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Oil and Investment Banks: Wrecking economies with hedge funds

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I've been blitzed with stories all week about what is driving oil to $135 per barrel. Most of what I've seen are soundbites and short blurbs from the talking heads known as pundits. Numbers are rare, making it hard to discern fact from fiction. In this case, there seem to be three prevailing theories: The first is that supply is failing to meet demand, or will in the near future. The second theory is that a weak dollar buys less oil. The third is that speculation in oil futures have rendered supply and demand less relevant.

 

One thing in particular from a short Reuters article caught my attention: "Crude oil prices rocketed to record highs above 135 dollars on Thursday, driven by growing concerns that energy supplies will fail to meet demand, analysts said." (emphasis mine)

Those four words - "driven by growing concerns" - are enough to convince me that speculation is playing some role in rising oil prices. Markets are often driven by rumor, and like all rumors, there's usually little substance to the ones that sway markets. The question then becomes how much substance is there behind these "growing concerns" of an energy crunch?

Supply/Demand & Peak Oil

On May 22, the Treasury and Energy Secretaries both publicly stated they believe rising oil prices are being caused by supply problems. The House of Representatives passed a bill two days earlier to sue OPEC for limiting supplies and price setting. Goldmann Sachs predicted on May 5 that prices could reach $200 per barrel over the next two years.

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I've been all over the Energy Information Administration's site and can tell you with confidence: There is no shortage of oil! There isn't expected to be a shortage of oil in either the short- or long-term, according to EIA predictions. In their May 2008 Short Term Energy Outlook, consumption is projected to go down in the US for 2008, and both national and global inventories are expected to grow as supply is (barely) meeting demand through 2009. The long term outlook, as stated in their 2007 International Energy Outlook, says, "In the high price case, oil prices are projected to be $100 per barrel in 2030 ($157 per barrel on a nominal basis)." In fact, the supply/demand picture looks good enough that a law was just signed to halt shipments of oil to the national reserve, which is 97% full.

The theory of peak oil is being thrown around as well. I admit to not being an expert on the subject, but as I understand it, this is the idea that we'll have a Malthusian catastrophe because our dependence on oil wasn't mitigated twenty years before peak production. However, there's little agreement on when peak production occurred - or if it even has yet. The reasoning and logic behind this theory seem flawed to me. It requires one to accept the premises that no further oil fields will ever be tapped anywhere, that advances in technology will never make extraction or refinement more efficient then they are today, that energy alternatives will never be found or switched to, and that current trends in population growth and economics will continue as they have for decades. Before oil, this country was dependent on coal and whale oil - when is the last time you used a coal stove or fired up that whale-oil lamp? On top of all that, focusing on the finite nature of one resource fails to address the true problem: over-population in a closed system where all of the resources are finite.

I don't entirely dismiss "peak oil" theorists. I find their arguments about minor disruptions in supply having inordinate effects on economies, due to those economies' critical dependence on oil, particularly compelling. I have no doubt that if we don't start seriously looking for energy alternatives (with an effort on the order the moon mission), their worst scenarios have a high probability of occurring. Yet, the supply numbers simply don't support the idea that we've already hit global peak production, so this theory's effect on oil pricing should be minimal. At least it would be in an open and free market, where the truth would come out before a rumor caused such a large rise in price.

One last note of interest from the EIA site: The majority of oil the USA imports comes from non-OPEC countries, and has since 1994. However, in the future the situation will switch again - and for the entire oil-importing world, not just the USA. This means we'll be competing with the rest of the world for OPEC's oil! Keep those things in mind the next time you hear a Republicrat get on their soapbox and rail against OPEC or crow about having passed a bill to sue them.

Weak Dollar

The Federal Reserve has lowered interest rates and dumped tens of billions of dollars into the economy as a result of the sub-prime crisis. The Federal government continues to fund endless wars that mean budget deficits year after year. Have these things devalued the dollar enough to cause these kind of price surges? According to Ed Wallace at BusinessWeek, "The dollar has depreciated 30% against the world's currencies since 2002, while the price of oil has gone up 500%." Is this correct? I'm not sure where the 30% comes from - it's a "fuzzy" number to calculate - however in terms of buying power, it's fairly accurate. The price of oil is easier to verify - it was $25.03 per barrel in May 2002, and hit $135 per barrel this week, for a 539% increase. If supply, demand, and inflation were the only market factors involved, we would only be paying around $32.54 per barrel!

Speculation

Telegraph.co.uk reported on May 24:

"Lehman [Bros] latest report - Is it a Bubble? - says commodity index funds have exploded from $70bn (£36bn) to $235bn since early 2006. This includes $90bn of fresh money. Energy takes the lion's share. Every $100m flow of investment money into oil lifts crude prices by 1.6pc, it said. "We see many of the ingredients for a classic asset bubble," said Edward Morse, Lehman's oil expert.

This week has seen a dramatic surge in oil contracts dated as far forward as 2016. Futures have moved higher than the spot price, a rare event known as "contango". This can cut both ways: either as a sign of an impending supply crunch years hence; or that the futures market has become unhinged from reality."

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Dave is a freethinker currently living in Colorado. He promises to someday make his bio either more informative or more entertaining.

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I think you’ve got a pretty good handle on i... by Christopher Wright on Sunday, May 25, 2008 at 11:52:54 AM
Great graph, thanks!I wonder if the Fed cares thou... by Dave Wheeler on Sunday, May 25, 2008 at 9:56:10 PM
You've got this one, and you won't here ab... by August Adams on Sunday, May 25, 2008 at 2:01:57 PM
Why is the price of oil going skyward?Heaven knows... by Wolfie on Sunday, May 25, 2008 at 4:57:34 PM
Want some insight into the kind of thinking that p... by delia on Sunday, May 25, 2008 at 7:42:54 PM
Want some insight into the kind of thinking that p... by delia on Sunday, May 25, 2008 at 7:43:06 PM
Here's a working link to the original blog.&nb... by Dave Wheeler on Sunday, May 25, 2008 at 9:50:58 PM
Many confuse production with the amount of oil ava... by pft on Monday, May 26, 2008 at 4:03:09 AM