The purpose of this article is to try to understand the oil price. It is not possible to make a price forecast here, but if we can understand the factors which influence the oil price we’ll be in a better position to make investment decisions about energy stocks.
It has been very difficult to understand how the price of oil could fall by three quarters from over $150 per barrel down to below $40 in such a very short time. On its way up many commentators - myself included - believed that the price was rising firstly, because demand was outstripping supply, and secondly, because of phenomenal economic growth in developing countries such as China, which have exponentially increasing oil consumption.
But how can the price collapse by 75%? Surely demand hasn’t fallen by that much. And there hasn’t been any sudden discovery of massive new reserves. In a free market, shouldn’t the price of oil reflect the value of oil? The value is determined by how much there is available, and how much is needed. Because neither supply nor demand can change by much over a short time, the price shouldn’t change by all that much.
Supply and demand have always remained roughly in balance, except for the oil shocks during the nineteen-seventies and early nineteen-eighties. Energy consumption is pretty constant. Power stations must still produce electricity. People still need about the same amount of transport. And Chinese demand is still growing. Importantly, global oil consumption is still growing, not shrinking.
The chart above shows how the world’s oil consumption is increasing year after year. Global oil production and consumption has risen quite steadily from around 20 Mbpd in 1980 to around 86 Mbpd today. Oil consumption continues to increase by about 1-3 Mbpd every year. At the right hand side the red box shows that the US will use less oil in 2008 than in 2007. But China (in green) and the rest of the world (in blue) are still increasing their consumption, guzzling more than the amount saved by the US. So total world consumption of oil is increasing, or at best consumption might remain steady. The International Energy Agency recently predicted that world oil demand will fall by 200,000 bpd, but that’s only a very small amount. Therefore world oil consumption is still as strong as ever, and increasing. Note the green Chinese boxes which show that Chinese oil demand continues to increase at a significant rate.
On average the oil supply has matched the demand. Oil consumption just can’t fall so quickly, because demand is inelastic. When one needs oil, price doesn’t matter. High oil prices don’t reduce demand by much. Inelastic demand means that small changes in the difference between supply and demand can cause large price swings. OPEC is trying to prop up the price by reducing the supply, but they seem to be failing. But the real reason for such wild price swings is that prices are not determined by supply and demand alone. Market prices often don’t make sense. Prices are also determined by psychology, emotions, and people’s expectations about the future. So a price reflects both value and market sentiment. Sentiment influences prices, and that’s what’s been happening with the oil price. If people expect prices to rise in the future, they will buy more now. It is not only speculators who do so, but also consumers such as refineries and airlines who seek to control their input costs. There have been suggestions that the oil price had been pushed so high because of speculators. But speculators only played a very small part. It was mainly commercial consumers who bought oil up in various ways.
When consumers fear the price will rise, sentiment can drive the price up to a level higher than it would otherwise be. And when sentiment is negative, it can drive a price lower than what it would otherwise be. This creates a snowballing effect in both directions causing prices to rise too high and then overshoot, and then to fall too low.
Economic growth uses energy, mostly in the form of oil. In recent years oil production capacity did not grow as quickly as world economic growth. The oil price rose because the market expected that demand would grow faster than supply, even at very high prices. Expectations about the future are embedded in sentiment. The market expected that the shortfall would persist for some time, because it takes time to increase oil production.
The chart above shows the amount of spare oil production capacity year by year. As demand for oil increased, excess or spare capacity decreased. But it is important to note that the world is still able to produce more oil than we consume, and we always have been able to.
Excess capacity started to shrink again during 2008. The tightening of spare production capacity was perceived as risk, causing market sentiment to favour higher future prices. As spare capacity gets tighter, fears of disruption are amplified. An outage will be harder to cover. If people feared a future threat to oil supplies, for example due to instability in the Middle East, then there will be a tendency to buy early to secure future delivery. These fears are reflected in sentiment. Another factor which influences sentiment about the oil price is (or was?) the “peak oil theory”. Today we consume about four times as much oil as we discover.
The graph above shows that in 2004 oil production was expected to reach its peak in 2006, and then decline. But if global discoveries and production have peaked, how can the price fall by 75%? Could such a price collapse imply that oil supplies won’t run out as quickly as claimed? Back in the early nineteen-seventies, during the first oil crisis, I chose to do a school assignment on global oil. Back then the information which was most strongly thrust upon me was that the world only had 15 years of oil supply remaining. I reported that in my school assignment. Fifteen years later, I noticed that the world was consuming more oil than ever, and it still had an abundant supply, more even than when I submitted my school assignment. I then realized that oil companies only need 15 years or so of known reserves for their development pipeline. They don’t need to explore to secure reserves further into the future than that. Therefore the world will never really have more than 15 years worth of oil left, so it will always look like supplies are drying up. So the fall in oil price raises the interesting question of whether oil production really has peaked. Is peak oil theory wrong?
Exchange rates also influence sentiment. Nearly all oil is quoted and traded in US dollars. The US dollar has been falling significantly since 2002, down by approximately 40%. The falling US dollar means oil actually becomes cheaper outside the US, and importantly, in Europe. That increases demand and consumption outside the US. And oil exporters reduce exploration because they earn less from their devalued US dollars. This tends to push the price up. So the falling US dollar creates an expectation of a higher oil price. Two thirds of the world’s oil reserves lie in the Middle East. 
Wars and instability fuel constant fears of supply disruption. When there is not much spare capacity a supply disruption would cause a serious shortfall, so the perception of risk is amplified. We can now summarize the four significant factors which influence the oil price.
- Fundamental value determined by supply and demand, and the fact that demand is inelastic.
- Fears of a growing shortfall in supply, observed as sentiment.
- Expectations of a fall in the value of the US dollar, observed as sentiment.
- And fears of a disruption in supply.
So why then has the price collapsed? At the time of writing oil was being sold off. Sentiment amplified the downside just as much as it did the upside on the way up. Commercial consumers who bought on the way up are now unwinding their positions, and oil investments are being redeemed as people bail out of investment funds. So it seems we had an oil price bubble, similar to the tulip price bubble. The only difference is that tulips were a luxury, whereas oil is a necessity, like an addictive drug. We can’t stop using oil. And what about the future? Should we consider buying oil and related stocks? There are rumours that we might be approximately three quarters or so of the way through the selloff, and that there might still be a little more selling to come, but no one can know that. The oil price chart certainly looks very grim. So maybe the price might fall a little further on this run down. But maybe not: this author does not know. And what about the longer term? Let’s consider each of the four factors. Demand continues to increase, demand is inelastic, and oil production has not grown with it. Moreover, the falling US dollar reduces the incentive to bring on new production. If the US dollar continues to fall there will be more upwards pressure on the oil price. New reserves will be more expensive to develop, even if production has not peaked. And development of new supply lags demand by years. And furthermore, if the “peak oil theory” is correct, there will be further upwards price pressure. Therefore the fundamentals over the longer term seem to suggest a growing shortfall in supply, and therefore a resumption of the uptrend in the oil price over the longer term. But we have already observed that sentiment can really mess up the price. The Middle East is in perpetual turmoil. Is it getting worse? It could be argued that political instability is increasing not decreasing. If that were so the fear premium is unlikely to evaporate. This author’s sentiments on the US dollar are bearish. But the sentiments of this author play no part in the oil price. What counts is market sentiment. What will market sentiment be? Some in the audience will seek a prediction about the future. This author is unable to provide one. All that can be said is that in the end sentiment will be driven by collective expectations about the future. I have attempted in this article to set out some of the ideas to think about in order to build an understanding of how the oil price might evolve in the future. I hope this is helpful. Thank-you, and I look forward very much to seeing you next time. Sources:
- “Emerging Demand Supporting Crude Oil”, Westpac, 1Q, 2008, www.westpac.com.au/.
- “Crude Awakening – Behind the Surge in Oil Prices”, May, 2008, www.dallasfed.org/research/.
- “What is Peak Oil?”, Peak Oil News, //peakoil.com/.
- “Interim Report on Crude Oil”, Interagency Task Force on Commodity Markets, July, 2008, www.cftc.gov/.
- “IEA Predicts the First Fall in Oil Demand since 1983”, Dec 11, 2008, www.prlog.org/.
Copyright © 2009 Nils Marchant.
This is an edited transcript of a talk delivered at the Options21 Market Briefings during the 4th - 7th of January, 2009.