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Oil Is Up Due to Fundamentals, Not Speculation

by: James Hamilton May 21, 2008 | about stocks: OIL / USO    

James Hamilton

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I've been offering reasons for believing that the flow of funds into commodity investing has contributed to the recent oil price highs. Although I believe this speculation has gotten ahead of fundamentals in the last few months, there is no question in my mind that market fundamentals are the main reason for the broader 5-year move up in oil prices. Here I review those fundamental factors.

(click to enlarge)

Data source: EIA.

The developed economies consume a disproportionate share of the world's energy, with North America and Europe accounting for about half of the total oil use in 2006. However, it is the newly industrialized countries and oil producers that account for the recent rapid growth in demand, with Asia and the Middle East accounting for 60% of the increase in petroleum use between 2003 and 2006. North America and Europe contributed only 1/5 of the growth.

(click to enlarge)

Data source: EIA.

Particularly dramatic in this growth has been China, whose petroleum consumption between 1990 and 2006 increased at a 7.2% annual compound rate. It's always amusing to project these impressive exponential growth rates. If that rate of growth were to continue, China would be using 20 million barrels a day by 2020, about as much as the U.S. is today. By 2030, China would be up to 40 mb/d, twice the current U.S. consumption.

Data for 1990-2006 from EIA. Green line is projection of 7.2% compound exponential growth.

Are such projections plausible from the point of view of potential demand? During 2006, China used about 2 barrels of oil per person. For comparison, Mexico used 6.6-- Chinese oil consumption could triple and they'd still be using less per person than Mexico is today. The U.S. used almost 25 barrels per person. According to the data collected for a new research paper by Max Auffhammer and Richard Carson, there were 3.3 passenger vehicles per 100 Chinese residents in 2006, compared with 77 in the United States. Yes, I would say that these astonishing numbers for potential future Chinese oil demand are not at all inconceivable.

(click to enlarge)

Gross new production capacity, in thousand barrels per day, from projects scheduled to begin production in 2008, by individual project name. Source: Wikipedia Oil Megaprojects.

Are such projections plausible from the point of view of potential supply? Not remotely. I do think there are prospects for a significant boost to world petroleum production this year, thanks to a number of big new projects scheduled to begin production.

The Wikipedia database reports 7 mb/d in eventual gross new production capacity eventually expected from projects that are supposed to begin producing during the current calendar year. Before you get too excited about that number, however, several cautions are in order. First, 7 mb/d refers to the eventual peak production, not the amount that can be produced this year.

Second, there is inevitably some slippage and delays. For example, the list includes 250,000 b/d from Thunder Horse, BP's Gulf of Mexico project that was initially hoped to start giving us oil in 2005, but is still undergoing repair work.

Third, the above tabulation refers to gross new capacity, much of which is needed to replace declining production currently being observed in the world's mature producing fields. At any point in time, some of the world's producing fields are well into decline, some are at plateau production, and others are on the way up. It is not clear what average decline rate is appropriate to apply to aggregate global production, but a plausible ballpark number might be 4%. That would mean that in the absence of new projects, global production would decline by 3.4 mb/d each year. To put it another way, a new producing area equivalent to current annual production from Iran (OPEC's second biggest producer) needs to be brought on line every year just to keep global production from falling.

Of the 7mb/d in gross new capacity from the projects tabulated above, projects in Saudi Arabia, Russia, and Mexico account for about a third of this gross increase. Data currently available for the first two months of 2008 show actual production in Saudi Arabia down 350,000 b/d from its average 2005 value, though the latest news suggests that Saudi production may be close to returning to 2005 levels. Mexican production is currently down 400,000 b/d from 2005, and Russian production is down 100,000 b/d from its average level in the second half of 2007.

To summarize, I think we will see some net production gains this year, and expect this to bring some relief for oil prices. But I cannot imagine that the projected path for China above will ever become a reality. Oil prices have to rise to whatever value it takes to prevent that from happening.

So yes, I do believe that speculation has played a role in the oil price increases, particularly what we've observed the last few months. But it's a big mistake to conclude that speculation is the most important part of the longer run trend we've been seeing.

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This article has 47 comments:

  •  
    May 21 04:59 PM
    Production figures are down because demand is down. Saudis had to reduce pumping because no one will buy the excess oil . Iranians have rented supertankers to store the extra oil they couldn't sell.

    Inventory is down because refiners anticipate less demand for gasoline, they are ordering less oil. Keeping less inventory is what every business does in lean times.

    Every bit of news is mis-reported by the big news media. Goldman Sach and cohorts own the media . From WS Whore to CNBC, they all toe their big advertisers line. We see Goldman come out on Monday call for $150 oil, T Boon Pickens come out Tuesday forcast 150. They even own the Treasury Department. Our congressmen invested their billions in hedge funds also want high oil.
    Reply
  •  
    May 21 05:15 PM
    Good call, Harus. This stinks of manipulation, blind greed, and collusion. I suspect the speculators that are driving the exploding prices we are now seeing are the same people also shorting for the future implosion. So they make money on the way up and on the way down. The fools coming in late and thinking "it's different this time" will lose all their money. I think I'll just sit this bubble out as I've managed to catch the last couple...:)
    Reply
  •  
    May 21 05:16 PM
    Harus, I dont doubt what you say but where did you get your info.
    Reply
  •  
    May 21 05:21 PM
    Speculators can only manipulate an instrument so much until arbitragours exploit inefficiencies in the market. Oil is one of the most efficiently traded instruments in the world given its volume and liquidity. Unfortunately, I have to concede that the fundamentals of short supply and increasing demand are driving it upward based on fundamentals. While I was wrong in my thinking last month (thankfully, the May options are expired) betting on a downward move with synthetic options, you can do the same in either direction and this is a pretty neat way to use no net funding to control blocks of 100 shares of USO or your desired oil proxy to capitalize on volatility up or down:

    everydayfinance.blogsp...



    Reply
  •  
    May 21 05:42 PM
    Dunno.. I know you are correct on the oil-tanker storage issue.. But all that really infers is that refiners are not buying, and or, cannot refine fast enough.

    As far as the Saudis are concerned, they may not be able to up their quota any further and the refiners probably know that. There was a very explicit article on Alpha a while back from an American engineer who was involved in exploring the Saudi oilfields. His statement was (1) We only have the Saudi's word that they have more oil than they used to... There is no outside verification as they do not allow anyone to verify. And (2) he didn't see how they could have any more oil and in fact showed maps of Saudi Arabia showing the flooding of their known oilfields with salt water.

    Lastly, our large refiners (Exxon, Chevron etc.. ) have been very busy repurchasing their own shares, rather than heavily investing in new fields, exploration and adding refineries.

    Thx jegan ;-)
    Reply
  •  
    May 21 05:57 PM
    If costs are up, why aren't profit margins shrinking? Ohhhhhh, because they want to coat tail their way to more money. Greed is good, but being stupid about it is not.
    Reply
  •  
    May 21 06:15 PM
    Another excellent article.

    To all who are outraged and bitter (including ourselves) having to pay such high prices for petrol, the only solution is to find a viable technology that the world can embrace now as an oil substitute. Going back to horseback or bicycles is NOT a viable solution.

    Renewable energy for the production of electricity is not the crux at this point; transportation is. Can someone please figure out how to build an anti gravity mechanism, utilizing the earth's gravity for motion in the desired direction...just dreaming.

    CrossProfit
    Reply
  •  
    May 21 06:25 PM
    Author,

    You have zero clue how Goldman Sachs truly operates. Even Warren Buffet called the investment banks "evil" within the past week.

    Goldman and company most likely sold their long positions and various calls tied to oil today. They will be shorting tomorrow. The Enron loophole will be closed within a week...that's why it "super-spiked&quo... quickly today.

    Remember - Goldman was creating AAA-rated subprime CDOs, then soon after, making movements to short subprime assets.

    Goldman is a cancer to American capitalism.
    Reply
  •  
    May 21 06:26 PM
    So China's consumption has increased 7.2% per year, and the reason NYMEX crude as increased over 100% is? That's right, speculation by the IB's and others. The market is not working.
    Reply
  •  
    May 21 06:46 PM
    Usage is down this year, due to the fact oil companies were merged years ago and ARE able to manipulate the complete market...from grond to consumer...this cause created aripple effect...your article is blind stupidity..oil usage has not increased enough to be comparable to the price run up from 20bbl - 130bbl over the last 8 years...that lack of anti-trust monitoring was the catalyst that started many of these problems. we would never have the utilities trade in the commoditity market.In the winter this will start killing people...when someone can't heat their home and the older folks get sick and die..this is all part of a major problem that we have to deal with and rectify quickly. IT NEVER should have been allowed to get here..Its a good reason to not vote RNC
    Reply
  •  
    May 21 07:02 PM
    Who among us could have predicted that *this* would happen once we let two oil men from Texas run our country?
    Reply
  •  
    May 21 07:53 PM
    Funny, but I posted almost the exact same thesis in my own blog a few hours ago with a few more tidbits on why speculators can't be impacting the price:
    www.investingminds.com...
    I completely agree with this author except I don't think speculation is having much of an impact at all. I guess people are just looking for someone to blame. I don't know how Harus can say demand is down.
    Reply
  •  
    May 21 08:08 PM
    Its like going to gas station 1,Goldman comes out tell you: Sorry ,I bought all the gas for $2, you want some you have to pay $3. You drive to station 2, T Pikens comes out: I boght all the gas here,I will let you have some for $3.20.....You drive to station after station, speculators bought up all the gas. Finally you come back to station 1, Goldman said: You can't have it for $3 anymore, the next hedge guy just offered me $4 a gallon. Would you like some for $5 ?
    Reply
  •  
    May 21 08:10 PM
    I don't know where you are coming from. Speculators are not "buying up" oil. Check out my post.
    Reply
  •  
    May 21 08:19 PM
    Demand did not double over the past 12 months.
    Reply
  •  
    May 21 08:33 PM
    www.huntingtonnews.net...

    www.marketwatch.com/ne...

    www.star-telegram.com/...

    hsgac.senate.gov/publi...

    www.spiegel.de/interna...

    online.wsj.com/article...
    Reply
  •  
    May 21 08:40 PM
    First, demand does not have to double in order for prices to double. This is econ 101. Sorry.

    Second, I don't find any of these "news" sources credible. Give me specifics on how dabbling in the futures market would affect spot prices. And the fact that congress is holding investigations is meaningless. Those guys need econ 101 also.
    Reply
  •  
    May 21 08:43 PM
    Please do read the star-telegram article
    Reply
  •  
    May 21 08:54 PM
    Dude, demand has not spiked in the last week. There is no way demand is spiking when prices are going hyperbolic. Everyone I talk to says they are driving less. Demand is down.

    Prices are spiking, demand is down...hmmm....sounds like a bubble to me. Yes MONEY is going in, but that is not demand. Money is pouring into hard assets in lieu of stocks and bonds. This causes the price to go up, even though DEMAND has not gone up.

    If you really think prices are up on fundamentals, please explain where the "fundamental"... increase in demand has been in the last 30 days, or even the last week. Supply has not changed one bit in that time, I promise you, so if you think prices are up on fundamentals, SOMEONE must be buying a crapload of oil.

    Finally, I figured out it was all crap the first time I heard them say the price of oil was UP because a refinery was DOWN. That's easily the stupidest thing I've heard on bubblevision.
    Reply
  •  
    May 21 08:56 PM
    Why is no one here correlating the spike in price to the dollar?
    The euro gained significantly against the greenback, if you were european you pay slightly higher but not that much higher. same goes for AUD ,etc.

    I don't however see how demand/currency value could push oil 15% in 1 month. I mean why? and why is gold not $1200/ounce.
    Reply
  •  
    May 21 09:05 PM
    The demand is coming from China and India, not the US. US demand must come down. That's the whole point of my post.
    Reply
  •  
    May 21 09:12 PM
    Yeah, I hear they sold an extra billion cars last week in China. Yeah. Keep thinking that.

    I'm shorting USO at $135.
    Reply
  •  
    May 21 09:17 PM
    They don't need to sell a billion cars in one week to move the price a lot. All that needs to happen is for a fairly inelastic demand curve to shift against a fairly inelastic supply curve.
    Reply
  •  
    May 21 09:24 PM
    To all the "oilmen" conspiracy theorists... yes, the oilmen are greedy profiteerists. But that doesn't change the fundamental gap, discussed in this article, between supply and expected demand. They are just taking advantage of it, not causing it.

    NOW is the time to start looking for alternatives, in your own life, and as a society and nation. If we have alternatives to oil, THEN THE OILMEN CAN'T EXPLOIT US! Even if you believe all the conspiracy theories, the best way to thwart their evil plots is to become LESS DEPENDENT ON OIL.

    I can't emphasize enough that I believe there is a seismic shift in energy availability from traditional nonrenewable sources, going forward in the next decade or two. People can't seem to see beyond this month or this year, but all signs in the long term point to high oil prices, and eventually, if we don't move away from oil, we will see shortages and rationing. Read the "peak oil" article in Wikipedia for more details.
    Reply
  •  
    May 21 10:10 PM
    To take out speculation from the market, there should be ban on short term futures trading on commodities. Only long term one Year+ contracts should be allowed. Then raise margin requirements to same as that of stock. Major countries should implement that.
    Reply
  •  
    May 21 10:12 PM
    A barrel of oil has risen nearly 400% since September of 2003!! Nothing in this world could possibly be in that much in demand to cause such a run up in the last 5 years -not the finest silk in all of China, or the finest wines from France. The "peak oil" canard just doesn't jibe. I believe it as much as do the Global Warming canard. Someone needs to investigate this racket, or start imposing severe windfall profits tax on these oil companies, and impose strict tariffs on all imported oil.
    Reply
  •  
    May 21 10:22 PM
    Another cause for high oil price is ethanol. It takes 1 gallon gas(diesel) to produce 1 gallon corn ethanol. (Some say as much as 1.25 gal gas)

    Ever since Washington mandated 10% ethanol gas, my mpg dropped 9% on both vehicles I own. I track my mpg every time I gas up. One car dropped from 24.5 to 22.5. Another SUV droped from 14.5 to 13. That 10% ethanol is not producing power like it should.
    Reply
  •  
    May 21 10:31 PM
    dot com bubble
    housing bubble
    oil bubble
    next bubble? anyone
    Reply
  •  
    May 21 10:39 PM
    Harus's posted links are recent and critical to understanding the current situation we are in with futures markets which are completely un-regulated by the CFTC.

    In particular the Masters testimony to the Commitee on Homeland security and Government Affairs Senate comitee is beyond compelling - its the plain truth.

    So what happens even if the CFTC starts regulating these markets? will an international effort follow to regulate international markets, or is it just the final resort of getting the UN involved, something I don't generally like, or even like thinking about.

    So much for free markets, the rich and powerful are still manipulating markets based on unsustainable greed - at everone's else's expense, and ultimately their own.
    Reply
  •  
    May 21 11:08 PM
    To all the conspiracy theorists: do the friggin math. The planet produces about 85 million barrels of oil per day, and the U.S. consumes about 21 million of that total. We have somewhat more than 300 million people. If the Chinese and Indians were to consume like we do, world production would have to be just under twice current world procuction just for China and India. I'm just tired of the friggin idiots that think what we're witnessing is some sort of artificial market manipulation. Get a clue!
    Reply
  •  
    May 21 11:19 PM
    Amen! Unfortunately, the politicians are not that smart and they are certainly not reasonable and they will do what is politically expedient and kill the markets and the price of oil will not go down. Just wait and see.
    Reply
  •  
    May 21 11:30 PM
    Allen Fuller is absolutely right. If the Chinese want to build their own car culture, let them. Nay, encourage them. Get rid of your car and start walking and using transit. Then the next time oil is rising 2% per day because of supply and demand, speculation, or some other reason no one cares about, you'll hardly notice the higher costs, your currency will rise against the RMB, and your investment in great oil companies like STO will power your portfolio at their expense.
    Reply
  •  
    May 21 11:53 PM
    For those who think that supply/demand is not the problem, read this:
    online.wsj.com/article...

    Honestly, it doesn't matter what's causing the short-term jump in prices. The most contentious issue is the fundamental supply/demand problem long term. Even if it's 40 years from now. We're going to be in deep trouble if we've peaked with oil and don't bring alternative energy sources online before the shortages/rationing start.
    Want a good article on peak oil? Read this one:
    pr.caltech.edu/periodi...

    Be afraid, be very afraid!
    Reply
  •  
    May 22 12:50 AM
    Someone stop Harus and others from posting - Oil can only go up even if it's already parabolic.

    Buy tons of oil related stocks and options on the commodity right now - please! It's so cheap, just do yourself a favor and make some cash.

    Don't let common sense stop you! This is not like the dot-com or the housing sector - it's different this time!
    Reply
  •  
    May 22 02:22 AM
    Technology sector can only go up. Humans always need new technologies. How can it go down?
    Home prices can only go up. There is just so much land and everyday we have more people that need a place to live. How can it go down?
    Oil can only go up. There is just so much oil in this world..........
    HOW CAN IT GO DOWN?
    Reply
  •  
    May 22 04:30 AM
    Supply /demand tension in future due to rising emerging markets. Parabolic move up on oil price (typical for a short term speculative bubble formation)...all that driving the price this days.
    But fundamentally, oil is getting harder to find, harder to transport from remote places and to transform in gas or diesel. That plus the fact that big old producer country s (Middle East, Russia, Venezuela,...) are happy to see the price of there main valuable resources making them richer every days to the last extractable drop...so they can buy even more EU and US assets and enjoy seeing arrogant occidentals suffering. How the price should go down then?
    Reply
  •  
    May 22 10:57 AM
    This is the biggest crock of Wall Street B.S. I have ever read. Fair warning! Within 12 months, there will be no more futures market for oil. A law will be passed calling for anyone caught gambling on the price of oil to be served their own gonads. Get out now while you still have them.

    Ask yourself why it is even necessary to have a futures market on a commodity with a known depletion rate and a known rate of production and consumption. That would be like betting on the number of hours of sunlight each day. It is a suckers bet and the suckers will have their revenge. Like I said, you are getting advance warning. Take heed.

    [ED - COMMENT EDITED TO REMOVE ABUSE.]
    Reply
  •  
    May 22 11:04 AM
    The angst of filling your vehicle with $4 gasoline is understandable, however, taking your frustrations out on oil companies, the market manipulators, and the government is futile.

    As Pickens stated day before yesterday... this is pretty simple supply and demand at work. The planet can only produce 85 million barrels of crude per day, and we are presently consuming 87 million barrels per day. Until that changes the price will go up.
    It doesn't look like that is going to change for some time, however.
    Oh sure, Americans will (and have) cut demand, but you won't see the developing nations doing such until the price goes high enough to break their governments subsidies.

    I suspect $7 gasoline is just around the corner. Rather than constantly complaining, it would be more appropriate to plan for the inevitable by investing in some hedges that offset rising energy costs.

    We have to drill ANWAR and other "out of bounds" coastal areas in the interim period of transition from petroleum to other energy sources. Like it or not our economy runs on oil and gas and there is no way for the country to transition quickly enough.

    Don't be caught up in the whining. Plan ahead instead.
    Reply
  •  
    May 22 12:40 PM
    Last I have heared refineries at the US are not operating at 100% capacity. There will be no efficient alternative to Oil in our life time. Yes demand is up and yes political uncertainties are playing a huge rule. Someone has to ask what was the dramatic change that has happened in the last 5 years.
    I can imagine in the near future (before the November elections) that the price of oil would come down. But beyond that it's more likely to creep up. There is high risk in buying now, if you are a short term trader (you can lose yor shirt). However, if you are a long term investor, the chances are that there is a lot of money to be made buy investing in oil stocks.