong price signal they’re receiving? Will the Peak trigger an acute crash or a gradual economic descent?
 
What actually happened confounded most prognostications. There will be debate for a long time over the proximate cause of the mortgage defaults which triggered the avalanche. Perhaps we’ll never have an exact answer (historians tend to wrangle over such proximate causality forever). Among Peak Oilers the question is to what extent constrained supply, by driving up fuel and food prices, helped generate defaults. We can leave aside that question for now (I attempted a short answer in an earlier post, The Bailout War III: Corporatism and Finance). Certainly the exponential debt run-up was unsustainable and highly unstable in itself and could easily crash on its own from any number of things. Fuel prices didn’t help the stability of the situation, but right now it’s not very important to figure out precisely how big a role they played.
 
What’s most important is that whereas Peak Oil expected a supply crunch to trigger the financial crash, and that demand would be forcibly destroyed by the two in synergy, instead the crash came first and accelerated the existing demand response to high prices. Supply ended up having to meekly constrain itself in demand destruction’s wake. So the acute Peak ended up being enforced by above-ground factors after all, and did not dictate the crash but rather was dictated by it. 
 
No sooner had producers, especially Arabia, been able to increase capacity and production to a small extent, than amid financial turmoil the price topped out at $147 in July and began a steep, steady descent. Financial woes and fears drove an unexpected level of demand destruction in the West and even in China. This fed into a bearish perception among traders which further encouraged price descent.
 
This price decline combined with the fierce credit crunch to cause independent and national producers to mothball or cancel many future projects. The first victims of this were alternative projects like the tar sands and some ultradeepwater developments, as well as refinery and pipeline expansions. So while projects already underway will largely be brought to completion, and for a few years new capacity coming online should counteract depletion from existing capacity, in five years or so the lead times will run out, we’ll be up against a void where new capacity was supposed to be, depletion will overtake spare capacity, and the Peak Oil effect will finally shine through, sending prices permanently upward, and in terminally downsizing economic activity.
 
That much seems to be the consensus. The mystery is in how production, demand, and prices will behave during this interregnum between the exponential debt civilization (that is, where pretty much everyone believed in its permanence, and called it the “Great Moderation”) and the post-Peak descent. Can the economy temporarily recover, and even artificially electrify itself into some residual zombie “growth”? How much more debt can the dollar take on? (I don’t think any sane person still believes the debt tower can be salvaged or manageably wound down, let alone keep building. I think they’re just helpless to change course. This might make sense if they were using their last debt push to build a new relocalized economy. But instead they’re using it for the Bailout War and the Global War on Terror, two utterly worthless imperialist projects. Economically speaking, two pure ratholes. So by now the federal debt binge is just a Dance of Death.)
 
It seems that Peak Oilers don’t believe there’s much chance of anything more than a temporary anodyne recovery of growth. There won’t again be enough economic mojo to drive demand up enough for another heroic production push. So it seems that we did see the acute Peak for conventional crude in July at 75 mpd. Whether or not all-liquids might still exceed its current peak of 87 mpd is more questionable, but also seems unlikely. It looks like the bumpy plateau is confirmed, and the only question is how bumpy it will be for the next five years or so, and then how steep and volatile the descent will be.
 
I’ll now give a brief summary of the pieces listed above, each an attempt to figure out where we are now and what’s happening.
 
Back in October Gail the Actuary (Gail Tverberg) asked, “Why are oil (and gasoline) prices so low?” Her answer was an attempt to itemize the factors fuelling demand destruction. She provides the basic rule of oil’s supply-demand fundamentals: that where supply and demand are very close, and supply is tight, such that their curves are nearly vertical, this makes for extreme price volatility, and a small change in either can have a huge effect on price. Until last summer Peak Oilers tended to emphasize the supply curve starting to shift left, but as we saw it ended up being the demand curve instead.
She adds in the effect of slowing Asian growth and demand. Since this has been such a dynamic force driving demand upward, any reversal here is likely to have significant effects.
 
Tverberg also emphasizes the above-ground effect of the credit crunch on intermediaries like suppliers and shippers. Where these become less able to get credit, producers are less confident about doing business with them, and the industry becomes further deflated. (This sounds similar to the banks being “unwilling to lend”.)
However, she also focuses intensively on speculator unwind (indeed 5 of the 8 factors she lists involve trading), to the point that it seems she’s attributing a significant role to speculation in the price run-up and subsequent decline as the speculators have to unwind their positions.
She says this speculator effect is likely to fade away as they are chased out of the market by low prices and the strong dollar.
 
Her predictions in October: continued volatility, while a weakening dollar over the long term, a shakeout of the smaller market players (mostly from inability to borrow money), and supply constriction as a result of the credit crunch and OPEC production cuts, all lead to rising prices in the longer term.
 
In December Tverberg revisited the question and offered a somewhat different prognosis. She says the debt unwind specifically, more than the recession per se, is what’s been driving prices down. This is because according to charts she shows, except for debt-enabled activity, the economy itself has been stagnant for the last ten years, and the alleged GDP growth of that period was really “debt-based pseudo-growth”.
(I highly recommend this chart as an excellent refutation of all the lies about trickle-down and tax cuts and growing wealth for everyone. Clearly the only wealth that was “growing” was financiers’ rent.)
Therefore as America must now try to unravel its debt it faces the end of growth, and from there the end of the wherewithal to keep the oil machine going (here again we see a reversal of cause and effect from what was expected, finances and demand destruction limiting supply rather than the other way around).
 
So here Tverberg says the above-ground factors of demand destruction and the credit crunch are for the time being firmly in command, and therefore we shouldn’t expect the oil price to trend upward again until depletion reaches down far enough to overtake depressed demand (i.e. five years or so).
 
Writing in February, Phil Hart focuses on the same fundamental dynamic of near-vertical supply and demand curves which prevailed up until last summer, and the price volatility which arises under that circumstance. He’s not as concerned with how demand destruction is functioning but rather takes it as given in order to ask, what will be the future effect on supply as new capacity coming online trails off, while demand possibly increases (in the event of a recovery). He sees the supply curve moving to the left with each iteration of the boom-bust cycle, so that Peak Oil will result in extreme oil price and economic volatility for the short to mid-term.
 
Jeff Vail has a similar idea with the “flubber cobweb”. Following up from his analogy of a predator-prey population relationship (with predator populations oscillating in sympathy but at a lower amplitude and lagging behind in time) with that between the oil price and that which it signals (producer investment, political policy, consumer behavior), he sees the boom-bust price cycle causing investment patterns to become ever more conservative, so that the next price boom has to “overexaggerate” in order to induce investment (for example, if in one cycle the producer required a $100 price in order to feel confident in investing such that he’d be able to profitably sell that oil at $50, the next time around, after having seen price crash below 50, he’ll have to see 150 before investing, and so on). Meanwhile, even as investments are made, the overexaggerated price is encouraging overproduction as well as destroying demand and provoking real or perceived policy change such that demand is likely to fall enough below production to overexaggerate the floor where a descending price eventually bottoms out. The result is a vicious circle, such that investment is further restrained each time around, less future capacity becomes available, each demand and price surge sooner runs up against the supply wall, from which it crashes again and finds it harder to recover.  
 
Vail envisions a boom bust cycle continuing however long and at whatever frequency, combining with depletion and growing geopolitical volatility to produce a price volatility which “rapidly accelerates over the next decade”.
 
The feature common to all these boom-bust model concepts under Peak Oil conditions is that each iteration will see higher ceilings and floors, no matter how much the oscillations overexaggerate.
 
This is true of Dave Cohen’s take. He sees continuance of the boom bust cycle; but where he believes the most recent crash was triggered mainly by factors extraneous to the oil price, he thinks in the future this price, along with the strength of the dollar, will pay the major role.
 
(Cohen also takes the most close-in view of day-to-day shifts and finds that here “market sentiment”, market psychology, is the decisive factor. Expectations rule the price, and the market sentiment of the traders dictates the expectations. If the mood is bearish, confirmation bias will tend to operate in selecting the evidence which confirms that mood. Thus last fall, where the mood was that oil prices are down and will keep going down, things like the hurricane shut-ins and announcement of OPEC production cuts, which seemed to indicate future supply restrictions, didn’t phase the mood, while the fall of Lehman was taken as big news, because it confirmed the mood. This dynamic prevailed throughout the rest of 2008 and into 09. Only with the recent news of actual OPEC cut compliance has the sentiment shifted somewhat, and the price showed some signs of life.)
 
One more analysis along these lines is Robert Rapier’s “Peak Lite” concept. Rapier thinks a sustained intermediate term recovery is possible in principle, and that perhaps we will again see a time of increasing demand and supply. But because of investment mothballing, it’s extremely unlikely that future increasing production will be more than at a trickle rate, while demand may temporarily resume robust growth. Under those circumstances Peak Lite is the scenario where demand overtakes even a still-increasing production with the same price effect as is theoretically expected from Peak Oil proper, a permanent rise.
(Rapier expects the historical boom-bust price and investment cycle would end at that point.)
 
There’s one last idea to consider. The foregoing examples, implicitly or explicitly, discount the likelihood of finding a single indicator with a strong correlation with oil price. But Jeffrey Brown claims to have found such an indicator in the export figure for the top five exporters: Arabia, Russia, Norway, Iran, and the UAE, who together represent around 50% of world exports. His figures show this correlation over the last decade, and from that his construction of the 08 price crash is that demand destruction overtook long-term export decline. (Exports, like total production, being largely stagnant since 2005.)
 
Brown predicts that exports from the top 5 will now decline from 24 mpd in 2005 to 12 mpd (middle scenario; range of 7-18) by 2015. This, he thinks, may have a more pronounced effect on prices than the general depletion from cancelled investment (of course these cancellations would play a significant role in export declines). From this he makes the most specific short term prediction which runs counter to the consensus – that on account of diminishing exports 2009 may see a higher average price than 2008’s $100.
 
So that’s a basic rundown. There’s a basic agreement that for the time being, at least during what seems to be the Depression we’re entering, that above-ground factors are playing the more important role, and that supply fundamentals aren’t likely to stand out from the above-ground volatility signal until c. 5 years, at which time new production coming online during those 5 years is overtaken by depletion from existing fields not being replaced on account of all the projects now being mothballed or cancelled.
 
The most important of these above-ground factors are demand destruction from the economic downturn and the related asset deflation and credit crunch. The ability of these to be temporarily reversed depends upon the economy’s ability to experience reflated debt and “growth”. There’s unlikely to be much of an inflationary force coming from this quarter.
 
There’s also the tendency for commodities prices to rise or fall in inverse proportion to the strength of the dollar. If (when) the dollar again weakens, toward its eventual devaluation, this may spur the price upward. Market psychology is the strongest day-to-day factor, and once it has momentum it’s hard for new evidence to change its inertia.
 
There’s also the relation with exports, which may soon be heading inexorably downward, ahead of supply per se. This, according to Brown, will be an upward influence on price.
 
As for supply-demand fundamentals themselves, demand is now further below capacity than at any time in years, and so long as this holds there won’t be as much fundamental-driven volatility or likelihood of a spike (although if an acute event confirms existing market psychology, it can trigger a short-term price spike or plunge).
 
Whether demand recovers (Rapier thinks it possible) and again runs up against the capacity barrier, or stagnates, seeing only an anemic rise at best, while depletion brings supply limits down to it (Vail, Hart, Tverberg), the result is still a price spike. Then the question is whether this spike is permanent (as Rapier thinks) or intensifies the boom-bust cycle through further iterations (Vail and Cohen consider it possible).
 
So to conclude: it’s likely that in five years depletion will exceed production, and the Peak will be complete. From there on price will likely remain permanently high. For the next five years we’ll see more or less volatility in demand and price, depending upon each other, and upon any temporary debt reflation (or further deflation) or dollar crash. If there are more “business cycles” during these five years, they’ll likely run concurrent with boom-bust cycles of oil price and demand.    
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2 Comments

  1. To further useful essays are –

    Therramus –
    Did Volatility in the Price of Oil Cause the Financial Crisis?

    Gail the Actuary –
    Was Volatility in the Price of Oil a Cause of the 2008 Financial Crisis?

    Comment by Svetty — December 28, 2009 @ 9:19 pm

  2. Thanks, Svetty.

    Theres lots of good stuff.

    Comment by Russ — December 29, 2009 @ 2:18 am


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