Thoughts, essays, and writings on Liberty. Written by the heirs of Patrick Henry.

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December 1, 2008

Oil Is Too Cheap

by Brad Warbiany

No, not for the reason these guys think:

Venezuela will back repeated cuts in OPEC oil production until prices stabilize, Oil Minister Rafael Ramirez says, and Russia is proposing closer cooperation with the oil cartel.

Ramirez said Wednesday that his country will back a proposed 1 million barrel per day cut when OPEC meets Saturday in Cairo. If that doesn’t halt the price slide, “We will keep cutting until the market stabilizes,” he said during a visit by Russian President Dmitry Medvedev.

Oil prices fell below $54 a barrel Thursday as dismal U.S. economic data and rising crude inventories outweighed the possibility of production cuts by OPEC and non-member Russia.

Russia, the largest oil producer outside OPEC, produces around 11 percent of the world’s oil and it could be eager to seek new customers to shore up its suffering economy. OPEC output is estimated at about 31.5 million barrels a day — about 40 percent of daily world demand.

Venezuela’s President Hugo Chavez has said OPEC should work to keep global oil prices in a “band between $80 and $100.”

I normally explain price moves using conventional terms of supply and demand. In this case, though, the rules are somewhat different*. There is certainly some demand destruction that has reduced the price of crude oil, but I hardly think it’s a large enough change to move from $147/barrel to $50/barrel oil. At this point, the price of oil seems artificially low, considering the fact that fundamental supply and demand forces haven’t changed.

Yet the response from OPEC, Venezuela, and the big oil companies is the same as if the price decline was natural — they reduce production. This is not only true of the state-owned oil companies, but areas such as Canadian tar sands and some of the more difficult offshore fields have stopped production or shelved new exploration projects. This only makes sense, of course, as the marginal cost of production of many of these projects is well over $50/barrel, and they don’t want to lose money.

This causes a major problem for two reasons, assuming that the fundamentals haven’t changed:

  • It takes supply offline in the short-term, and due to the nature of drilling, shutting down existing fields may reduce the ability to pump oil from those fields in the future. I.e. if a field is pumping 500,000 bbl/day before being shut down, it may only reopen with the capacity to produce 460,000 bbl/day. Thus, taking oil offline in the short term reduces potential oil recovery in the long term.
  • Reduction of exploration projects reduces oil supply in the future. While this may only push out exploration projects 2-3 years, current IEA projections of decline suggest that we should be searching for oil right now — and fast.

What does this mean for future oil prices? They’re going to go up, and they may be going up faster than before. This isn’t a return to the norm, this is the swinging of a seesaw. We’re at a low point right now, but an 800-lb gorilla just got on the other side.

Of course, to hear that oil prices are too cheap is not a common theme these days, as here in California gas has dropped under the $2/gallon mark. From a personal level, of course, I’m enjoying the reprieve. But now may simply be the best time to jump out and buy yourself a gas-saving auto, because these prices will not last.

* The new paradigm can still be related in terms of supply and demand, but it’s the supply of money that has shrunk. The deleveraging process has sucked money out of a number of markets, and while the monetary base hasn’t shrunk (in fact it is growing quickly), the velocity of money is far lower. In a fractional reserve world, that has a deflationary effect. Demand is still strong for gasoline, but there is a far smaller supply of dollars on a commodities trading floor to pay for it — all this at a time when the costs of production are still paid in old dollars. Supply and demand still applies, but it requires a different vantage point to understand the change.

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7 Comments

  1. The actual price is set by speculation not true supply or demand, the speculators are worried about what the demand will be not what it is.
    Modern firms and investors couldn’t care less about the ultimate limited nature of oil supplies as their corporate financial structures are tied to quarterly results, maybe a year ahead, few modern firms are seriously exploring and readying themselves for what markets will be like in 2,5 or 10 years.

    Comment by James Jarvis — December 1, 2008 @ 1:31 pm
  2. All growth between late 2006 and early 2008 was speculative. (personal opinion)

    The preaching of energy independence should cause a speculator to bail out of the oil market (or short it). The prices should be below 2006 levels (approx $60/barrel).

    Further, the US has stated an interest in drilling for more oil in areas protected since the 1970′s. This should reduce the prices as well, since transport and competition for resources would both be reduced.

    With the increasing wealth of China and India, one would assume increased oil prices. However, China depends primarily on coal for now, and an oil binge is yet to be seen.

    Lastly, speculators may be driving down the prices artificially to reap huge profits in the future. This supports your statement.

    We’ve seen lots of market manipulation this past month. The false rally before Thanksgiving in hopes of easing people’s fears, to get people to spend more on black Friday. The real crash today of 7.7, 8.93, and 8.95% in the DOW, S&P, and NASDAQ respectively.

    Tomorrow, more manipulation. Just watch the last hour of trade. Take a look at the volume. There is definite manipulation, but step back and look at the trend. The crash flattening out, with lots of volatility.

    Comment by Paul — December 1, 2008 @ 2:46 pm
  3. Paul,

    I wouldn’t say that all the price growth was speculative. Conventional oil production probably has peaked. There had been a complete peak in 2005, but the world returned to that level in Feb 2008. With this reduction in supply, it’s unclear whether we’ll ever be able to produce at that rate.

    All during that time, demand is increasing and continuing to increase on a global scale. Between India and China, there are about 2.5 billion people, and if there average oil demand goes up even slightly it will dwarf any oil reduction we undertake in the West.

    Simply put, I do agree that a good portion of the price increase was due to large-scale speculation caused by a global financial credit boom, and that the added money drove up prices. I don’t agree, however, that the fundamentals support oil in the $50-60 range, and the current low prices will only exacerbate the fundamental supply-demand imbalance.

    Comment by Brad Warbiany — December 2, 2008 @ 12:42 am
  4. Oil prices dropping to HALF of what they were 4 months ago. Here is a theory of mine: Russia has a lot of oil, as does Venezuela and Iran. Russia has the only military capable of hurting the U.S. so Iran and Venezuela really dont count. Russia has sour crude which has to basically be refined twice to get the sulfur removed. The U.S. pushed Georgia into attacking Russia hoping Russia would get sucked into another war, tying them up for at least 1-2 years and leaving their ally Iran exposed to an attack from the U.S.

    The U.S. had over 50+ warships and 4 carrier groups in the Persian Gulf ready to do this. What they didn’t count on was that Russia spanked Georgia’s ass in 5 days time, sent warships to the Georgian ports, and divided the country in half overnight. This gave the U.S. no time to attack Iran because Russia was ready for such a dumb move. Bush is an IDIOT (along with the rest of the Neo-cons) who is incapable of planning anything. Vladimir Putin is a man capable of planning for such things and he did just that. Russians are busy teaching their children to play CHESS while American parents give their kid a video game as a baby sitter. Reality & Strategy vs fiction and no planning.

    The ONLY way to get back at Russia now is thru the oil market. Russia has to sell their oil at a minimum $50 a barrel in order to make any type of profit. Bring down the price of oil below $50 and wait them out.

    Here comes the Infomercial: “But wait there is MORE!!!” So now we have the world being flooded with cheap fuel prices and cheap oil again……..WUT!?!? Am I the only person asking “What the fuck happened to the Peak Oil theory? I thought we were running out!?” Do we have a lot of oil or not?? Apparently we do, but I am sure after Russia is brought under control again, the Peak Oil clowns will be all over TV telling us how thanks to the low oil prices, people consumed 10X as much and NOW we are running out!! Last time they were just bullshittin’ but THIS TIME they are serious!! Just in time for Exxon to make another record profit quarter.

    If you don’t believe in the Grand Chess Game, that is cool with me. NOBODY with half a brain that actually reads my blog can deny that worldwide oil, food and metals markets are not being toyed with by a very few people on top of the pyramid for their own gain (Yeah, THAT pyramid on your $1 bill). They tell us we are running out of oil and jack the prices to $147.50 a barrel and gas to $4 a gallon (for the cheap stuff). Then when it suits them, they drop it to $56.00 a barrel and gas to $1.75 a gallon.

    I dont EVER want to hear someone talking about “Peak Oil” again. Peak Oil is like a Sasquach or the Chupacabra. It don’t exist!! There is no such thing!

    Wake up people! The banking industry has ruined this country. The signs are all around you: The average American spends 2% MORE than they make! NOBODY is going to keep financing this operation indefinitely. IT HAS TO STOP.

    Comment by Travis — December 2, 2008 @ 10:05 pm
  5. Travis,

    Your hypothesis is seriously out of whack with economic reality:

    1) Prices are set by purchasers. I can’t arbitrarily jack up prices for my services without idling my business. Oil companies charge what the market will bear, yes, but it’s their customers making the buy/not buy decisions.

    2) Producers cannot easily set prices of commodities by withholding and then flooding the market with supplies. Economists and historians studying cartels have long noticed that cartels rapidly come apart when some members “cheat”. The fact is when a cartel holds back product from the market, the first member of the cartel who “cheats” and releases its supplies benefits from the high quantities and prices. OPEC, for example struggles with this – its members notoriously violate the production limits that were agreed upon during OPEC meetings. Saddam Hussein, incidentally, used to act as an enforcer, threatening to invade neighbors who violated these agreements.

    3) The theory behind peak oil – that there is only a finite supply, and that the published figures of “proven reserves” are not reliable – is correct: a) most reserves are held by governments who have an incentive to lie, b) we are most likely using oil at a higher rate than it is being produced by biological/geological processes.

    To me, the wheels come off the peak oil bus when they announce that some sort of government intervention is required to remedy this situation. The price system will take care of it; as oil becomes scarcer, and production slows, prices will rise, leading people to reduce consumption and cast about for substitutes for oil. Europe is pretty deforested right now, yet we have no problems due to peak wood for just this reason.

    One thing to bear in mind is that the amount of proven reserves keep going up. The product of improvements in the technologies of producing and prospecting for oil, it appears that oil companies are discovering oil at a faster rate than they are pumping it out of the ground. While I believe that the figures are likely being fiddled with, I think the increase in the total reserves is likely a real phenomenon.

    4) The masons (the guys who put the pyramid on the dollar bill) are not running any secret worldwide conspiracy. Judging from the fact that they are now advertising for members on my local television station, and in my town have moved out of their palatial digs into a tinier and less swanky meeting hall, I am pretty confident that they are pretty hard up for cash and members.

    Comment by tarran — December 3, 2008 @ 5:50 am
  6. BTW, if you are typing he words WAKE UP on a blog, it’s a pretty reliable sign that your writings will come across as the ravings of a kook.

    Word to the wise…

    Comment by tarran — December 3, 2008 @ 5:52 am
  7. [...] week, I posted about my belief that oil has currently dropped to a price level that is damaging to the long-term [...]

    Pingback by The Liberty Papers »Blog Archive » Oil — Where Is It Going? Up, Up And Away! — December 9, 2008 @ 2:08 pm

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