Common Tragedies

Thoughts on Environmental Economics

What is up with oil?

Posted by Daniel Hall on December 19, 2008

The pithy answer is nothing — not production, not consumption, and certainly not the price.

I have heard some head-scratching and shoulder-shrugging about the recent behavior of the oil market.  (Yes, you have to listen closely to hear those things.)  In the last year we’ve had:

  • the biggest run-up in oil prices in history
  • the biggest collapse in oil prices in history
  • the biggest announced production cut from OPEC in history
  • oil prices continuing to slide down after this cut

Whiskey.  Tango.  Foxtrot.

My short answer — and I would be only too happy to receive corrections or alternate theories from more educated readers in the comments — comprises 3 factors:

1) The price rise was demand-led; the current collapse is demand-led as well. It turns out that even in car-loving America you can get a nice bit of short-term (and perhaps long-term) demand destruction with $4 per gallon gas.

2) Oil futures are not tremendously influenced by OPEC’s announced cuts.  OPEC does not have a great track record for maintaining cartel discipline when the market is loose.  Too many of the small countries oversell their quotes, and the budgetary pressure on some of these governments — who spent the last year making all their plans with $80-140 barrel per oil in mind — will be intense.

3) The most important factor in oil futures right now is not the OPEC announcement but expectations about future economic conditions.  And in this sense the oil future prices we are seeing right now are terrifying.  America is going to remain in recession in 2009 and demand will be weak, but you would think that even moderate economic growth in China would be enough to buoy the oil market.  I find the fact that futures are down so far to be extremely worrying.

By the way, here is a fascinating map that depicts where US oil imports come from.

4 Responses to “What is up with oil?”

  1. John Fleck said

    The demand destruction seems to have two phases to it. Phase one, going back to mid-2007, was a result of price elasticity, as we made modest cutbacks in consumption as prices began to rise. Phase two was a dramatic case of income elasticity heebie-jeebies, as consumption fell off a cliff beginning in August or so when many of us began to suspect we weren’t going to get Christmas bonuses and/or have jobs soon.

  2. Carlos Ferreira said

    I’ve been wondering about 2 things:

    1. The price movements are mostly demand-driven, as you say. But, is it the transport sector or the industrial sector that has been cutting down the most?

    2. Is all this demand destruction going to result in supply destruction in the short run? With such low prices, countries (and a lot of oil is in the hands of governments) won’t be willing to invest – and this might lead to price increases in the medium-term future. The IEA has been stating, in the World Energy Outlook, that investment right now is key to maintaining a safe supply in the future.

  3. What about good old speculation? Seems that with the demand growth and price rise, hot money flowed in and further drove up prices. With the credit collapse, and all the associated margin calls, the same then became true in reverse. A demand destruction and speculation downward spiral.

  4. Daniel Hall said

    Ok, I am back from my Christmas holiday — apologies for the lack of response until now.

    Carlos, I don’t know the answer to your first question for sure, and I don’t have any evidence at my fingertips, but my sense is that more of the drop in demand for oil is coming from the transport sector. On the other hand more of the drop in natural gas has come from reduced industrial demand (although NG has not fallen as far as oil, partially because it was never at the same heights). As far as your second question, I remain skeptical that there will be enough short-term supply restriction to push prices back up in the next few months (for the reasons I list under point 2 in my post). On the other hand, the investment question you raise is more of a medium- and long-run question. I would focus less on the role that current prices will play in reducing investment, since it is future price expectations that should be more important. However, I think it is very interesting to consider whether credit and liquidity constraints (partially brought on by the current low price of oil) and substantial price volatility are likely to significantly hamper investment in the near term.

    Dave, I decided to pull your comment out and write a full post.

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