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What's the Right Price for Oil?

by: James Hamilton July 27, 2008    

James Hamilton

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Oil was selling for $123 a barrel on May 7, and that's where it closed this week. Sounds like a calm and rational market, except for the fact that just last week it was going for $145.

Spot price of West Texas Intermediate in dollars per barrel. Data source: EIA and 321 Energy.
oil_price_jul_08.gif

Which price was right, $123, $145, or something else? Before you let anybody give you an answer to that question, try to get them to comment first on the following two facts.

  1. According to the Energy Information Administration, China consumed 7.6 million barrels of petroleum each day of 2007, which is 860,000 barrels/day more than in 2005.
  2. EIA also reports that the world as a whole produced 84.6 million barrels of oil per day in 2007, which is 30 thousand barrels per day less than 2005.

 

World Production of Crude Oil, NGPL, and Other Liquids, and Refinery Processing Gain, in millions of barrels per day. Data source: EIA.
oil_supply_jul_08.gif

Now, how could it be that China is burning 860,000 b/d more than it used to, but no more is being produced? Well, it could be that there are errors in the consumption or production numbers, and both will likely be revised. Or it could be that we're drawing down global inventories. But the most natural inference is that somebody else in the world must have been persuaded to reduce their consumption of oil between 2005 and 2007 to free the barrels now being used in China. And indeed, according to preliminary EIA estimates, petroleum consumption in the U.S., Japan, and those countries in Europe for which data are now available fell by 760,000 b/d between 2005 and 2007.

Here's the framework I would propose for answering the question of how much the price of oil should have risen since 2005 -- the price of oil needed to go up by whatever it took to persuade places like the U.S., Europe, and Japan to reduce their consumption by the amount that China, the newly industrialized countries, and oil-producing countries were increasing theirs.

And how big a price increase would that be, exactly? Somebody who claims to know that would need to have more confidence in their estimate of the price-elasticity of oil demand than I have in mine. But if your answer is that a much smaller price increase than the one we observed would have been sufficient to produce the requisite decline in quantity demanded, that would seem to imply that, since price went up by much more than you believe was needed to reduce demand, the quantity demanded must have fallen by much more than was called for.

One place that might have been expected to show up is in the form of an accumulation of inventories. The black line in the figure below shows the average seasonal behavior of U.S. crude oil inventories. The red line demonstrates that current inventories are if anything below normal. On what basis, then, could one insist that the quantity of oil consumed has fallen more than was necessary?

U.S. weekly crude oil ending stocks excluding SPR (thousand barrels). Data source: EIA.
oil_inv_jul_08.gif

OK, suppose you believed that the price increase we actually saw -- from $42/barrel in January 2005 to $96 in December 2007 -- was just the right amount to accomplish the task of balancing global demand and supply for 2007. Should the price have held steady from there in 2008?

Figures reported by Rigzone imply that China imported an additional 8.97 million tons of crude and 2.96 million tons of refined product in the first half of 2008 compared with 2007:H1, which converts to a 480,000 barrel/day increase. Where's that supposed to come from? A U.S. recession, which many of us were anticipating in January, certainly would have brought demand down. But current U.S. GDP growth is likely to come in higher than many of us had predicted earlier, meaning if you gave one answer for the correct price of oil in January, you should be giving a higher value for that number today.

On the other hand, the data coming in the last two weeks have raised the probability of a recession in Europe. If that occurs, it will bring a reduction in the quantity demanded from those areas even if the price begins to fall. Whatever the correct price of oil was two weeks ago, I think it's a lower value today.

What about the delayed response of quantity demanded to the price increases already in place? If that proves to be substantial (and I'm of the opinion that it will), U.S. petroleum consumption should continue to decline during 2008 even with no further price increases and no recession. There's also been some increase in global production this year, and more is expected. Won't that be enough to satisfy those new and thirsty Chinese vehicles? If so, $123/barrel may be way too high a price.

But don't forget, while you're doing these calculations, you'll need to meet Chinese demand for 2009, and 2010, and 2011.... which, if you project the current trend and tried to satisfy entirely by cuts in U.S. consumption, would have us down to consuming zero barrels of oil in the United States in about 17 years.

Is the price of oil today too high given the fundamentals? Could be. Is it too low? Could be. But one thing I'm sure that's too high is the confidence on the part of those who insist they know the answer.

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This article has 23 comments:

  •  
    Jul 27 05:46 AM
    Enjoyed reading this article particularly the research that goes into it. James' conclusion is there is no short term conclusion on the direction of oil prices! Long term conclusion is interestingly inconclusive, as it should be! despite Matt Simmons' peak oil theory. I agree on the short term and long term inconclusiveness on the subject of oil price trend. What's a trader to do? As a short term trader of hours to at most 6 months holding I would try to look for uptrend/downtrend in oil prices based on historical charts then trade accordingly with downside risk controlled by stop loss limits; much like the way the TURTLES do.
    Reply
  •  
    Jul 27 06:38 AM
    China itself is slowing down and just reduced gas subsidy substantially (18%) not long ago. I dont see any economic catalyst driving up the oil demand for quite a while except the geopolitical situation.
    Reply
  •  
    Jul 27 08:25 AM
    Supply and demand.

    The supply is infinite: oilismastery.blogspot..../

    Hydrogen is the most common element in the universe and carbon is the fourth most common element in the universe.
    Reply
  •  
    Jul 27 08:34 AM
    James says: "There's also been some increase in global production this year, and more is expected."

    Really? Where, exactly? And is it enough to offset declining production in Mexico's Cantarell oilfield, declining production in Venezuela, Russia, the North Sea etc???
    Reply
  •  
    Jul 27 08:39 AM
    Supply and demand.

    The supply is finite: logic and common sense, and lots of links, but I will post just one: www.mcdep.com/barrons5...




    Reply
  •  
    Jul 27 08:49 AM
    I beleive that fuel consumption and speed go together
    the fast you drive the more fuel you burn, actually its a
    fact.
    So if the owners of vehicles that have a high consumption
    rating slowed down to the posted speed, and are stuck in these
    vehicles, we as a country could see a big savings.
    Use less, reserves go up and prices go down, hopefully.
    Just an idea.
    Reply
  •  
    Jul 27 09:05 AM
    The answer lies in the Eye of the Beholder, you see what you wish to see rather than reality.

    China this and China that, the US and Old Europe in recession, Demand Destruction, etc.

    In Reality, the China increase in demand is clearly up even though they are currently facing a slowdown. A natural disaster, Olympic related slowdown from 12% to 10%...we should be so lucky. After the Olympics anyone who expects the restarting of the currently idle industrial complex to create less demand is smoking weed. If it were China alone, a balance might be maintained, but it is not.

    Demand is growing throughout Asia and the Middle East. The Middle East in particular has pumped up supply but not entirely for export. Meanwhile, consumption is going up as the Asian populations experience their first "Wealth" effects. And while China/India populations currently face increases in fuel costs, the people coming into this Arena for the first time won't know the difference. The Asian expansion is only halfway there in China and India is about 5 years behind China. The populations of just these two countries combined are about 4 times those of the US/Old Europe combined.

    They are the future. And just like the Dollar replaced the pound, so will some other currency replace the dollar.
    Reply
  •  
    Jul 27 09:10 AM
    Thanks for a really thoughtful offering! I agree with your point that it took a very high price to drive consumption significantly lower in the short term. Also, I agree that we will see continuing declines in the USA, probably less decline in Europe as they are already doing many of the things we will need to do here. Personally, I think the very high prices we are seeing will drive significantly increased capacity (oil sands, additional exploration, oil shale, much better biofuels, etc.) at the same time we will see automobiles transition to plug-in hybrids, transferring the load to electrical generation. The equation must balance and in the macro sense, there is no conspiracy driving long-term pricing.
    Reply
  •  
    Jul 27 09:18 AM
    There is also the variable as how much the cost of oil goes into inflation by companies that transfer the extra cost into the products and services. Dow Chemical is good example of this.

    So, it can be argued that oil is trying to find a "true value" in the marketplace. This would be a price that did not transfer a large amount into inflation and created demand destruction without it being so drastic.

    There are many handicaps with oil finding it's true value since countries like China subsidies and how slow companies are to increase prices due to raw inventory costs. So anytime you have a quick run up in oil price, the true effect is buffered and slowed. It would be better if the price of oil gradually increased over time so as to be able to better see the effect of the price increase.

    Also, inventories of oil thinning out would be an effect of over value. You would not keep the normal amount of inventory of anything if you felt the price was to high and would come down fairly quickly. This would be like filling your gas tank up full and then the next day the price at the pump drops 5 or 10 cents. I do not know about you, but since oil has been dropping back, I have only been putting about 5 gallons at a time in my tank instead of filling it up.
    Reply
  •  
    Jul 27 11:05 AM
    Hey James,

    You probably already read about this in the FT. Looks like other firms found out that SemGroup was short so they were buying more and more long to drive there competitor under forcing the crude price ever higher and higher. After SemGroup's BK the competitors are selling crude cause they no longer have any reason to buy long. Wow! Mean world out there!

    www.nakedcapitalism.co...
    Reply
  •  
    Jul 27 11:11 AM
    I forgot to add this Steven Schork interview had it right all along. Listen especially around the 3:00 minute mark.

    www.bloomberg.com/avp/...
    Reply
  •  
    Jul 27 11:17 AM
    I like your last sentence. *too much confidence in knowing the true price* The true price is determined by the market and those who think they know (even though we all guess). Some think there is a "true price" which the gov could set. This is not so--the true price is set by the market (millions of investors and users). The millions are genius while the individual is a fool.
    Reply
  •  
    Jul 27 11:26 AM
    Simple question----Simple answer---
    The absolute maximum the seller is able to extract for his product! within the limits ow the law-ie a gun!.

    Which is the most you are willing and able to pay, the same as everything else.

    The Marketplace is not known for it's Charitable Institutions! --wellll--maybe Hugo Chavez, but Socialist nut cakes like him do not supply the world.
    Reply
  •  
    Jul 27 11:28 AM
    Hi, everyone. Please also see the comments on this article at James Hamilton's blog:

    www.econbrowser.com/ar...

    Thanks.
    Reply
  •  
    Jul 27 11:56 AM
    Nice piece on supply/demand issues. I tend to think whatever reductions we make in use will be offset by increased use (roughly) in developing nations.

    But why all this work, only to omit the single most important factor in oil's price? That would be monetary inflation. If the dollar is being debased by overspending and easy credit, so that it buys less of ANYTHING each year, wouldn't that have a huge effect on the number of dollars needed to buy a barrel of oil?

    The dollar is way down vs gold, euros, wheat, corn, oil, just about anything. Much of the price spike we've seen is nothing but our fiat currency becoming weaker. How much exactly I'll leave to the experts. But you can't forget this factor.
    Reply
  •  
    Jul 27 01:28 PM
    Anyone notice that the spikes up in oil happen when the Fed lowers the interest rate? Everyone still talks about the price of oil as if the value of the dollar is constant. Historical charts and models are useless if they don’t take debasement in to account. For oil, anticipation is more important than history. If traders anticipate that the Fed will start raising interest rates to slow inflation, then oil will drop. If tensions in the middle east rise, oil spikes up. I think these are the two most important factors in oil right now.
    Reply
  •  
    Jul 27 02:54 PM
    I tend to agree with the point about the dollar. I strongly believe the dollar will strengthen in the coming year resulting in little growth in the price of oil. There is no doubt that while the demand for oil in the short term is relatively inelastic, it will change significantly in the long run. At $100+ oil, people are willing to make changes to reduce consumption. This is not to say oil will not go up in the long run, but I think that some people overestimate its long-term growth.

    emervest.blogspot.com
    Reply
  •  
    Jul 27 03:00 PM
    Dollars buy oil. Who has dollars? Why, the US for starters. Then those who run trade surpluses with us, e.g., China, Japan, Germany. When supply can't keep up with demand, the price (number of dollars) goes up until they balance. Still no problem for us; we have "unlimited" dollars. If you are sitting on large US $ reserves, why not trade them in for oil? Fill your strategic reserve. Chances are oil will be more valuable down the road than dollars. The countries left out of the party are the ones lacking substantial foreign reserves.

    As more and more dollars flow out of the US, they will bid against our "unlimited" supply. The value of the dollar will go down relative to oil, i.e., the price of oil will rise. All US dollars will eventually flow to the oil producers, even if they pass through the hands of exporters first. Ultimately the oil producers will wind up owning America, only fair since all that borrowing was a promise to give real value in the future.
    Reply
  •  
    Jul 27 04:00 PM
    Dollar supply will increase dramatically going into the end of the year. The financial institutions are selling assets to shore up their books and Mark to Market will finally hit the radar screens.

    Currently, most of the assets involve internal non public divestitures. Sovereign Wealth Capital has virtually disappeared. Raising capital through the issuance of shares, preferreds, whatever has also met its wall. Lehman raised a lot and a formerly astute investment group now shares its pain.

    As the Mark to Market FASB decree passes from the Majors, it will hit insurers of all types and sizes. Where do you think they put their funds when interest rates were at 1%? The current market slide has not helped shore up their books either.

    Currently, we have yet to see any decrease in Level 3. Hundreds of Billions of unmarketable assets sit on this Level. But like I said before, Mark to Market will shine its light on them eventually. And Changing that rule at this point would be a financial disaster.

    When everyone of them, lemmings that they are, decide to raise capital by selling their share holdings, then the Blood In the Streets scenario will really be felt.

    S&P below 900, Dow 9,000.
    Reply
  •  
    Jul 27 04:18 PM
    Good thoughtful article! Good thoughtful comments! I tire of reading from those who know everything absolutely. My own two cents has to be that we are somewhere along the path to peak oil and only high prices can allocate the remaining supplies. But in the meantime there will be volatility, that's why I trade!
    Reply
  •  
    Jul 27 08:03 PM
    Not one person has mentioned the greenhouse gas emissions regulations that are virtually guaranteed by the next president, congress and Kyoto successor treaty. Long term, oil price will and should go up significantly.
    Reply
  •  
    Jul 27 08:15 PM
    I would expect higher and higher volatility, with a ever increasing price base (or trend) - all this as a result of Peak Oil (diminishing supply), a shift in consumption from developed countries to developing countries, relentless population growth and the new prosperity effect.
    Reply
  •  
    Jul 28 06:14 PM
    Your correct Blutown. Let's see if the global citizen is willing to pay this tax or it will simply be the U.S. taxpayer. I know where I would put my wager. I believe your also correct Kunst but the new handlers of America may find it is a little tougher to tame then they may think.
    Reply
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