Discussion on:

A model of oil prices

First, allow me to say that I appreciate writers who take a lot of time and effort to make these sorts of analyses. But I would like to discuss the relationship of quantitative easing and oil prices.

First, quantitative easing was not simply just to nominally lower interest rates, but to also ease the credit crunch, specifically by first buying up mortgage-backed securities from government-sponsored enterprises. Short-term rates dropped, but so did oil prices.

Second, during QE1, there were three other announcements (Dec 16, 2008, January 28, 2009 and March 18, 2009) of support for QE1, via announced purchases of US Treasuries, as an effort to lower rates. So what happened? Oil prices rose from the floor of $33.73 on December 26, 2008, but more importantly, nominal 3-month rates also increased from the floor of .01% reached on December 22, 2008, to a high (during this period) of .32% on February 24, 2009.

Third, QE1 stopped by the end of Q1-2009. But between QE1 and the expectation of QE2 taken from Ben Bernanke's speech at Jackson Hole in late August 2010, 3-month rates dropped on its own.

So in the first case, oil prices diverged from the expected correlation to short-term rates where oil prices dropped even as rates dropped. In the second case oil prices diverged again from the expected correlation to short-term rates where oil prices increased even as short-term rates increased. In the third case, short-term rates correlated to oil price increases, but rates were not influenced by QE, because the QE program had already ended.

I believe markets react to the expectation of the correlation between oil prices and short-term rates. That is to say, oil prices ARE affected by short-term expectations of the movement of rates, but not of the actual movement direction of rates.

But I don't believe prices will continue to go up: Eurozone austerity will come to a head, shortly, and not for the better. Oh, and I should add: I completely agree with the conclusion that the only way out of the madness is to stop the addiction altogether.

@Gork: I don't disagree. Again, I was trying to avoid getting too deep into the extremely complex subject of monetary policy risk here. But I think you are right that its effect is more about expectations than actual rates, which would make it more of a "headline risk" than a sustaining influence. On the other hand, while QE may have "ended" in the sense of fresh money supply, it hasn't actually ended due to rollovers - What Rickards called "perpetual QE." So I suppose one could argue that there is a sustaining price support there, at least until/if that new money supply is actually withdrawn. And the risk of additional EZ QE still looms. Another deep subject for another day. But I really didn't want to get too far off on the monetary policy tangent...

Chris,

Your articles are always an education in the details of the energy picture. Thank you.

There is a lot of denial out there about petroleum. Whenever I bring up supply and demand in a discussion it seems I always get negative votes. Too many people think there are large sources of supply that haven't been tapped yet. I even have people trying to bring up abiotic oil as if that could replace the supply as fast as we use it. But as you said in the end it always comes down to supply and demand.

One thing I find especially humorous is when politicians imply they can get gasoline prices back down to $2.50 or less per gallon. Someone needs to hit them over the head with a clue stick.

I would add to your list the regulatory mandates which inflate the price of refined gasoline. The requirement to have different blends in different localities raises the price significantly. The mandate to blend ethanol has an adverse impact for the consumer as well.

Speculation, currently, plays a major role in keeping the price of oil high. The western benchmarks, West Texas Intermediate and Brent Sea Intermediate serve as a major benchmark for the all the other grades. Production of each is only a very small percentage of global production each day and they are delivered only locally for refining. With total production of Brent and WTI only a few billion dollars worth a day. It is quite easy for a small number of traders to bid up the long contracts for a sustained period. If these benchmarks are inflated then every other grade that is priced off the benchmarks will be inflated as well. There is no other way to explain the persistently high prices in the face of falling oil demand and ever increasing production. Eventually, the long positions in Brent and WTI will be unsustainable and prices will collapse.

@Jardinero1, you'll get no argument from me that different local blending requirements contribute to higher gasoline prices in places like California. But if you want to argue that speculation currently plays a major role, then I think you need to show some evidence.

Chris, wouldn't it be fair to say that speculation plays a big role in the price volatility of gas, but a quite small role in average price over time?

Ron: Yes, speculators do enhance volatility at the extremes - the highs AND and the lows. Of course, we only hate speculators at the highs. But over time, the fundamental price driver is supply and demand. As I said in the article, there is a decent body of technical research out there on the influence of speculators, if you really want to dive into it (but it's very technical).

Different blending requirements will result in higher prices for all consumers not just those consumers in the states where the blends differ. Every additional blend, screws up the supply chain for every other blend. Smaller, localized gasoline markets mean fewer refiners participate in them and there is less competition between them. If refiners had but a single national blending requirement there would be a great deal more competition between many more refiners and lower prices, consequently.

I don't have any evidence but the fundamentals, which are that global demand for oil is currently declining and production continues to ramp up. Prices should have broken by now.

I predict that when the longs on WTI and Brent get broken and the shorts take over, the whole price structure will collapse and I don't know where the bottom will be. Last time we went through this in the late eighties the bottom was nine dollars a barrel. Just do me a favor when that happens; don't suddenly change your analysis and say the reason that prices are low and stay low is because the short sellers on WTI and Brent are holding the price down.

Sorry, Jardinero1, it's simply not true to say that global demand for oil is declining and production is rising. Here are some charts
http://omrpublic.iea.org/balances.asp
The only way to make your argument is to cite actual numbers for both oil supply and demand, then examine the balance of net long/short contracts and who holds them. Be sure to include ICE exchange balances, not just NYMEX.

World oil supply is up:

http://omrpublic.iea.org/world/wb_wosup.pdf

Total demand for all products is cratering:

http://omrpublic.iea.org/demand/oc_tp_dg.pdf

Which is why I disagree with their projection for 2012:

http://omrpublic.iea.org/world/wb_wodem.pdf

There is just no way you can reconcile the cratering demand for product in the second chart with the projected demand in the third chart.

You do realize that you chose a chart for OECD demand only to show that "demand is cratering?" It is not. Here's the world demand chart:
http://omrpublic.iea.org/world/wb_wodem.pdf

The chart you selected shows what I said above: Developing countries, particularly in Asia, are outbidding the West. Global demand has been consistently running just ahead of supply. That's why prices are remaining high. But again, you can just look at the spare capacity data to tell you the same thing.

I think we're done here. You have not shown any data to prove the influence of speculators, which would be found in the exchanges, not aggregate supply/demand data. We have drifted off-topic here. The IEA's projection for 2012 is an entirely different subject.

There is a disconnect between the 2011 actual demand for products in http://omrpublic.iea.org/demand/oc_tp_dg.pdf and the IEA projection for oil in 2012 here: http://omrpublic.iea.org/world/wb_wodem.pdf .
You can't have a nearly four percent year over year decline for refined product and project a one percent increase in demand for un-refined product. Those are the fundamentals I refer to and the reason why I question why prices have not broken south.

But you are right, we are drifting off topic. I agree with the rest of your framework. Ultimately, time will tell the rest.

I have the greatest respect for Chris, but I find his failing to discuss the only real controlling factor of oil prices disconcerting - the avg. global cost of producing a barrel of crude. Clearly the cost of a barrel of crude will vary from well to well, from the type of well, depth, technology required and other characteristics of the field and not to mention the age of the field. Even so there is a mathematical global avg. production cost of crude - where is that number?

Ifwe don't have a clue what it cost to produce the over all avg. barrel of crude - we have no way of knowing how badly producers are gouging us. I challenge anyone to provide a credible reference that discusses the actual avg. production costs of crude. The difference between the cost of a barrel of crude and the market price of crude - is an indicator how badly or the not the consumer is being taken advantage of by producers. As recently as 1998 the price of a barrel of crude had dropped to below $13.00/barrel and crude dropped to less than $30/barrel in just 2008. If they could produce it 2008 for $30 a barrel - and demand has fallen since - so why are we paying over a $100 now?

It would seem that these low crude price numbers are a far more accurate indicator of the actual and real cost of crude than any artificial contrivance of market/marketing factors (OPEC cartel), or spare capacity in crude production, or refinery production, or speculators that occur after the crude has been purchased. The avg. production cost of crude sets a base price for the commodity. The price of few essential commodities are allowed to vary 300% by producer manipulation above production cost - diamonds (another cartel manipulated commodity) for example are not essential, but when have you seen the price of wheat triple? It would seem consumers are being remarkably abused - because why... because like most abuses that are caused by the powerful few on the many, it's because they tolerate it. So, where are those global avg. crude production costs?

@dduggerbiocepts, I did discuss the production cost here: it's the bottom of the narrow ledge. I am working on a future post about forward production costs that should satisfy you, stay tuned.

Interesting looking model ... is there some useful prediction re: oil prices to be had in there somewhere?

Mr. Nelder seems to be saying oil prices will bounce around $75-$125, with occasional, temporary spikes to higher values. That doesn't seem particularly catastrophic to me...