Crazy oil price behavior

If you’re anything like me, your head has been scratched many times in the last year because of the price of crude oil. When I started at Stanford in 2001, both gas and oil prices (15US$/barrel) were low. Much too low to encourage rapid development of greener alternatives for transport or electricity production. My colleagues and I certainly expected (and hoped!) that the oil price would go up in the years following. Global demand was clearly increasing, with most of the demand rise caused by growing economies in China and India. But none of us had anticipated the very sharp increases between mid 2006 and mid 2008, with the extraordinary peak of $145US just this last summer. While I write this story, the crude oil indicator to your left gives $48.85 after another 2% decline since yesterday morning. And I certainly also had not expected that!!

In the 70s we also experienced an oil price shock. At that time though supply disruptions were clearly to blame. These last couple of years it’s not so easy to understand what drives the global oil price. Of course, balance or imbalance between global supply and demand is still a critical factor, as is the strength, or weakness, of the American dollar since oil prices are expressed in this currency. But these can not solely explain the steep increases and very rapid decreases that we have witnessed. Certainly, demand outstripped growth in crude production and oil-refining capacity up to mid 2008 (IEA World Report 2008), and contributed to the price increase, and the US dollar significantly weakened in the same time frame. However, the sudden drop of the last two months, which was not accompanied by a major shift in demand and supply, seems to indicate that there is more to it than simple market and currency analyses.

I personally believe that speculation also played a role in driving up the oil prices. In the last couple of years the expectation has grown that the oil supply side will be (significantly) constrained in the near to medium future. These speculations were amplified by growing unrest in Nigeria, one of the largest oil exporters to the US, and other worries, such as the Iran nuclear energy program and the increasingly felt vulnerability to foreign energy dependency in the US.
However, it is easy to point the finger to speculators, and much harder to give convincing evidence that speculation is indeed a major factor. The amount of money invested in the petroleum commodity market certainly has increased. But it is not clear to me if this in itself drove up prices. You see, a speculator is involved in both sides of the market: he/she buys but also sells, and must sell before the contract expires. Very rarely do oil speculators in fact physically receive and store oil and so little oil is kept off the market.
At the same time, the sharp decline in recent months does lend support to believers in a speculative bubble in late 2007/mid 2008.

Since I’m not a market analyst, I was very interested to hear the outcome of the March 2008 Expert Roundtable organized by the IEA (International Energy Agency) to discuss this very issue. The experts could not agree however on the mechanism and extent to which money flows on the oil market affect prices. In IEA’s opinion (and I quote here from the World Energy Outlook 2008), “the limited information available makes it impossible to account meaningfully for the cross-market interactions that routinely take place between different future exchanges and over-the-counter markets. Gaps in market as well as financial data obscure the real drivers of prices”.

I am really fascinated by the current oil price behavior. I am sorry that the oil price has slipped down so much as this decline is, increasingly, affecting investments into current and future alternative energy projects as well as oil exploration and production projects. The latter is negative, rather than positive, because I fear that in the next years we are facing a potential short term oil crisis unless we heavily invest in production capacity and infrastructure, but more about that some other time. The former is lamentable for obvious reasons. I’m half expecting increased SUV sales in the next quarter. Perhaps the current crisis in Detroit and the financial uncertainties will prove me wrong. Let’s hope.


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