Oil is on a tear. Another attack on a Shell platform in
It’s easy to make excuses for why oil is going higher. The problem is, they’re largely just that: excuses. To the extend that they are actually impacting supply (as with Nigeria), there is a real impact on oil price. Unfortunately, it’s often difficult to differentiate between real supply issues and speculative concerns over geopolitical events. But not today. Today is the expiration day for the February NYMEX future contract, and it’s already up $1.46/barrel. Is there speculative pressure affecting the price of crude oil? Sure, the December ’06 contract is trading at roughly $2 more than the February ’06, and some of that is the so-called “risk-premium.” I just don’t buy the statement by many that there is a $10-$15 risk premium on a barrel of oil, because that would quickly disappear as derivative traders arbitraged from crude to delivery on refined products (I don’t think that many finance reporters actually understand the multitude of arbitrage options available…). But when the front contract expires in under an hour, the last-minute surge just can’t be credibly attributed to “speculation.” The only speculation that you can do with a thousand barrels of delivered crude oil sitting on your front porch is to arbitrage it with the new front-month contract (March), and that same speculation could be done with far less risk by simply purchasing March options. No, the price is surging to create an appropriate equilibrium between supply and demand.
Which brings up one of my favorite topics, demand destruction. The common wisdom is that, above a certain price, people increasingly conserve or shift to alternatives to oil, and this destroys demand. This is the cornerstone of most arguments that oil prices will never get to $100/barrel (a few years ago they used “demand destruction” to argue that prices would never reach $60/barrel…), and that if prices get too high they will destroy so much demand that prices will plummet, maybe back to $40/barrel. This argument is simply bad economics. “Demand destruction” doesn’t decrease marginal demand. At $60/barrel people have reached a collective equilibrium about how much oil they will use. If prices rise, demand may be destroyed, but not marginal demand. Essentially, at $5/gallon gasoline, people might drive less, but the most that can do is to create friction on prices rising further. Should gasoline drop back to under $3/gallon (i.e. current US prices), then they’ll drive just as much as they did before the price spike—but not less. So demand destruction acts as a brake on price increases, but it won’t cause prices to drop to lower than they are now. The caveat to this argument is that, over longer time periods, it is possible that high prices cause investment choices that, when prices then fall back to lower levels, have affected the underlying marginal demand. For example, most people buy a car with plans to use it for several years. If prices stay high enough for long enough to cause them to buy a more fuel efficient car AND to drive less, then potentially if prices return to present levels and they stop driving less, they are still using less oil because they have a more fuel efficient car. This process will require high prices over at least several years before it begins to take effect—and is largely cancelled by efforts to maintain “economic growth” (read: oil usage) by programs such as car-maker’s SUV incentive programs and low interest rates. Demand destruction is a very real phenomena. But if you’re waiting for it to bring oil prices back down to $20/barrel, I’ve got bad news for you. . .
And as I end my rambling, NYMEX crude is nearing very close to $69/barrel. Certainly makes me happy about my call options.