USA TODAY reports Saudi Arabia offered to boost crude oil production by over 9.7m barrels per day (bpd) in July. That's if– and only if– the market requires it. Anyway, say the Saudis, under-supply isn't the problem. "I am convinced that supply and demand balances and crude oil production levels are not the primary drivers of the current market situation," Saudi Oil Minister Ali al-Naimi announced at the global energy summit in Jiddah. King Abdullah joins both John McCain and Barack OBama in blaming "speculators who play the market out of selfish interests." The Saudis remind us that they have already boosted production twice this year (by 300k bpd in May, and 200k bpd in June), and neither increase has had much effect on climbing prices. American and British diplomats expressed disappointment with the Saudi position, having hoped for a promise of specific production increases. Echoing US sentiments, British PM Gordon Brown said that with a clear production increase "instead of uncertainty and unpredictability, there is greater certainty, and instead of instability, there is greater stability." But the Saudis aren't alone in looking away from production levels for the cause of high oil prices. The joint statement issued by the Jiddah summit is deliberately vague, reflecting deep divisions over the causes of the oil price shock– and the cure.
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At least SOMEONE is trying to help. Otherwise, all I hear is talk.
This past week has been a perfect example of how disconnected the market is from supply and demand.
The price has stayed the same or climbed in the past 7 days while:
1. SA is boosting production – 500 K barrels this year alone
2. Iraq signed landmark private oil development contracts which will boost production as much as 1.5 MILLION barrels per day
3. Demand fell 2% year over year
4. China announced reduction in fuel subsidies which will increase prices and reduce demand in the long term
The only negative news all week was Iran and Israel posturing and some idiots in Nigeria shutting down a pipeline for a couple of days. Yet the price continues to go up.
The speculation angle has FINALLY hit the mainstream, maybe the increased pressure and regulatory changes will take the air out of the balloon.
The Sauds woudl have to be crazy nto to increase production if they think the price increases are independent of supply and demand. Under those circumstances, you’ld want to dump as much oil on the market as you possibly could and continue doing it until the price starts to drop to maximize your profit.
Sigh. More economic illiteracy.
The Saudis are technically correct to say that the market isn’t demanding more oil. They’re leaving out (or saying really quietly) that the market isn’t demanding extra oil AT THE CURRENT PRICE.
Supply and demand do not exist independent of price. They are curves. They intersect at the present market price. You more accurately care about “quantity demanded at this price”.
So, yes, there’s no unfulfilled demand out there, because the price is being allowed to float, and therefore the price is clearing the market. Every barrel demanded at the market price is being sold. Technically correct, Saudis. Not really what people are complaining about, but our media and our bloggers are too stupid to understand the difference.
And, FWIW, the Saudis have been claiming to have extra production ready to go many times in the past when what they really had was crappy heavy sour crude that nobody wanted at the price that light sweet fetches.
So the headline would be:
Saudis Increase Oil Output, U.S. Refuses To Do Same
Well. At least someone understands the concept of supply & demand.
Sad when I’m more prone to believe the Saudi’s theory for high gas prices (speculation) over our own governments (supple and demand).
M1EK:
Thanks for the observation; however, it could also be said that you are possibly missing something as well. Futures markets speculate on future supply and demand and that is what we are talking about when we say the price for oil is at $135 per barrel. That is the future price that people are willing to pay. The oil actually being delivered now was not bought yesterday or even last week and actually cost significantly less than the “current” price of oil. If people who trade in oil were confident that the supply would outstrip the demand at the current futures price, the price of oil futures woudl actually go down. The fact is that the price has been going up because more traders think the future demand will outstrip the future supply at the current price so they buy oil futures thereby driving up the price.
If I’m wrong correct me. Seriously, point me in the right direction.
USA Today reports Saudi Arabia offered to boost crude oil production by over 9.7m barrels per day (bpd) in July.
I think the article states the Saudis will “boost crude oil production TO over 9.7m barrels per day…”
Lumbergh, in your scenario, the correct way to describe the situation is that in the future, the quantity demanded at $135 is likely to be too high to be supplied; so the price will likely rise higher.
Remember, again, demand is a curve – not a static number. People don’t demand X barrels of oil; they demand X1 barrels of oil at price P1; X2 barrels of oil at price P2; etc.
The Saudis are using economic illiteracy to make it look like the price of oil has nothing to do with the market – because they’re scared to death that we might make some moves in the (much saner) Western European direction on the energy front, which would be very bad for them in the long run.
M1EK and Lumbergh,
Here is what seems strange to me. It seems when there are speculators making huge gains on bets for higher prices, that money seems to disappear into the economy without benefit. OTOH, when there is eventually a turnaround and some huge losses occur, we will hear about it for weeks, see companies go under, read about layoffs and suicides, etc. In the case of oil, no one will care because they are saving a couple dollars on a fill up, but still.
Also, both events seem to be reasons to raise taxes. Has anybody else noticed this?
M1EK:
Actually, what I’m saying is that they are betting that it will be. If the price of oil goes up, they make money. If it goes down, they lose money. Of course, as long as the majority of the market believes that the price of oil will continue to rise, it will because they will continue to bid up the price of oil futures. At some point, production will outstrip demand at a given price point by a meaningful amount, and the house of cards will come crashing down on the people who jumped on the bandwagon too late. The oil companies and the OPEC nations will still make a profit even if the price plummeted to half of what it is trading at today. The OPEC nations were raking in the dough at $20 per barrel.
That’s wishful thinking, Lumbergh. The key difference between oil futures and stocks is that you actually have to store oil you bought somewhere, and that’s very expensive, so there’s an actual physical drag on a speculative bubble. The people who think speculation is responsible for this run-up are betting on a very flimsy premise.
The key difference between oil futures and stocks is that you actually have to store oil you bought somewhere, and that’s very expensive, so there’s an actual physical drag on a speculative bubble.
This is wrong. Brent Oil contracts don’t even require physical delivery of the oil at their expiration. Speculators don’t buy contracts to take physical delivery.
If speculation was never an issue, bubbles would never exist. But of course, they do — we’ve just seen two major bubbles implode in this decade alone.
This is like the 70’s all over again. We were running out of oil then, too. Prices then were at equilibrium and supply constrained…well, until the bottom fell out of the market and the price fell in half within a few months. Of course, that wasn’t supposed to happen, yet somehow, it did….
If you take one semester of economics, prices appear to fall where the supply and demand curve intersects, with no distortions. But get beyond the first semester of economics, and it becomes clear that while prices are theoretically at equilibrium, in practice they dance around equilibrium.
At times like these, pricing becomes arbitrary, as much of the trading volume is based upon the greater fool theory, rather than the fundamentals. Barring some major catastrophic event or irrational fad, dramatic price increases don’t generally make economic sense, and there has been no such event to justify the price hikes.
Anyone who understands finance knows that leverage can distort the market, because betting big can reward tremendously high payoffs. That’s what explains the enormous run up in trading activity in the face of relatively flat demand for the commodity itself.
When the market falls out, the fund managers will have already collected their bonuses, so it won’t bother them much. They money that they’ll be losing doesn’t belong to them.
Pch, unlike pure equity, if you actually buy the oil, you have to store it somewhere. The futures are thus only one level removed from a real physical good that can’t be stored cheaply for long.
Not that oil speculation can’t exist at all, but it’s more a method to hedge than a method to bet on other suckers. It’s not speculation built on ten other layers of speculation like you get in an equity market. The magnitude of the potential bubble is thus a lot less.
And in the 1970s, we KNEW why oil was so expensive – it was because OPEC was voluntarily selling much less than they could. This is obviously not the case today – even the Saudis appear to be pumping essentially as much as they can.
Again, you guys are engaged in wishful thinking. Occam’s Razor suggests that when demand increases quickly and supply can’t keep up with demand (and nobody other than the Saudis is even claiming to be able to produce any more supply, and there’s strong evidence they’re lying), you should probably stop bleating about speculation.
Pch, unlike pure equity, if you actually buy the oil, you have to store it somewhere.
Again, this is wrong. Investors can and do purchase Brent contracts without taking delivery, even if held until the contract expiration. The contract is closed out with a cash settlement; no oil changes hands between the buyer and seller.
The producer produces the oil and delivers it to someone. The speculator buys the futures contract and bets on the price movement. The speculator never bought it with the intention of taking delivery, and nobody producing the oil expects to deliver 10,000 barrels of crude to the doorsteps of the speculator who bought it. That is not how it works.
Occam’s Razor suggests that when demand increases quickly and supply can’t keep up with demand (and nobody other than the Saudis is even claiming to be able to produce any more supply, and there’s strong evidence they’re lying), you should probably stop bleating about speculation.
Supplies have been sufficient. If they weren’t, we would have rationing and gas lines. There is no supply problem.
Apply Occam’s Razor to economic theory, and you can see that steep short-term price increases are almost never sustainable, barring an extreme circumstance like calamity or war. That’s because economies and prices tend to evolve over time, they don’t radically dart around based upon fundamentals.
I have previously tossed out this challenge on this forum — name a single example of a commodity that has shot up dramatically in price over a short period, as has oil in the last three years, that was able to maintain that high price point permanently.
So far, no one has taken me up on this. The reason — this sort of thing just doesn’t happen, it would essentially violate the laws of economics. Under normal circumstances, sustainable price increases occur gradually and aren’t achieved radically, as we have seen recently with oil.
PCH,
“When the market falls out, the fund managers will have already collected their bonuses, so it won’t bother them much. They money that they’ll be losing doesn’t belong to them.”
I wonder if anyone would bother to figure out what effect this is having. How much of the buying decisions are being done by people who have a greater upside incentive than downside one? It seems all of the people I have met who played in this game got out when they made a good pile of cash rather than reinvesting their own money back in the game (at least in any large percentage). This is the system that allowed Enron to start down the road it ended up on. Their traders were allowed to claim commissions on a position without selling it off. The company then booked the profit. Losses were rarely, if ever booked, and the commission had already been paid. The off book entities that allowed them to hide losses and pump the ledger were a spinoff of this.
I looked into starting a commission payment consulting practice, but found that it wasn’t a big market of managers who realized how important the commission plan can be. It never got off the ground, but I have seen several companies fail due to badly designed commission plans.
Lastly, you guys can talk past each other on the delivery thing all day. I do know a person who was forced to take delivery, but I don’t doubt that you can trade in contracts that are somehow protected from this.
Luckily, this gentleman found a place to sell his oil, and it was only a truckload, but he did scramble and worry for a couple days.
I wonder if anyone would bother to figure out what effect this is having. How much of the buying decisions are being done by people who have a greater upside incentive than downside one?
I’m not sure how much of it has been studied formally, but anyone who is familiar with private equity should get the concept.
Here’s your basic problem — the high flying investment vehicles (hedge funds, venture capital firms, etc.) split returns based upon how high they are. The higher the return, the more that goes to the fund manager. They also get fees for each deal that is put together, so the more money that comes into their products, the more they make.
On the surface, this all sounds great, pay for performance and all that jazz. But in practice, it creates massive distortions, because the fund managers profit the most when investment volumes and returns are highs, while the money they lose is not their own.
That encourages aggressive risk taking by fund managers, because they share disproportionately in the upside and avoid most of the downside.
This explains a lot of the dot.bomb stocks. Those VC fund managers would get huge payoffs if they could hit a home run. A VC guy stands to gain much more from one home run and nine strike outs than he would from ten singles, because the home run pays him generously, while most of the money that he loses on the strike outs belongs to somebody else.
The same thing is happening right now. The number of futures contracts has tripled in the last three years, while oil demand has barely nudged upward. Lots of investment products have popped up, while “analysts” who work for the same investment banks who put these oil funds together tell you how the sky is the limit. Until it isn’t any longer, of course.
Pch, you just betrayed a complete lack of understanding of the fact that demand (and supply) are curves, not static numbers; with slopes defined by elasticity.
Oil demand is very inelastic. Double the price, and you don’t come remotely close to halving the demand.
Once again, though, it is useless to talk about supply being ‘insufficient’. If price floats, supply will by definition match with demand, because demand itself is measured by “how much do I want AT A GIVEN PRICE”. The only time you end up with a true shortfall in supply is in cases where price is not allowed to clear the market – as in the 1970s with price controls and government-directed rationing, for instance.
Forgot to mention that if you think the runup in oil is purely or even mostly speculative, you have to reconcile this with the fact that the market is currently delivering oil which was part of that very same futures market N months ago (where N is fairly small), and it’s now a physical good for which people are paying real money to acquire and/or store. Again, this is very different from a stock market bubble in the fact that it’s a very short chain to the guy that’s got to put the stuff in tanks, and he doesn’t have that much space to store it either. If _that_ (non-speculative!) guy couldn’t make a profit selling it, you’d very quickly see a reaction in the futures market.
Oil demand is very inelastic.
That is wrong. Oil demand gains elasticity over the medium term. We saw this occur during the last OPEC crisis.
The same goes with supply. Oil producers need time to adjust to higher prices, but over time, they will.
Sadly, I’ve taken more economics than I care to remember. I am quite familiar with the concept of supply and demand.
Beware the One Course Wonders, who took the intro class in college and never went beyond it. Those people will get rather misleading impressions based upon the elementary discussions of supply and demand.
And if you don’t understand leverage, bubbles will forever baffle you. Your first semester course would suggest that they can’t exist, thanks to equilibrium. Reality, however, suggest that those basic supply and demand models are tools for learning, but that when misunderstood are likely to lead to inappropriate conclusions.
The nature of futures contracts is that they are highly leveraged. As we just saw with real estate, speculators and legitimate end users alike become less price sensitive when leverage is readily available.
You can control 10,000 barrels of oil with less than $10,000. Those who don’t understand that this phenomenon motivates bets being places on investment products just haven’t been paying attention.
PCH,
Yep, I agree with you. It sounds to me like there are distortions being created by pay plans. This one will be inbetween the mortgage mess and the dot.bombs though. The crash can, and will be stopped when many of the producers turn off the spigot. In the case of the dot.bombs, there really was no underlying value to much of the stocks, and they could simply vanish and not return. In the case of the mortgages, there is value, but it’s hard to figure out how much. But fuel is only a problem if you have no place to store it, and that will only crush people in a short term.
I was obviously referring to short-term elasticity. In the medium-term, increases in demand (at price P) from other economies will make up the difference for us – demand destruction here may eat up some refinery margins, but the price of crude is likely not headed for a crash.
Again, there’s a real guy with a real product who’s got to sell it underneath these futures contracts, and not that far underneath either. These aren’t instruments which are four or five or ten levels removed from anything of actual tangible value.
In order for the futures prices now to be 50% speculation, the price a month or three months ago had to be 30-40% speculation, yet the actual sales price at this time for a barrel of oil is as high or higher than the futures price predicted N months back. What does that tell you?
For this to match real estate, you’d have to have a lot of sales and resales of oil going on, as well as a much smaller proportional carrying cost (you don’t need to store houses to sell them to the next guy; they are their own storage).
In the case of the mortgages, there is value, but it’s hard to figure out how much.
What’s interesting is that standard valuation models don’t pay attention to leverage. In theory, value is the same, with or without it, because value is derived from income, a figure that is exclusive of debt.
In practice, we all know that this is nonsense. Leverage has everything to do with creating liquidity, which in turn spurs demand.
In this case, speculators have jumped on a commodity gravy train. They will stay on board until the first train wreck (big news event) appears. That will be followed by some second train wreck (yet another big news event) that really kicks off the downward spiral. Most investors are ultimately followers, not leaders, and they will follow and, in turn, spur the prevailing trend.
Speculative bubbles almost always begin with some rational basis. This tends to get in the way of those who refuse to see the bubble, because they see only the rational foundation but miss the betting fever that follows and compounds investor interest.
Speculators were right to see the internet as a breakthrough technology with deep, long-term consequences; their mistake was in believing that a business can go the distance without turning a profit.
Real estate and mortgage speculators were right to see that low interest rates and a post-9/11 economic recovery would bolster the economy and support housing demand; they missed that not everyone can afford housing, and that borrowers need to have skin in the game to stay motivated to keep their mortgages afloat.
Oil demand is already waning. Over time, inelasticity unwinds as users adjust their habits and infrastructure to use less. Meanwhile, exploration activities are increasing, as producers are confident that $15 oil is ancient history. Replace that $15 figure with the $3 floor of the early 70’s, and we’re back to 1980-1981.
James Hamilton has weighed in on the issue and concluded that speculation can’t really be responsible for most of the price rise.
Also, from a commenter there:
I was finally convinced that “speculation” was a bogus hobgoblin by this argument: Refiners are willing to pay $135 for a barrel of oil. They do this because they believe that they will be able to sell the refined products for a profit. If they were wrong, the gasoline market would be glutted, and gas prices would have to fall until the market cleared. Refiners (or someone downstream, gas wholesaler/retailer) would be taking huge losses on every barrel. They aren’t.”
PCH,
We agree again, so we must be right, or some astronomical bodies are aligned or something.
M1EK,
Your commenter is off. US refining margins have been so slim for months that they are really negative. The reason they can do this is because almost all refiners are also oil producers, or they also refine in other markets, or they have contracts for oil at below market rates they are still using, or they know they will make it up when the price of oil goes down, so they are playing along rather than selling out their facilities.
I know that doesn’t jive with the perception of “Big Oil”, but that’s what is going on. If they tried to maintain their historic average margins right now, demand would drop to the point they would be shutting down refineries (or at least that is their fear).
Landcrusher, that’s a pretty flimsy argument – relying on essentially a conspiracy theory among actors who have no incentive to play well together.
It’s no conspiracy at all. It’s a market acting just like markets do.
Gas prices may be inelastic over the whole, but they are REALLY elastic right now for each player. I would say that a few years ago, most people were rarely motivated by a couple pennies a gallon to switch stations. Right now, if your price is a penny over the one across the street, you may not be getting any customers in to by coffee, soda, and cigarettes (where the REAL money is).
You either keep your prices low, or you will be losing market share faster than you can sell off assets. Like I said, sell low, or shut down. (Note: if the government owned the refineries, the price would be higher because they would presumably have a set margin).
It’s the opposite case that requires a smoke filled room of oil men all agreeing to to raise prices that is the standard “Big Oil” conspiracy theory.
Which brings us back to domestic production. The price of oil is set by OPEC and others like them because the free peoples of our planet presently control very little of the production. Dictators and Autocrats control the price of OIL (because they control the supply), the market still controls the margins for gasoline refining. Big oil does a helluva job playing in this mess.